Why The Latest European Bailout, Aka "The Debt Buyback" Plan Is Also DOA, And Why The CDO At The Heart Of The Eurozone Is About To Become Extremely Toxic

Tyler Durden's picture

Over time many have wondered why the ECB, in order to "extend and pretend", does not simply do an episode of QE and monetize bonds outright? Well, in addition to Germany's flashbacks to hyperinflation which have so far kept Trichet from pursuing an all too aggressive bond buyback program in the primary market, the ECB does have the Securities Market Programme (SMP) which however since inception has bought only €74 billion (this week the number is expected to rise, or, if it doesn't, it confirms that now China is directly buying European bonds in the secondary market). The problem with the SMP is that it was conceived as a modest marginal debt buying program, never intended to surpass much more than a few dozen billion in debt. Alas, by now it is becoming all too clear that the ECB will need to monetize hundreds of billions of insolvent PIIGS debt in order to extend and pretend forcefully enough so that a new bailout is not needed every other week. But how to do it without monetizing debt on the ECB's books? Enter the EFSF, or the off-balance sheet CDO "at the heart of the eurozone" which according to the latest iteration of the European rescue package (Remember that most recent DOA plan to rollover debt? Yep - that's dead) is precisely the mechanism by which Europe's own open market QE is about to take place. "European Central Bank Executive Board member Lorenzo Bini Smaghi suggested the EFSF be allowed to provide funds for a buy-back of bonds from the market, where prices have in some cases fallen 50 percent from levels at which the debt was issued. "This would allow the private sector to sell bonds at market prices, which are currently below nominal value. At the same time, the public sector could benefit monetarily," Bini Smaghi told Sunday's To Vima newspaper in an interview." Translated: another market clearing perversion courtesy of the same structured finance abominations that brought us here. The problem, unfortunately, is that Moody's announced nearly two and a half years ago that the whole distressed debt buyback approach is... a dead end, and will lead to the same "event of default" outcome that all the prior bailout plans would have achieved as well (we correctly surmised that Bailout #2 was DOA, about a month before the "efficient" market did). Here is why.

For the toxic CDO to work, the SPV will have to sell the varios BB through AAA-rated tranches to another batch of morons, who will later blame the same rating agency that everyone in Europe is now blasting, for keeping the top most tranche rated AAA. Naturally, those with a lot of other people's money (as opposed to just a little) will go well below the AAA-tranche, and well into BB territory in pursuit of insolvent sovereign debt yield, until such time as the cumulative losses hit 100%, the attachment points become meaningless, and the next and final credit bubble implosion blows up Europe. 

Naturally, this whole plan is predicated upon the continued goodwill of the rating agencies to keep the various tranche ratings where they are instead of downgrading the whole thing to D, which is it true rating if objective cash flow, and loss projections are used. So Europe may want to be a little careful as it conducts open warfare with S&P and Moody's.

But the best thing is that, since the whole thing is off the books, nobody's direct credit rating is impaired, and the ECB can pretend it is not monetizing debt.

The second key point is that the ECB will be able to pretend that it is not engaging in inflationary activities, and during the next ECB press conference, Trichet will have to play even dumber than usual, pretending to be insulted by questions that doubt his inflation fighting capabilities.

The third point is that, as Germany acknowledges, private losses will have to be taken. Although as is now well-known, with the bulk of Greek exposure contained at the Greek bank level, and at various US-based hedge funds, nobody really cares, especially since Greek banks have secondary liquidity conduits that will allow them to remain "solvent" even as they are forced to write down their Greek debt holdings. After all, as long as the ECB continues to provide them with 100 cents on the dollar for insolvent bond collateral, all shall be well, and everyone can continue to pretend the system is stable.

From Reuters:

Wolfgang Franz, head of Germany's "wise men" economic advisers to the government, said the huge size of Greece's 340 billion euro ($480 billion) debt pile meant it was "inevitable and justified" for the private sector to accept losses.

"One possibility would be that the current EFSF euro rescue mechanism swaps -- at a significant discount -- Greek bonds into bonds it issues and guarantees," Franz was quoted as telling Focus magazine at the weekend.

Alarmed by the spread of market jitters over Greece to Italy and Spain, where bond yields have surged in the past 10 days, European governments are struggling to put together a second bailout of Greece that would supplement a 110 billion euro rescue launched in May last year.

Germany is insisting private investors be involved in the second bailout, and Merkel indicated on Sunday that if they did not voluntarily agree to a major contribution now, they might eventually be forced into a more costly solution to the crisis.

"The more we can involve private creditors now on a voluntary basis, the less likely it is that we will have to take next steps," Merkel told public broadcaster ARD without elaborating on what those steps might be.

Three weeks of talks between European officials and the private sector have failed to reach a deal on the second bailout of Greece, but the lobby group representing commercial banks said on Sunday that some progress had been made.

"Progress has been made and the discussions are continuing," the Institute of International Finance said in a brief statement. It said the talks were focusing on "several options related to Greece's financing needs and longer-term debt sustainability".

As expected, the rollover, or maturity extension plan, is now as dead as the dodo, with the rating agencies refusing to back down from qualifying it as an EOD:

Other options on the table include an extension of the maturities of Greek bonds. But German weekly magazine Der Spiegel, citing finance ministry sources, reported at the weekend that a debt buy-back had become the option most likely to attract a consensus.

Greece could cut its public debt by 20 billion euros if it bought back its sovereign bonds at market prices as part of a rescue deal, the magazine said.

The funny thing is that if Europe intends to pursue the buyback path, which is effectively a "coercive" distressed tender and/or exchange offer, it will once again raise the ire of the rating agencies. Because, lo and behold, Europe is not the first to think of this. In fact, as Zero Hedge wrote back in April 2009, when most US corporations were pursuing precisely this "distressed tender" approach to benefit from below par prices on their debt, Moody's came out in March 24, with a piece that said the following:

In recent months, issuers have increasingly been proposing
debt exchanges and tender offers at discounts to par. In many instances,
these proposed exchanges reflect an opportunistic motivation as
financially healthy issuers see a chance to reduce debt levels at
attractive valuations. In other cases, however, the proposals are
being made by financially distressed issuers and the effect of the
exchange is to allow the issuer to ultimately avoid a default event,
whether it is a bankruptcy filing or a missed payment on principal or

Exchanges made by distressed issuers at discounts
to par which have the effect of allowing the issuer to avoid a
bankruptcy filing or a payment default (i.e., "distressed exchanges")
are considered default events under Moody’s definition of default.
However, since whether an issuer would have defaulted absent an exchange
is unobservable, the determination of whether an exchange constitutes a default event is inherently a judgment call. As
such, it is important for market participants to understand the
criteria Moody’s considers in evaluating whether a particular exchange
offer constitutes an event of default.

The critical take
home message here is the subjective determination that Moody's and
Moody's alone will make whether or not a company is to be branded a
Defaulter or not. The implications across the capital structure, in the
case of even one security defaulting, are obviously staggering, due to
legacy limitations on what securities can and can not be held in a given
defaulted corporate issuer by many asset managers. However, whereas the
distressed exchange is much less of a judgment call if one is familiar
with Moody's approaches and criteria for evaluating these events, a
minor addition to the terminology by Moody's could jeopardize the
recently gaining significant popularity phenomenon of open market distressed buybacks. As Moody's says:

All formal debt exchanges and tender offers are candidates for distressed exchanges. Additionally, open market and bilateral negotiated purchases of debt are also possible candidates for distressed exchanges.
While purchases and exchanges are typically voluntary transactions,
they can have the effect of allowing the issuer to avoid a bankruptcy
filing or missed payment and, therefore, constitute an event of default.

evaluating exchange offers, Moody’s interprets the term "debt exchange"
very broadly. For example, when distressed issuers restructure or amend
bank loan agreements which have the effect of allowing the issuer to
avoid a bankruptcy filing or payment default, such transactions will be
classified as distressed exchanges.

And while one may have
been forgiven to assume that this is merely posturing on the side of
Moody's, the rating agency showed it was not bluffing when it assigned a
rating of Limited Default to Hovnanian, following its presumed "debt
exchange." From Moody's Hovnanian release:

Investors Service assigned a Caa1/LD probability of default rating
("PDR") to Hovnanian Enterprises, Inc. ("Hovnanian") following the
company's disclosure in its most recent 10-Q filing that between October
31, 2008 and March 11, 2009, it repurchased approximately $368 million
face value of senior unsecured and senior subordinated notes at
substantial discounts to par. The open market transactions, considered
together, constitute a distressed exchange and a limited default by
Moody's definition. The LD designation signifies a limited default and
also incorporates Moody's expectations of open market transactions at
substantial discounts to par over the next twelve months.

Bottom line: we are certain that within 1-2 weeks the ratings agencies will determine that this latest scheme to "baffle them with bullshit" has failed, but at least it will buy Herman von Rompuy and the other bureaucrats another 2-3 weeks of navel gazing. Unfortunately, the much anticipated miracle will, needless to say, not materialize. Which is why Europe may be able to kick the can down for a few weeks, but in August, with no more "bailout plans" and with its back against the wall, the House of Cards will finally commence toppling in earnest.

Below is the full piece from Moody's which we urge Europe's buraucrats to read promptly before it is too late, which explains "Moody's Approach to Evaluating Distressed Exchanges"

Moody's Approach to Evaluating Distressed Exchanges