ESM - A Primer - Not So Big, And Not So "Paid-In"

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From Peter Tchir of TF Market Advisors

ESM - A Primer - Not So Big, And Not So "Paid-In"

So the ESM is going to be implemented ahead of schedule.  Or at least that is the current plan, although it seems that Finland is insisting that it retains unanimous voting and most (all?) countries still need to ratify it.

The ECB will oversee the ESM and EFSF, which is good as they have more market experience than the EFSF head, but does mean they will be reluctant to print which is what the market really wants.

I’m basing my analysis from an 11 page term sheet from March 2011. 

The ESM will have an effective lending capacity of €500 billion.  That document states that the lending capacity of €500 billion includes any capacity being used by the EFSF.  The EU statement confirms that.  So between EFSF and ESM, the combined lending capacity is €500 billion. 

“The ESM will use an appropriate funding strategy so as to ensure access to broad funding sources”.  So the ESM has paid in capital but it will continue to try and raise money based on guarantees and commitments.  I know this is a detail that people want to ignore in the rush to proclaim “paid in capital” but the reality is that the ESM is not so dissimilar from the EFSF.

Capital Structure

So let’s look at how the original ESM was designed.  By accelerating it, they may change the capital structure, but since that sounds like effort on their part, it is probably safe to assume the first attempt will copy the March plan.

“The ESM will have a total subscribed capital of €700 billion”   So far so good.

“Of this amount, €80 billion will be in the form of paid-in capital provided by the euro-area Member States”  (€700 billion of subscribed capital becomes €80 billion of paid in capital?)

“of which €40 billion bill be available from July 2013 with the remaining share being phased in over the three following years”  So at launch it would have €40 billion of paid in capital and then would add €13.3 billion per annum for 3 years?  Where is Jon Stewart when you need him.  He would do a much better job of making you laugh while he incredulously walks through how 700 becomes 40.

“In addition the ESM will also dispose of a combination of committed callable capital and of guarantees from euro Member States to a total amount of €620 billion”   This is beginning to sound more like EFSF than a funded vehicle that is bank-like.  I am not sure they meant to say “dispose of” – that makes me think of throwing something away, but then again, maybe it is just a Freudian slip on their part.

“The contribution key of …”    Straight from EFSF. 

There are provisions for capital calls if there would be losses that need to be paid.  It is unclear that they could make capital calls in lieu of trying to issue debt.  Though if they issued debt and couldn’t roll it, it looks like they could make a capital call.   Being able to call for capital if you can’t raise debt based on guarantees is hardly a smart ploy.  That is the death spiral scenario that has plagued EFSF – the concern that the cash won’t be there on guarantees when investors who relied on the guarantees need payment.

So the existing ESM looks like EFSF except that it has 8% of the lending capacity in cash up front.  Yes, 8% is paid in capital on day one.  It is not contemplated that it would have more than 16% of paid in capital.  Maybe the new details will be different, but I highly doubt it since the EU is big fan of providing guarantees rather than cash because the vigilantes have trouble tracking all the guarantees (once again, I ask how much has France guaranteed to the IMF, EFSF, EMS, EIB, EU, Dexia?).

Instruments

There is a lot of discussion about what the ESM can do.  Some will be superseded by the documents of last week that are meant to drive EFSF.  More ECB involvement in decision making, more flexibility, and less emphasis on the IMF.  That is all fine.  There is no mention of the ESM being able to use leverage.  There is no mention of either leveraging option.  If so, the ESM is then even smaller than the EFSF could be (theoretically since they haven’t demonstrated any ability to actually leverage the EFSF).

Private Sector Involvement

Gonzo.  German caved, so now private investors can never lose?  No, they just can’t be forced to participate as part of a bailout.  Since that hasn’t worked on Greece where bonds are trading below 40 and the haircut is at 50, it was never going to work as a formal procedure anyways.  Though removing it from here makes it even more unlikely that Greece will get banks to restructure without an actual failure to pay to force the issue.  Banks will understand that the pressure is on Greece and that so long as they keep delaying there is a chance they keep getting paid 100% of what they are owed. 

Preferred Creditor Status of the ESM

Say what?  Yes, ESM loans are meant to be senior to regular debt.  I’m not sure how that will work if they are buying bonds in the primary and secondary market, but it is their intention that any loans made by the ESM would be senior to other creditors.  Again, I don’t see how that could apply if they just buy bonds, but is worth considering.  It may be a reason that the countries are rushing to implement ESM over EFSF.  Maybe they think they are getting preferred creditor status?  That wouldn’t surprise me if they believed that and were trying to take less risk.  This may be dropped when they go through the ratification process but doesn’t really make sense since the policies have shifted more to involvement in the public bond markets rather than private loans.  If it isn’t dropped, bond investors will become concerned about getting subordinated. 

The ESM would be subordinated to IMF loans.  Is this why the national central banks are lending to the IMF who is then lending to countries?  Is it so that the IMF can get preferred creditor status?

Contribution Key

There is a contribution key.  There is a total of €700 billion of commitments (allegedly).  So why is the lending capacity only €500 billion?  I am assuming it is for the same reasons that EFSF can only get €440 billion of AAA rated bonds issued.  I am not sure if there are stepping out members (ie, countries that commit to give the big headline number, but then step out and don’t provide the capital).  We need more details on this.  It is possible that there is the potential for this vehicle to be bigger than €500 billion if all  commitments were done as paid in capital.  On the other hand, if they only get €40 billion up front, I don’t think they could get a AAA on even €440 billion of bonds to be issued (some of the AAA guarantees would be used up by their portion of the paid-in capital).  So the ESM may have an effective size of less than €470 billion, not the €500 billion everyone is talking about if they rely on guarantees to raise money.

Every step of the way, the headline numbers have never matched effective capacity.  Also, if France is downgraded, then ESM’s effective capacity is DOA unless they go for actual paid in capital.  I am not sure that countries will ratify a proposal that really makes them commit capital.

The ESM primer is useful to read...it is far less
impressive than the headline would make you believe.

On central bank loans to the IMF back to the countries,
is that a ploy so that the IMF can get seniority over existing bondholders and
gain direct control over budgets?  I've
been confused why the IMF needs to be involved and assumed it was a problem
with central banks lending money directly to countries.  Maybe that is the case, but maybe this is a
way to get more control over those countries, using IMF policies, and maybe the
IMF loans will in fact be senior to existing debt?  That might be cynical but would be par for
the course. 

On a side note, Europeans seem to love night clubs much
more than Americans.  Maybe that is why
they make all these announcements at 5 am? 
They are used to "table service" shutting down around that
time and having to make a decision of what to do next.  I can count how many good decisions I've made
at 4 am after an all-nighter on one hand. 
Why will this be any different. 
It feels to me like at the end they shrugged their shoulders and decided
to settle because it wasn't going to get any better and they didn't feel like
saying the night had been a waste.