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

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mynhair's picture

EFSF = European Foundation of Stupid Fucks.

dlmaniac's picture

MOPE goes global, bitchez.

StychoKiller's picture

I've never been stupid enough to stomp on the gas & brake pedals at the same time, especially on an ice-covered road!

disabledvet's picture

The claim by Trichet is "oil prices are too high" as his reason to raise rates.  Isn't this what some guy by the name of Greenspan tried and resulted in some "Mad Money" guy screaming "they're NUT'S!" live on CNBC?  And of course when "the Mad Money guy" screamed this "that was speculative" since "the economy (sic) was doing great at the time."  How can anyone claim "the collapse in Europe is speculative" now that we know Belgium got 30 plus billion from our Fed?  Unless of course "gold was the collateral."  Just speculating of course.

koeleköpke's picture

That's maybe the reason why a fucking belgian VLD-parliament member called Mr. Tommelein (a liberal not a socialist) wants to sell the Belgian 200 T gold (at these "all times high " prices) stored with the Fed NY. 

Cleanclog's picture

Sorry to say again . . . QE3 will be buying Sov. debt and munis.  Can't let banks and pension funds fail.  Can't let Portuguese, Spanish, Hungarian, Italian, Californian, Oakland, Texan, Chicagoan debt have service costs rise 500 bps.   More debt will be issued to "fix" the problem of too much debt.  It would be funny if it weren't so absurd.  

tony bonn's picture

this is a solution which only a chairsatan could invent...

fuck you bernanke...

RobotTrader's picture

Like I said.

Everything is going to get monetized or bailed out.

It is the only solution.

Particularly when the world looks in amazement at The Bernank's ability to sky the SPX 100% in a scant 2 years with horrid economic fundamentals.

Printing and flipping electronic digits has proven to be the magic elixir for any and all financial convulsions.

kengland's picture

Who's the largest holder of Portuguese debt?

disabledvet's picture

my understanding is Spanish Banks "and by extension Germany itself"--although it sure looks like the ECB now.  I mean "the line in the sand is Spain" yes, yes?  Meaning "bank bailouts European style" of course.  There have been no actual "bailouts of the States themselves."  Good question.

kengland's picture

Margin call on Spain then?

Yardfarmer's picture

CreditAgricole, SocGen, and other French financials hold over $10 billion.

RobotTrader's picture

What is amazing is that no matter how low or cheap these PIIGS stocks go, there are always swarms of speculative locusts ready to pounce on these stocks to make a quick 70% gain.

Just goes to show you how in today's world, virtually every trick will be attempted in order to "make your year" so you can spend the rest of the summer out at The Hamptons.

MarketTruth's picture

Robo, with your looks and brains, are you telling us you don't spend the summer in the Hamptons? i'll gladly invite you over for our normal weekend party. All those great trades you talk about, surely you must have a few acres with a modest home of your own. Right?

Ferg .'s picture

Ugh , AIB . I have relatives who bought ( and unfortunately still own ) this garbage back in 06-07 when it was trading at/near record highs .

mdwagner's picture

It's not possible to stop QE without the US government defaulting, IMO.  We'll probably see state and city QE next.

I know, silver bitches and BTFD.

mynhair's picture

No, an end to QE just means most of the Lib voters will die in the street.

falak pema's picture

prost and goulash soup for all!

MachoMan's picture

Goddamnit Tyler, you can have your cake and then eat it...  you're better than that...  you just can't eat your cake and then have it...

The Count's picture

And now for something completely different:

Who else thinks that ABC News' Martha Raddatz is starting to look rediculous when she dons a helmet and body armor and reports from Afghanistan? I mean, she looks like a freakin grandma that pooped in her pants. Ever see her smile...? Add to that the not really young looking anchor and the program just looks silly. And hey, I am a senior citizen myself!



magpie's picture

It should be good fun to have two "good" and "bad" Central banks at the same time. Swap them around, maybe have some Doppelgänger laughs, lose some bonds, print and repo back and forth - learning the tricks from Maestro the Great Depression Professor.

mightybillfuji's picture

And lets be clear. Every member of the pigs is Also a member of the efsf. Each of them is now EVEN MORE INDEBTED as they own percentages of the Portugal would be a great zerohedge article to show how many billions each piig owes now to Portugal at an 80 billion number

mynhair's picture

So, when does the EUR jump up?

thatthingcanfly's picture

I'm just stoked I'm not the only one who knows it's "eat your cake and have it," vice "have your cake and eat it."

<wipes tear from eye, stifles audible sob>

MachoMan's picture

Actually, the title was updated after a quick flogging by me, see above. 

BlackholeDivestment's picture

After reading through this bullshit, there is no doubt what is upon the alter. This is about the sacrifice of the individual, independence, freedom, liberty and justice for all. The entire offer upon this generation is an offer to sustain  tyranny and corruption. This neo-world order Europa ''ConTRAPtion'' is not going to saddle the beast and ride accross the bridges of Babylon to security. ''The Ghost And The Darkness'' remains. Deep Capture rules this criminal global market both night and day. The clueless murdering bastard ECB Euro Peons are pathetic, entrapped theives, robbed of intelligence and they are not alone. 

  Europa, she's ah drunka off of da market cup of ''BTFD''! I see her image on the 2002 Greek Two Euro coin The combination of that old saying, ''like a two dollar whore'' and that Revelation scripture,  makes you go hmmm?

News flash, the whore riding the beast was known as Ishtar in Babylon, before it became fallen, and that saddle was on a man eater. 

 Communist China PIIGS love Barack Hussein of Babylon now but, they might ''change'' their mind if they new about his favorite 80's beer. Crack and Old E never measured up to European standards but, Europa is to drunk to escape what is now written upon the King of Babylon's wall?

Ahmeexnal's picture

Major war is about to break out between EU members.

It's already priced in. BTFD!!

Itsalie's picture

All the talk of EFSF of 440b euro, but check out its website link below. So far it has only issued 5b euro of bonds and disbursed just 3.6b euros. Either they are getting insufficient demand from the PIIGS (which means the PIIGS are doing better than advertised - so why then is Portugal surrendering?) or their bookrunners Citi/HSBC/Socgen are having a tougher time selling more bonds than they are letting us know.

Anyway the first 5b euros had 9 times more bids than the issue size with japan finally buying 20% of whole issue (yes, the yield was low 2.89% but better than toilet paper yields). Yet since January they have stopped issuing more EFSF, aka 3 months of silence. And Portugal will need 5b euros next week, and another big chunk in June. So why is Mr Regling the EFSF CEO so busy rebutting the FT for calling the EFSF a huge CDO (aka Ponzi scheme) yet doing nothing to raise money for PIIGS?

ak_khanna's picture

All the Euro strength of the last couple of weeks is dependent on whether ECB raises interest rates on Euro today and commits to raise them in the next few ECB meetings. If the ECB does raise interest rates today they screw the weaker euro economies like Greece, Ireland, Iceland, Portugal etc. as their cost of borrowing goes up. If they do not raise the interest rates then there will be substantial Euro weakness.  Keep in mind that the stronger countries in the Eurozone, the Germans and French want a weaker Euro which will boost their exports to the rest of the world.


Urban Redneck's picture

Raising rates & increasing monetization

one little formula change

QE^ to QE∞

Trichet is a socialist out to save the single EMU at any cost.