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Guest Post: ESFS - Has Europe Finally Discovered Alchemy

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Submitted by Peter Tchir of TF Market Advisors

ESFS - Has Europe Finally Discovered Alchemy

Markets are better this morning, at least in part because there is renewed hope that Europe will band together and create a new and improved EFSF.  This EFSF V3.0 will, allegedly, finally solve the European debt problem.  It sounds great on the surface, but is it possible?  I think there are problems with virtually every step in the process.  The ability for EFSF to retain a AAA rating is dubious, and the willingness of investors to buy an expanded mandate EFSF may not be as great as the politicians believe.  Here is a quick summary of many of the problems facing the new EFSF in reality as opposed to in a quick and optimistic press release.  Just like the “rollovers” that were announced, the details will prove to be unworkable and will not provide the benefits expected.

Self-Guarantees

The last round of EFSF had the Over-Guarantee Percentage increase from 120% to 165%.  Italy is the 3rd largest guarantor at 18%, just below France’s 20%.  Italy is Aa2 on negative watch at Moody’s and negative outlook at S&P.   Spain is the 4th largest guarantor at 12%.  It is Aa2/AA on negative outlook at both agencies.  So 30% of the guarantees are coming from 2 countries that are rated less than AAA, are on negative outlook, and will likely draw on the EFSF funds?  Even the rating agencies must be scratching their head wondering how to let AA entities guarantee themselves and still provide a AAA rating.

Guarantees that will never be provided

The latest version still includes Ireland, Portugal, and Greece as Stepping-Out Guarantors totaling 7% of guarantees.  Ever since EFSF V1.0 I have been confused by the insistence of the EFSF to include in the list of Guarantors, those that have already said they won’t provide guarantees.   So for anyone keeping score, only 93% of the guarantee amount is available in the first place, and 30% comes from 2 countries that will likely use the facility.  At some point the ability of Germany and France to carry the AAA rating by themselves becomes doubtful.

The EFSF will be guaranteeing far worse assets than previously planned

Under the original terms, the EFSF was going to lend money to sovereign nations.  The terms were very strict.  Money would be withheld in escrow to cover the spread payments and other amounts deemed necessary for the safety of the EFSF.  The loans were structured in such a way that the EFSF loans were structurally senior to existing debt of that nation.  The move to open bond purchases was one reason the Over-Guarantee had to increase.  These bonds were not as well protected as the original EFSF loans.  They do not have additional covenants and there is no initial hold back, so the rating agencies had grown more concerned about giving the EFSF the AAA rating.  Now, there is talk about lending to banks directly, not just sovereigns.  That is a massive move down the credit curve.  Not only do banks actually have a much higher risk of default, the severity of loss in default is usually very high.  Recovery rates vary widely for corporations that default, but for banks, the recovery is usually very low.  This higher risk of default, coupled with lower recoveries has to be taken into account.  It was one thing for EFSF to go ahead and fund a couple of select sovereigns, but opening it up to banks increases the risk dramatically.

Who will sell bonds to the EFSF

There seems to be so much hope that the EFSF will be able to buy bonds cheaply on the open market.  I just don’t see how this happens.  The weak banks that hold these assets in non mark to market accounts have demonstrated that they are not willing to sell their PIIGS bonds.  They have had ample opportunities over the past 18 months to sell their bonds at much higher prices than where they currently trade and have not sold.  You can only assume they didn’t sell because they didn’t want to take the loss, so nothing has changed and they still won’t sell.  If anything, this new round of government capitulation will only encourage them to hold onto their PIIGS debt because of their belief that the EU and ECB will eventually take them out at par as the debt matures.  So the banks won’t sell, which leaves only the hedge funds and mutual funds and bank trading desks.  They already trade these bonds so that won’t change much, but with knowledge that there is a deep pocketed buyer with no trading skills out there will likely lead to a short term surge in the prices of these bonds.  The fast money/mark to market accounts will reap a nice profit as they sell the bonds to the EFSF at inflated prices.  Briefly, the market may even believe the problem is solved, as bond prices increase, but once funds are out, who represent only a small portion of PIIGS debt, we will be right back to where we are.  Nothing about EFSF open market purchases will have a meaningful long term impact on the market, though it will give some funds a nice monthly gain.  It would be ironic (and par for the course) if funds used those gains to place shorts on other sovereigns or even the EFSF itself.

EFSF helping sovereigns buy back their own debt

The most intriguing aspect, on the surface, is the willingness of the ECB to let sovereigns buy back their own debt at a discount to par.  As mentioned above, I don’t think the ECB will be able to accumulate large positions at deep discounts.  The “free float”, or those bonds that are held in mark to market accounts represent only a small portion of PIIGS debt outstanding.  The free float holders are likely to be able to use the knowledge that the EFSF is buying to drive the prices substantially higher, eliminating a big portion of the benefit.  But let’s pretend for a moment that the EFSF accumulates blocks of bonds at a discount.  They will then lend money to the sovereign nation to buy back debt?  Let’s say that they bought €50 billion of Greek 10 year bonds at 60% of face.  The EFSF spent  €30 billion and owns assets valued at €30 billion.  So far, so good, but what happens if they lend Greece €30 billion to buy the bonds back?  If the new loans only have a €30 billion par amount, where would those loans be valued?  If the loans have the same maturity and same interest rate and same seniority as the bonds they sold back to Greece, the EFSF loan to Greece would only have a value of €18 billion (60% of 30).  Greece would be in better shape as €20 billion of debt would have been forgiven, but the EFSF would have lost €12 billion on the transaction.  How long do investors lend money to EFSF to do that?  How long can they throw away money and keep the AAA rating?  How likely is it that hedge funds drive the price of PIIGS bonds up knowing that the EFSF is a dumb buyer and then turn around and use those excess proceeds to short EFSF bonds?

Just like the proposed ‘rollovers’ that were going to save Europe, once the smoke clears the room and the politicians and finance ministers are done patting themselves on the back, the markets will realize there is nothing workable in practice about this new EFSF solution.  Some will profit from the new proposal, but likely not the people the government wants to support.

 

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Wed, 07/20/2011 - 09:47 | 1473446 SheepDog-One
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'Renewed hope' is suddenly sweeping the bankrupt carnage of Europe today! HOORAY! The drunken alley hobos are optimistic and in fine spirits on this fine morn!

Wed, 07/20/2011 - 09:51 | 1473459 Popo
Popo's picture

"Renewed Hope"  =  "Shorting Opportunity"

Wed, 07/20/2011 - 10:13 | 1473528 Mr Lennon Hendrix
Mr Lennon Hendrix's picture

"Renewed Hope" = "Drinking Opportunity"

Wed, 07/20/2011 - 10:22 | 1473561 snowball777
snowball777's picture

And it ain't even check day.

Wed, 07/20/2011 - 09:48 | 1473451 Quintus
Quintus's picture

No, they haven't....but they would like to believe they have.  Press releases will be issued every 5 minutes until the entire world capitulates and accepts their version of events.

Wed, 07/20/2011 - 09:48 | 1473452 Robslob
Robslob's picture

You can fool some of the people some of the time....

Ahh...screw it...I am sure Goldman will serve up their clients to the debtus maximus offering while taking the other side...

Wed, 07/20/2011 - 09:51 | 1473458 jkruffin
jkruffin's picture

The people have got to be tired of bailing out these same countries every month....no matter what they do, it does not change the facts....this creative economic crap needs to end...put this crap out of its misery....including the US Treasury.

Wed, 07/20/2011 - 12:27 | 1474148 LawsofPhysics
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But then there is that little problem with all of these financial fucknuts (who have no idea what real value is or any skills to actually create real value) finding jobs.  Hence, the stalling.

Wed, 07/20/2011 - 09:51 | 1473460 Peter K
Peter K's picture

Can't they just go the Goldman and get a AAA wrap?

Wed, 07/20/2011 - 09:51 | 1473461 hound dog vigilante
hound dog vigilante's picture

 

Literally a poor man's Fed... printing their own IOUs.

 

Wed, 07/20/2011 - 09:53 | 1473466 jkruffin
jkruffin's picture

EU warning of economic collapse if Greece summit fails.  Where have we heard this line before?  Aw, only every week for the last 3 years.  No matter what they try, it all amounts to a hill of beans....they are all insolvent along with US banks and the Treserve.

Wed, 07/20/2011 - 10:12 | 1473525 Clueless Economist
Clueless Economist's picture

..but...but this time they mean it...really

Wed, 07/20/2011 - 09:54 | 1473472 jkruffin
jkruffin's picture

EU warning of economic collapse if Greece summit fails.  Where have we heard this line before?  Aw, only every week for the last 3 years.  No matter what they try, it all amounts to a hill of beans....they are all insolvent along with US banks and the Treserve.

Wed, 07/20/2011 - 09:58 | 1473490 Scisco
Scisco's picture

I saw a post of 4chan of all places that I do believe summarizes this logic very well.

How to make 12 year old Scotch:

1) Obtain 3 bottles of 4 year old Scotch from different distilleries.

2) Mix bottles in equal parts into one large bottle.

3) Enjoy

Wed, 07/20/2011 - 12:28 | 1474157 IQ 145
IQ 145's picture

 he, he. yeah, very good.

Wed, 07/20/2011 - 09:59 | 1473492 Sudden Debt
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They can say whatever they want.

I don't expect them to say: GET YOUR MONEY OUT! THE EU IS DOOMED!

Nop.

The politicians will get their money out for sure.

The bankers and elite will also.

And suddenly, somehting nobody saw comming. It will be over.

 

Wed, 07/20/2011 - 12:33 | 1474178 IQ 145
IQ 145's picture

 Yeah; they're in a difficult situation; the one they created themselves. There's a very old saying in English that I like, "if wishes were horses, then beggars would ride".

Wed, 07/20/2011 - 09:59 | 1473496 narnia
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in an alchemist's world, gold & silver would be as valuable as sand & salt water and it would get old being young.  

Wed, 07/20/2011 - 10:47 | 1473498 Version 7
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There's no direction in the EU. Current politicians are plain terrible, they keep applying the old solutions to new problems, and basically spend their time going around from meeting to conference and from place to site, just to see how the markets 'react'. This game will be played over and over until the can hits the wall and (they hope), most importantly are no longer in power.

Wed, 07/20/2011 - 10:00 | 1473502 texpat
Wed, 07/20/2011 - 10:04 | 1473505 jkruffin
jkruffin's picture

OT but IMPORTANT!!

 

US reports a US drone was shot down over Iran....all those warships in the area might be getting busy soon........There is going to be an escalation boys........

Wed, 07/20/2011 - 10:10 | 1473520 jkruffin
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Shot down over Nuclear Facility......oh Nelly....

Wed, 07/20/2011 - 10:20 | 1473553 Mr Lennon Hendrix
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You report well, JK, but do you have a link?

Wed, 07/20/2011 - 10:28 | 1473582 jkruffin
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It's all over the place  yazoo, msnbc, etc...

Wed, 07/20/2011 - 10:39 | 1473623 Mr Lennon Hendrix
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Sorry [rubs eyes] still waking up.

Wed, 07/20/2011 - 10:11 | 1473521 Version 7
Version 7's picture

No big deal. The Kursk was torpedoed by an american sub and the incident was handled. Clashes between military/espionage happen all the time and are dealt accordingly. Not a false flag - yet.

Wed, 07/20/2011 - 10:23 | 1473567 Sudden Debt
Sudden Debt's picture

Actually, flying a drone over a country where your not a war with yet, is a act of war.

I might not sound bad but consider that China buys a lot of oil from Iran and is thus a ally.

Let's not forget Mr. buddha from Tibet who visited Obumble and the rest of the shit and you've got yourself a mayor incident.

 

Wed, 07/20/2011 - 10:25 | 1473570 snowball777
snowball777's picture

Unless it's Pakistan...or someone else on the payroll.

Wed, 07/20/2011 - 10:36 | 1473593 Version 7
Version 7's picture

consider that China buys a lot of oil from Iran

China has agreements with Iran for the supply of oil (as with many other countries), that's why I don't think a war with Iran is on the cards or is a problem that can be solved with the usual american pragmatism, ie 'if they have oil and we don't we gotta go there and get it'.

Wed, 07/20/2011 - 11:35 | 1473878 spear-x
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Israel will likely start it. US will follow in tow.

Alliances are now being strengthened.

The war machine is accelerating.

Wed, 07/20/2011 - 10:04 | 1473506 HITMAN56
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and I heard as it were a the noise of thunder...one of the 4 beasts saying come and see and I saw...and behold a white horse....

Wed, 07/20/2011 - 10:26 | 1473574 snowball777
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and i read a book....and quoted it everywhere....regardless of how tenuous the connection...

Wed, 07/20/2011 - 10:16 | 1473540 Boxed Merlot
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Even the rating agencies must be scratching their head wondering how to let AA entities guarantee themselves and still provide a AAA rating...

 

MBS revisited.  "Ownership / possession" is as much a conjured sentiment as fiat currency or sovereign debt instruments.  Now that the rule of law and universally accepted objective points of reference are set aside, dis-integration follows.

 

Tower of Babel, diaspora, olly-olly oxen free. 

Wed, 07/20/2011 - 10:26 | 1473572 Central Wanker
Central Wanker's picture

The ratings of US rating agencies don't matter in Europe. We european geniuses just decided so.

We think that we rock. That matters!

 

Wed, 07/20/2011 - 10:31 | 1473592 css1971
css1971's picture

We do rock! Queen were British. They ROCKED! The Queen IS British!

 

We will rock you all.

 

Wed, 07/20/2011 - 10:43 | 1473633 snowball777
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Never fails to make me laugh when I watch a US sporting event where thousands of homophobic Americans are singing along with Freddie.

Wed, 07/20/2011 - 10:28 | 1473585 css1971
css1971's picture

Self-Guarantees

What could possibly go wrong? We have politicians and moneylenders telling us this will work. Who am I to question?

Wed, 07/20/2011 - 10:39 | 1473619 oogs66
oogs66's picture

anyone else remember the simpson's episode where homer's brother lets him design a car?  the car has EVERYTHING! and bankrupts the brother

 

 

Wed, 07/20/2011 - 11:36 | 1473881 slewie the pi-rat
slewie the pi-rat's picture

i was reading down the string, my thoughts:  maybe we could use bob hope in a pith helmet, here... 

Wed, 07/20/2011 - 10:46 | 1473643 Non Passaran
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From the site's T&C's

>By clicking "I agree " below, you represent that you are not physically present in the United States of America.

What the heck is that about?

Wed, 07/20/2011 - 11:01 | 1473725 dracos_ghost
dracos_ghost's picture

They've become their own grandpa ( debt-wise)

 

http://www.youtube.com/watch?v=eYlJH81dSiw

Wed, 07/20/2011 - 11:28 | 1473835 Reptil
Reptil's picture

yes, they did (discover alchemy).

dissolve two pints of CS gas in one ounce of feta cheese, let simmer for one month, then add 3 pints of fresh Italian banker spit and stir well with french wine vinegar from the finest halls of political Paris, add some stale irish beer to taste and top it off with some nice rich german pig fat. it's not gold but it certainly looks like it if you squint your eyes.

Wed, 07/20/2011 - 14:03 | 1474468 brent1023
brent1023's picture

Is the AA for countries? If so, then provided the country - politicians and people - understand they have a problem, understand what the problem is, want to change then it could work.

Yeah, that't not going to happen.

Wed, 07/20/2011 - 17:11 | 1475226 Edward Fiatski
Edward Fiatski's picture

Paper2Gold is much more profitable than Lead2Gold. :) Stacking that Au for the AnnUnaki, bitchez.

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