Pricing the EU WI bonds

Bruce Krasting's picture

It appears we are getting a Monoline to solve the problems in the EU. For the life of me I can’t figure how this will work, but we are about to find out. There are no details on this as yet, just planted rumors.

The talk is that EU sovereign debt to be issued in the future would have the benefit of an insurance guaranty that covers the first 20% in the event of default. This guaranty would be backstopped by the EFSF.

The thinking is that a new bonds issued by Spain, Portugal, Ireland, Italy (and presumably Belgium but not Greece) with the guaranty would be widely perceived as a money good investment. As a result, huge amounts of capital could be raised in the global bond markets under very attractive terms (total = Euro 2+ trillion). Funding costs for the PIIBS would plummet as a result. With the debt market stabilized, economic prosperity would soon follow. I say "rubbish".

The enhanced bonds would be “Story” bonds. In my experience story bonds have a very limited investor interest. I have no doubt that ten of billions of these bonds could be sold, but Trillions?

The USA Treasury market is the most liquid in the world. The total public float (excludes Fed and Intergovernmental) is about 9 trillion. The proposal is that an amount equal to 1/3 of the US public float of new EU enhanced bonds are issued in just a few years. IMHO that will never happen.

The global bond markets will have to figure out how to price this new debt. I’ve been pondering this for days. I can’t come up with a pricing structure that works.

Consider a newly issued ten-year Italian sovereign bond that has a 20% first loss guaranty by the EFSF. Assume that the German ten-year was 2% and Italian at 5% (about where we are today). You tell me, how is that new bond going to trade based on this?

This is not equivalent to 20% German risk and 80% Italian. That would be far too easy. But if the market were to trade it as an 80/20 it would imply that the new Italian Enhanced Bond (“IEB”) would yield about 4.4%. This would mean that the IEB/German spread would be 240bp while older Italian debt had a spread of 300bp. If that were the result, it would be a disaster.

While 60bp is a big deal, it would do nothing to stabilize Italy’s long-term debt cost. For a new program to work, it would have to drive the IIB/German spread to 100bp.

In order to evaluate the 80% Italian risk and price it properly one must first make an assumption as to the probability of an Italian default over the next ten years. One must also make some assumptions regarding what losses might be incurred should there be a default.

Folks, those are very complex questions to answer. I’ll give it a shot.

Probability of Italian default over ten years = 20%

Probability for loss > 20% in the event of default =100%.

While I think that Italian default risk is relatively low, I believe that should it happen, the net haircut would be substantially above the 20% first loss protection. A country like Italy would not go through the pain of a default to achieve a 19% debt reduction. If push comes to shove and Italy decides it is best to default, the haircut would be in the 50% range (a la Greece).

Any investor who looks at the new bonds and concludes that they’re money good is just nuts. That will not happen.

My conclusion is that the new enhanced debt has to trade cheap. There is a massive amount of this story paper coming our way. That mountain of supply has to mean the bonds have to have a high yield. If one wanted a litmus test for this I would ask the Swiss National Bank. They have E200b in reserves. I bet they would not put a dime into these new securities. Neither would Singapore, Venezuela, Kuwait, Hong Kong or Saudi Arabia.

It’s quite possible that the new paper does very little for Italy. If that were the result for Italy (a relatively strong borrower) it would be the kiss of death for the weaker ones like Spain and Ireland.

What I find fascinating about this is that the deep thinkers in the EU are relying on the global bond market to price the new securities in a way that would produce the desired results. The deciders are going to trust Goldie, Citi and good old JP to price this swill on the rich side? Not a chance in the world.

After four agonizing years the inescapable conclusion is that complex derivative securities were at the heart of our problem (they hide risk). The response by the EU is to give us the largest derivative transaction that has ever been created. Talk about a sign of weakness.

The most amazing thing is that the global markets are lapping this up. Any confirmation (the silly Guardian story) that the Mega Monoline is in our future is a cause for celebration.

Wait and see how these new bonds trade. I think they will trade on the cheap. If I’m right, then you can kiss off the possibility of an EU soft landing.

If the markets give the new bonds a thumbs down it will be the final act in the story. There’s an "event risk” to look forward to.

Note: The only way the new enhanced bonds can trade rich is if the ECB stands ready to buy them such that the spreads are very narrow to German paper. I see a very small chance that this would happen. But if they did step up, the markets would see through the charade in a NY minute. The lights would start to go out shortly after they started buying.


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master of the mews's picture

testing new avatar on old post

John_Coltrane's picture

Nice article Bruce.  Just more shell games, eh?  The markets want to believe so badly there is a painless way to deal with all this bad debt.  We realists know its not going to happen.  Only three rules apply:

1)You pay down the debt, which destroys money  (recall the fundamental equation:  debt/credit = money).

2)You default on it, which destroys money.

3)You try to inflate it away, which debases the value of money.

In all cases sound, stable money is a illusion, and economic prospersity is impossible.  So, its extend and pretend for a little longer.

GoldbugVariation's picture

Great article, Bruce, real quality.  I hope policy makers get to read this some time.

So you're the CIO (Chief Investment Officer) of a Sovereign Wealth Fund.  You have e10m to invest.  Why not invest it all in a basket of Italian, Belgian, Spanish, French etc sovereign bonds, and use a part of that 200-300 bps yield spread over the Bund to buy yourself some default insurance.  (Hint: you can still buy CDS if you own the bonds ... at least, you can for now...)  You could easily cover the first 20% of a default at quite a low cost.  For example, if you assume a real-world default will involve a 50% haircut, then you could buy CDS to cover 2/5 of your portfolio.

Basically the EFSF plan involves EFSF giving away 20%CDS, for free, to any person who steps up to buy an Italian government bond.  That's nice, we all like free gifts.  Doesn't cover the other 80% though.


ceilidh_trail's picture

All this math is givin me a headache. I need a laugh. Where's milliondollarbonus?

ThirdCoastSurfer's picture

In the confidence game, timing is a crucial element. 

Madoff, Enron & Stanford (need 1 more for MESS), held out for years.

The plan doesn't have to be credible, it only needs to extend time.  

Just look at that sad saga that is Jefferson County, Al. When, if ever, will that enormous debt problem be resolved?  

If I can get a 4% yield with a 20% guarantee and risk no more than a 50% haircut then chances are pretty good that the CDS will make me whole.  

walküre's picture

Pricing the EU WI bonds..

Soon to be called the Oy Veh! bonds

mind_imminst's picture

They cannot do it through bond issuance. They (Fed and ECB) will print, print, print. That is all they know how to do. I am afraid I have too much short position in equities right now. When the printing presses get turned up to 11, stocks might soar (ala QE2)

HD's picture

Will the bubble gum and band aids holding the market togther last?  Of course not...but you have to give TPTB credit for the best three card monte in human history.

MrPalladium's picture

You guys just don't get it. This structured product is a caricature mimicking the very worst aspects of the ponzi so it must be intended to kill off the ponzi once and for all.

Nobody could be stupid enough to try this unless they intended to discredit such schemes for all time. :)

Element's picture

No, not for all time, just until the next generation forgets. They know this is a once per century gig, so they know they'll have to teach their sprogs, the bankster kiddies, the art of the fiat ponzi, and teach them to be patient, as they steadily corrupt and rippen the next generation.

What people don't realize is that 'derivatives' were speculative tools in the 1920s and 1930s, these derivatives are not new scams at all.

They are older than this current generation's memory though. These are not 'financial innovations' ... these are the OLD pincers that were designed long ago to rip the economic heart and life out of whole countries, and continents ... and this time, everywhere at once.

Implicit simplicit's picture

There is no question that they are desperate, and I wouldn't be suprised if they are stalling for time until they can set up covert transaction facilities on islands wih funny names to  monetize the debt instumnet that can't be sold, all with the Feds help of course.

zero intelligence's picture

The problem with these guarantees is that they are not money up front, like a CDO equity tranche, they are promises to pay which become obligations to pay when there is a default. Sooooo....


Let's say Italy defaults. Now the guarantors (France and Germany) need to come up with that 20%. Where does it come from? They don't have any money, so they have to issue bonds -- a whole raftload of bonds. Got that? They have to issue them into a market which has just had a major sovereign default. On top of their regular issuance and rollovers.

When you think about it, the real guarantor is the ECB's printing press. Because, that's where they'll turn to in that situation.

Element's picture

Which is a way of saying they are inventing impromptu trillion doller debts ... with no money-down! ... NONE!

It's totally insane.

So who has a credit-rating that is so good that they can do this then? ... is a credit rating agency's word/research good enough, that such should be permitted to make these unrepayable guarantees?

That whole 'market' should be wiped away, with no losses, and no gains.

Just zero out all bets.

Here's a quaint idea;

You are 'worth' the exchange(able) 'value' of what you actually physically own and possess/hold.

All else becomes zero.

Why ... that's so crazy ... it just might work!

Because that's what's really happening here.

That's why they created MERS, and bought the Judges, and Legislative-Chamber scum and you can't get suitable, and timely, and affordable legal redress.

RiverRoad's picture

You sure got this one right Bruce:  all the derivitives and financial alchemy in the world ain't gonna save us from the Global Black Monday that's a comin' down the pike. 

Mark123's picture

I don't think this latest proposal will work sounds desperate.  Even if it did work such that these messed up countries could continue to borrow, that would just enable them to keep the system shored up (basically transfer some of the losses when the system finally crashes). 

The game of reckless spending by countries is drawing to a close no matter party while it lasted though.

We were in Italy in the summer of 2008 staying in a town north of Rome.  We rented an apartment in a 15th century building, which had been completely gutted and renovated (and lost most of its character in the process!).  The people that owned it were from Britain and had moved there about 7 years before and now owned about 3 apartments and managed many more - all weekly rentals.  According to them, the deal was that if you lived in an eathquake zone, the Italian government would pay 100% of the cost to upgrade to earthquake standards including interior renovation AND pay for your rental costs while the work was done.  There were an incredible number of construction cranes in this hilltop town....everywhere!  Apparently they were rushing to take advantage of this before the program shut down at the end of the year.  I can only imagine the sweet heart deals that were involved on these construction projects.

This sort of thing happened everywhere...all over the world as the free money sloshed around the system.  What seemed like a miracle will turn out to be a nightmare.  It will not be fun for the average Joe.

disabledvet's picture

"complexity is everywhere and always the hobgoblin of sound finance" it seems so obvious that's why it will never happen: post all the gold as collateral (and whatever else isn't nailed down) and borrow the money. This is either Apocalypse Now Redux or the humorous satire starring Charlie Sheen. I do know this: if Greece descends into anarchy all this hooey will be irrelevant. And never underestimate the Power of the Pibb either. That's another thing I know.

THE DORK OF CORK's picture

 Bruce -  What do you make of this BIS cracker ?  

This BIS paper seems to suggest most of the worlds capital flows was coming out of Europe - so capital was extracted from Europe , they financed 2 coal fired power stations a week in China and Europe reimported the interest income until it went bad.

When the euro structure was put into place back in 1992 the banks could no longer make enough revenue from countries unable to consume and invest because of the euro fiscal rules - they exported European capital to the BRICs

When they came back to their host in 2008 the Euro sovergins had atrophied & decayed as the ratio of credit to goverment money had exploded during that time.

The world is one giant slave arbitrage - it has never changed.

But no new net capital has been built - slave empires have a weakness - they do not create enough technology , why should they ? - everything is fine until it is not.


The Euro is at the center of everything in the last 20 years - including Rubins "strong dollar policy"

Its the Heart of Darkness.



max2205's picture

Just have Ben issue them with a backstop and pigs only pay 1.5% for ten year and 2.5% for thirty. Who gives a fuck, we are all in this together, right?

Stack Trace's picture

My head hurts. Hoping for a nice dip in gold.

Problem Is's picture

2 x 3 = 5, Bruce...

God what's wrong with you??

Nice post... +7

Motley Fool's picture

That should be 2x4 = pain .

Hannibal's picture

New European Bank Regulations Kick Ass..

Element's picture

I liked the bit about slapping rude and impolite fools ... without the nanny/fascist state rsuhing to intervene to "keep the peace" when a 'citizen' stands up for themselves ... i.e. to suppess all appropriate and necessary actions ... yep, he's on to something there.

Sutton's picture

I'm sure there's a man in Washington who will buy quite a few of these dogs, either straight up or synthetically.

CompassionateFascist's picture

Yes, the Redshield will wolf 'em down. Fed is the last port in this Storm, then it too will go under when the Dollar collapses...Israelites don't care because our gold went to Zion long ago. Judging from ZOG noise on radio and in cyberspace, Zionists are tightening the screws on B.H. in order to force the Iran War before the election. We all saw that murderous False Flag a few days ago. When attacked Iran will close the Hormuz Straits, cutting off most of China/Japan oil supply. Oil price goes to >$300/barrel, they'll then dump their $$$ and TBs, and we are at endgame.  

Big Ben's picture

If you assume a 20% probability of a 30% haircut over the next 10 years, that would indicate the risk premium should be .6%. This is better than the 1.0% risk premium that you would have without the guarantee, but I still don't think it is enough to save Italy.

Which leads one to suspect that the 20% probability estimate is too low, which means that the risk premium should be higher than 6%, which means that the default probability should be increased even more, etc.

Also, chances are increasing that the ECB may be forced to monetize PIIGS debt, which adds an inflation risk to all euro debt, even German.

Nate H's picture

I am not a huge precious metals bull (I own some for collapse insurance not because I think they are good investment), but it strikes me as odd that the days before this monoline announcement which really IS printing (or promising to), as opposed to QE..N, that PMs are languishing.  Either funds are still especially long PMs or......other...

mechawreck2's picture

Seems to me the market will quickly bifurcate this instrument - either with structured CDS or synthetic bonds.  The stubs will trade to ESFS credit and the rest to [fill in your favorite PIIG].  Also seems likely the total pool of debt extant from each PIIG covered will rapidly simply expand 20%.  Game theory...each PIIG instantly highly incentivized to issue for God & Country as much as can be until the market won't take them.  This won't end well.

Bruce Krasting's picture

Well said. You highlight my point. This is no easy process to value $3T of new securities. As a result, the yields will be high. It won't work.

Big Ben's picture

Actually it appears that the markets may be pricing in a higher probability of default or perhaps a shorter time period to default.

And there is also the fact that no one likes to purchase bonds when interest rates are rising because the prices of existing bonds may decrease. So these two risks (delta-interest and default risk) may also be feeding each other in another positive feedback loop.

Its_the_economy_stupid's picture

This makes the most sense to me of any pricing paradigm

kaiten's picture

Eurozone will definitely not depend on Goldman, Citi or JPM to determine the yield as most european sovereigns are bought by eurozone banks/pension funds etc.

kaiserhoff's picture

Bruce is always at his best when discussing bonds.  At this point, all of this nonsense is circular.

1. To the extent that this succeeds, it will destroy the value of older bonds and crush the banks.

2. To the extent that it is even attempted, it will destroy the credit ratings of the stronger sovereigns.

3. Expect  1 and 2 to interact in fun and unintended ways. 

    Soviet Central Planning is its own reward;)

wang's picture

you are correct on that



Manthong's picture

Boy, this all seems like someone who drinks all day and then goes to happy hour just to dull the pain..

of liver disease.

Village Smithy's picture

I keep wondering why those who have the ability have not brought this house down. Is it compassion, or greed in that they are still positioning.

NotApplicable's picture

Because they have the ability due to living large inside the house. If it comes down, they're all homeless. Game over.

Lord Welligton's picture

"The proposal is that an amount equal to 1/3 of the US public float of new EU enhanced bonds are issued in just a few years. IMHO that will never happen."

Would those currently holding be prepared to roll-over?


Bruce Krasting's picture

We shall see. The answer is maybe. But at what price? Is the price for this one that Italy, Spain and the rest can afford? I would not bet on it.

You are the Chief Investment Authority for the Kuwaiti Fund For Future Generations. You just had a maturity of  E10mm of Bunds. So now you have to reinvest this money and those future generations are counting on you to do the right thing.

Would you buy Spanish enhanced bonds if you only got 150bp better than Bunds?

I'm telling you, the people who make these decisions are going to take a pass on this paper. The don't want (more) Italian paper at +300. They're unlikely to want Italian story paper at +150.

Cat On A Ledge's picture

Actually, it's more likely that the first few auctions will be widely endorsed by the sov funds, esp. the smaller ones. Above and beyond generating returns, they too have a vested interest in a stable europe; at the very least, an interest in preventing instability at home due to an european fallout.

Same reason why they injected liquidity into Citibank during the sub-prime crisis; HSBC, Standard Chartered when Dubai imploded. (If my memory serves!)

However, actual amount of support is unlikely to amount to much, maybe in the range of 50 billions combined? Just taking a wild guess. Primary consideration being exchange rate risks.

Also, it's probably folly to short these new bonds right off the bat, they'll fight the 'heretics' tooth and nail, that you can count on.

Pike Bishop's picture

The problem with whatever they put out there, is that you can't take it back or rescue it.

Suppose the take down goes along (somehow) OK.

You now have the most dangerous debt leveraged shit ever, out in the markets.

You know we're fucked, if the old stuff gets re-priced because of it.

Then you have no "new and improved". Just one big pile of shit.

There is no room for a modest writedown/haircut, because the bottom 20% is the most at risk.

And if it goes, everything (new and old) goes with it.

There are risks that nobody has thought of, which will appear half way into the issue stream.


All they are doin' here is chosing a name for the way they want to die.  

Lord Welligton's picture

Fair enough. Just asking for clarity.

In any event I don't think it would work without a full debt and fiscal union.

And that would require treaty changes.

IQ 145's picture

The available book that describes the origen of the Euro makes all this very easy to understand; it shows you that this is inevitable; although the irony is thick enough to choke on; it had to come to this. The Euro came into being, a very, very short time ago; in response to a perceived need, actually an ongoing irritation, on the part of French, Belgian, Socialists to stop the market from punishing the free-spending French vis a vis basis points for bonds with the German Mark. They extorted an agreement from the leadership in Germany to go along with the developing program for the common currency as a quid pro quo to get permission to re-unite Germany, and get signed off as being a sov. nation. At the time Germany was still occupied by foreign troops as a defeated nation from WWII. The German leadership agreed, as they were passionate about re-uniting their country. Now we see the entirely unresolved, and indeed, un-resolvable situation coming to the fore again; the necessary differential between German, French, and Spanish, and etc., interest rates. This Chicken has come home to roost; Even a science fiction author couldn't invent a "solution" to this problem. The Euro will go down in history as another odd, un-realistic experiment in the world of Fiat Currencies.

NotApplicable's picture

Or war with a little famine. That does wonders for winning hearts and minds.

Aunty Christ's picture

Bruce, if these bonds price cheaper than 80%/20%, the arbs will buy these bonds and short the underlying (non-insured) bonds.

Bruce Krasting's picture

No problem. Just ban naked shorting.

But you make a good point. Does the existence of new enhanced Sov bonds make the old ones trade cheaper? If so, that is a nuclear problem. As old bonds get cheap it will force the uninsured portion of new bonds to get re-valued. One leg sucks down the other which in turn sucks down the first.

Captain Willard's picture

What follows is an possible explanation, not a justification:

They may be willing to make this trade-off (new issue versus seasoned) to keep the financing window open for all these countries.

The seasoned bonds would trade off, but would roll off the books as they mature. For countries with short duration of outstanding debt, this would only take 4-5 years ( a little longer for Italy I guess). They would be replaced by "insured" bonds in new auctions.

In the meantime, I guess thay would either try to re-capitalize the banks/insurance companies with the biggest exposures and hope for the best. The regulators are already overlooking these MTM losses, so the collective suspension of disbelief would just continue, albeit on a bigger scale.

But I cannot see this plan working without simultaneous bank/insurance company recaps and nationalizations.

Element's picture

As I pointed out about just above, with unemployment approaching true depressionary levels, and a global GDP slump in effect, all this talk is kind of beside the point ... none of it has worked, nor will work.

Yeah, you can make ponzi money off that, of course, but don't look for a 'workable' anything here.

This is a genuine debt-deflation. And it will have its way.

The politicians are along for the ride ... they just don't want to (dare not) admit this to the voters that they have COMPLETELY lost control of the economy, and the national policy direction and will, and their sovereignty, and the trust of the 99% ... and ... and ... etc.

They are terrified that everyone is about to realize this (or has) ... so they necessarily lie and fiddle, while Rome burns, and all they can do is throw more paper atop the Bonn-fire ... it's all they know, they have no answers, as these are not the people who will renew the system.

Anything they vomit-up in any emergency session, or meeting, or international 'agreement', will come to naught, every time. It's happening.

Until they're all swept aside ... and all those bonds go towards zero ... and most private banks are no more. The truth is than not only is the music synthetic and toxic, no chairs are there ... when that music finally stops.

masterinchancery's picture

At the big picture level, no scheme this complicated can possibly succeed, at least without many ugly unintended consequences.  And I very much doubt that the Germans are willing to lend their credit rating to such a scheme.