How Europe Can Eat Its Cake And Have It Too: Hiking Rates As The EFSF Goes Into Overdrive

Tyler Durden's picture

With Portugal about to enter the warm embrace of the EFSF, even though nobody still knows just what the constantly updated and revised EFSF actually is, and the IMF (read America) is far more likely to end up footing the cost of the latest European bailout, it makes sense to find out just what the status of the latest incarnation of the EFSF is, or as Peter Tchir of TF Market Advisors calls it, the EFSF V1.5. This is especially important as in 14 hours, Jean Claude Trichet will most likely announce a 25 basis point increase in the ECB funds rate, even as more and more of the European periphery is struggling with solvency and liquidity access. That tightening by the Central Bank will either make life for the PIGS even more complicated or make their lock out from traditional capital markets complete. On the other hand the ECB has no choice with inflation in Europe surging, and Trichet forced to do something, anything. Therefore, courtesy of the EFSF, Europe will quite literally have its cake and eat it too: it will have a QE-like debt monetization instrument in the form of a €400 billion monster CDO, while at the same time it will be removing market liquidity: this is supposed to achieve one goal and one goal only - keep cheap liquidity flowing for the insolvent part of Europe and slow down growth in the healthy part, read Germany. This has never been tried before, and nobody is willing to risk their career with a statement that it will work. On the other hand, this set up provides some perspective on how Bernanke may proceed in the future: he may be forced to tighten even as he continues to monetize various pieces of debt. Although by the time such a "solution" is implemented, there will be enough precedent to determine if the latest European experiment has been a complete or just partial failure.

From TF Market Advisors


EFSF was launched with great hype last summer and with the expectation that it solved the European debt problem.  As Europe's weakest countries continue to limp along , many of the flaws of the original plan have been exposed.
So, like a giant software developer, the European nations have slapped on some additional bells and whistles, leaving us with EFSF 1.5 and promised that EFSF2 will be even better and this time really will solve the problem!

The big question is, can EFSF2 actually work?  I believe there is a chance that it could work, but it needs to be structured correctly and I highly doubt the governments of Europe have the will to do it properly.  To figure out what can be done, it's worth reviewing the flaws of EFSF1 that have led us to this limbo.

Last summer, the European nations banded together to create EFSF because they firmly believed that the capital markets were unfairly denying funding to worthy borrowers.  The original program was developed as a way to stop the evil capital markets, the vile hedge funds, and the devilish CDS players from vilifying worthy countries doing their best in tough times.  Certainly, when the U.S. government stepped in to support the commercial paper market back at the height of the financial crisis, that market was in chaos from a dearth of liquidity rather than any widespread belief that those companies would default in such a short time frame.  Investors lacked liquidity and there were better investment opportunities (IG bonds were trading a deep discounts and extremely wide spreads).  So the government stepped in and offered support to that market.  It resolved itself over time and functions properly again.  But that was clearly a liquidity rather than a risk problem.  It was never clear to me that the problems of Greece or other periphery countries were related to a lack of liquidity.  Over time it has become obvious to me that the problem isn't a lack of liquidity, its real concern over the ability of these countries to repay their obligations.  So the original premise of EFSF, that it was a lack of market liquidity, causing the PIGS' problems, has proven false.  There is plenty of liquidity.

The real problem is that more and more investors don't believe these countries have the ability to meet their obligations.  So, EFSF2, must now rely on the assumption that over time these countries can correct their fiscal problems and repay their obligations.  This is a much harder sell for the countries involved - on both sides of the equation.  While it was relatively easy to convince people that this was a market problem last year, it's a growing minority of people who believe that.  A growing number of people now see the problem as long term structural, which is much harder to solve than a temporary liquidity problem.

EFSF2 must be based on the premise that these countries are being denied funding because investors don't believe in their ability to pay.  Its not a question of liquidity it's a question of solvency.

EFSF was not prefunded.  Each time a country wanted to access it, they would have to apply and other countries would then have to support bonds issued by EFSF to support that loan.  This created a slippery slope (see link below for more details) where countries who had been guarantors of previous loans would now be asking for loans.  It also ignored the fact that the countries were correlated, so that if one country was asking for money, it would be likely that other countries would also need money (Ireland and Portugal), and that at the same time, some of the countries who would be providing the guarantees, would also be in worse shape (Spain, Italy).  By relying on funding or guarantees at time of need, rather than up front, it did not resolve the domino effect.  It also has left the funding more exposed to political uncertainty as the reaction time is weeks or months, which is just too long and constantly tests the political will of the countries providing the support.

EFSF2 must be prefunded and not rely on capital calls.  The market must know that the money is already there and is available for use, otherwise the availability will continue to be questioned.

Why was EFSF so complicated?  It relied on structure rather than money from the participating sovereigns.  The guarantees were 120% of the loans.  There were holdbacks equal to the NPV of the spread.  Certainly part of this was so that the group could join up to issue bonds to the market with a 'coveted' AAA rating, while making loans deemed extremely safe (possibly senior) to the countries that needed to borrow.  Maybe there is something valid about how it was structured, but to me, it always felt as though the countries claimed they were willing to support the weak countries, they really weren't.  Why guarantees and not cash?  These countries could easily go and borrow money and then fund the loans directly.  So why use guarantees?  I'm assuming that the guarantees don't show up as obligations of the country, or can at least be obfuscated away (ala Fannie and Freddie) so that people don't treat it as real debt.  Why hold back the NPV of the spread?  EFSF would lend money but effectively defease the spread payments.

I'm not sure why, either the country is creditworthy or it isn't.  Making a PIK loan to the country would have seemed weak, so they got around it by making a proper loan but holding back the future interest payments.  The EFSF pretended to be willing to lend, but really wasn't prepared to take any risk.  That leads to the next question, why use privately negotiated loans to lend to the countries?  Do you really need to do that to get the country to agree to austerity measures? Again, the answer is clear, you can make it seem like you are lending to that country and taking risk, but structure away so much of the risk that your loan is very safe and structurally senior to any other debt of that country.  It's like a magician's dream, everyone watching the left hand and not noticing what the right hand is doing.  The left hand is saying we are providing big support to the weak members, meanwhile the right hand is taking 20% haircuts on the guarantees, using guarantees rather than cash, defeasing future interest payments, and then privately negotiating each loan to create a structurally senior piece of paper in event of the country failing to meet its ongoing austerity commitments.  Maybe since the original premise was that this was a liquidity problem, this makes sense, but it's hard to see that the lending countries ever had any real risk appetite.

EFSF2 must be prepared to lose money.  It cannot just pretend to be a lender, it must take risk pari passu with the market.

So I believe that EFSF2 can work, but it must be prefunded, have the ability to intervene or trade in the market, and accept the real risk of loss on a pari passu basis with other lenders.  A 400 billion war chest, managed by smart investors could work, though finding a 'smart' investor willing to lend to these countries might be a difficult challenge.  The reality is, in my opinion, that the countries wanted to provide the appearance of support without actually taking much risk.  There were probably lots of 'wink-wink' conversations in the back rooms explaining that although EFSF looks big, its structured in such a way to be ultra safe and not really take much risk.

That's how it was sold in the countries to get the necessary votes.  I don't think a real risk taking solution is acceptable to the countries that would be taking the risk.  At the same time, more of the same will not be acceptable to the market as they won't want to take the risk of being structurally subordinated to EFSF, and the countries receiving the money are less and less inclined to bear the massive austerity programs in face of other countries continuing to spend their way out theirs (U.S. and Japan as prime examples).  We can probably kick the can down the road and hope and pray that time fixes the economies in the weak countries, but without a new, much more aggressive EFSF2 program, we will likely be listening to a whole new cast of politicians discussing EFSF3 and why that will work.

Alternatively, if EFSF2 could be made to act like QE2 that too could work.

The QE programs, for better or worse, have the advantage of simplicity.

Print money (or electronically create fractional reserves) and buy your own debt.  It's simple and easy and works.  It's hard to see EFSF morphing into anything like that.  I'm not sure the framework of the European Union would allow it.  While the Fed sees no risk in debt issued by the Treasury, I'm not sure that the ECB believes there is no risk in debt issued by Portugal.

It doesn't seem like a feasible solution and who knows what it would do to inflation, but I wouldn't be surprised if we hear some rumblings of a potential European QE solution, especially as it becomes clear there is no real support for a EFSF2 that is materially different than EFSF1.

In the meantime enjoy the rally in European sovereign debt with Ireland 10 year bonds now 100bps tighter in a week.

Prior article on the slippery slope nature of EFSF