Goldman On Europe: "Risk Of 'Financial Fires' Is Spreading"
Germany's recent 'agreement' to expand Europe's fire department (as Goldman euphemestically describes the EFSF/ESM firewall) seems to confirm the prevailing policy view that bigger 'firewalls' would encourage investors to buy European sovereign debt - since the funding backstop will prevent credit shocks spreading contagiously. However, as Francesco Garzarelli notes today, given the Euro-area's closed nature (more than 85% of EU sovereign debt is held by its residents) and the increased 'interconnectedness' of sovereigns and financials (most debt is now held by the MFIs), the risk of 'financial fires' spreading remains high. Due to size limitations (EFSF/ESM totals would not be suggicient to cover the larger markets of Italy and Spain let alone any others), Seniority constraints (as with Greece, the EFSF/ESM will hugely subordinate existing bondholders should action be required, exacerbating rather than mitigating the crisis), and Governance limitations (the existing infrastructure cannot act pre-emptively and so timing - and admission of crisis - could become a limiting factor), it is unlikely that a more sustained realignment of rate differentials (with their macro underpinnings) can occur (especially at the longer-end of the curve). The re-appearance of the Redemption Fund idea (akin to Euro-bonds but without the paperwork) is likely the next step in countering reality.
Section 4 below is the most critical to understanding the pitfalls of the consensus thinking...
1. EFSF Has Helped Contain Tensions in Peripheral Hot spots
The EFSF, which became operational in August 2010, was the first authority empowered to redistribute fiscal resources to support adjustment programs across EMU member states. The Facility has EUR54.5bn in bonds outstanding (including EUR30bn as part of the Greek debt exchange) and EUR8.9bn in bills. Earlier this month, it was authorized to raise a total of EUR241bn. This amount exceeds the aggregate committed capital to the three program countries by roughly EUR50bn, partly to provide for liquidity buffers. By comparison, the amount of bonds outstanding from the European Investment Bank—another supranational issuer—is in the region of EUR405bn.
The EFSF supply replaces the market funding programs (covering amortizations and deficit) for Greece, Portugal and Ireland. Thus, from a flow perspective—and taking into account that most EMU countries are reducing their borrowing requirements—the net supply of EUR government bonds available to private investors is declining.
The stock of Euro area government debt has increased substantially in the wake of the 2008 financial crisis, as has been the case elsewhere. Reflecting a process of ‘mutualization’ of the debt owed by the smaller issuers through the EFSF, the average quality of the pool of investable Euro area securities is progressively being upgraded. The ECB has contributed to this dynamic by removing around EUR200bn-worth of debt from private hands through its Securities Market Program (EUR150bn of which are Italian and Spanish bonds).
The EFSF issuance does not constitute a ‘Eurobond’, defined as a claim backed jointly and severally by the EMU countries. Rather, investors in EFSF securities effectively hold a (credit-enhanced) portfolio of Euro area sovereign issuers, excluding those currently under financial assistance programs. The country allocations of the portfolio map the ECB’s ‘capital key’, which roughly correspond to GDP size. Relative to a bond market capitalization, the capital key over-weights Germany and under-weights Italy.
The EFSF has no paid-in capital, but rather is backed by financial guarantees (amounting to EUR726bn) that exceed the maximum lending capacity of the facility (EUR440bn, corresponding to the sponsorship of the highest rated countries). After the downgrade of France, the weighted average rating of the sovereign guarantors is AA minus, and the weakest constituent (Italy) is rated BBB. EFSF long-term bonds are currently rated AA+ by S&P, and have the highest rating by both Moody’s and Fitch.
The EFSF securities currently span maturities ranging between 3 months and 20 years. They trade below the Euro-swap curve at the short end, and around 100bp above it at the long end. Benchmark 10-yr EFSF bonds currently trade around 10-15bp above the corresponding maturity government bond issued by France—the closest rated core sovereign issuer. EFSF bonds are also broadly aligned with the weighted average funding cost for the facility’s sovereign backers, indicating that the benefits of over-collateralization and the costs of lower liquidity broadly offset each other (the Facility lends on to program countries at funding costs plus operational costs, and the recovery on loans is assumed to be zero by rating agencies). If bond yields move in line with what our valuation work suggests, EFSF securities should increase in value against the Euro-swap curve, and trade tighter in relation to France.
Demand for EFSF bonds from the first issuances has been split as follows: 46% to the Euro area, 33% to Asia and 10% to the UK. Central banks and Sovereign Wealth Funds purchased 38% of the bonds, with banks buying another 29% (see charts on the next page). The share acquired by Euro area financial institutions has progressively increased, as investors in the core countries switch away from low-yielding German Bunds in favor of securities that reflect the sovereign risk syndication being conducted directly through the fiscal schemes and indirectly on the ECB’s balance sheet.
2. Two Ways to Increase Pressure in the Fire Hydrants
Pressures to increase the EFSF’s endowment at the height of the sovereign crisis last year eventually resulted in allowing the Facility to leverage its resources. This has now been crystallized into two Special Purpose Vehicles (SPVs): a European Sovereign Bond Protection Facility and a European Sovereign Bond Investment Facility. The first scheme aims to provide partial risk protection certificates for sovereign bonds (i.e., a ‘first-loss insurance’ scheme). The second is a co-investment fund open to both the private and public sector dedicated to EMU area government bonds.
We assessed the idea of ‘first loss protection’ favorably when it was first circulated last year. The advantages of ‘credit wrapping’ new issuance of government securities are associated with the combination of a credit risk transfer from the guaranteed sovereign to its guarantors (the AAA-rated backers of the EFSF), which, in turn, benefit from a decline in systemic risk; and the reduction in refinancing risk accruing to the previous bond holders, which over time mitigates the potential segmentation of the market.
However, faced with the largely unquantifiable risks stemming from a potential breakup of the monetary union, the scheme has become less appealing to investors. The Protection Facility has other shortcomings too. Based on the rating agencies’ published methodologies, the rating impact of a higher recovery assumption in the case of Investment Grade securities is small (a 1-2 notch increase at most), hardly changing the position of countries such as Italy or Spain. Particularly if associated with multiple instruments, the protection certificate could be treated as a derivative instrument in banking books, rather than a ‘financial guarantee’. As such, it would fall under mark-to-market rules, with detrimental impacts on demand.
The Sovereign Bond Investment Facility is a more interesting proposition, especially if directed at the primary market. The first loss tranche is remunerated at the EFSF’s cost of funds. This is to the advantage of senior investors, who access a levered return (maximized by the Facility’s manager under a set of guidelines) with lower risk. As an example, Italy’s main fiscal problem pertains to its high debt stock, which needs to be rolled over. The SPV could cover 2 years’-worth of Italian medium-to-long-term maturity bond supply (around EUR400bn). The ‘equity’ tranche could amount to 30% (or EUR120bn), the ‘senior tranche’ could be 50% (EUR200bn) and the remaining ‘super senior’ tranche 20% (EUR80bn). Assuming a recovery assumption of 50%, the expected risk-weighted returns accruing to the senior tranche are attractive. For reference, EFSF July 2021 trades at 3.0%, while BTP August 2021 trades at 4.9%, and 10-year EUR Libor at 2.3%. With the capital allocation used in this example, the expected return on the senior tranche is around 220bp over the BTP, with a higher recovery.
So far, however, it is not clear who would participate in this SPV. Suggestions that sovereign wealth funds and/or the BRIC countries could become potential investors have not led to reported progress and have overlapped with demands for higher contributions from the BRICs to the IMF. Seniority considerations, the legal regime that governs any shortfall and the mechanism for a possible transfer of the participation from the EFSF to the ESM would need to be clearly spelled out for the scheme to work.
3. The ESM—The Permanent ‘Fire Department’
The European Stability Mechanism, or ESM, is a permanent facility that will replace the EFSF from July 2012. The ESM will have an initial lending capacity of EUR500bn (reviewed periodically) and a total subscribed capital of EUR700bn, of which EUR80bn will be in the form of paid-in capital to be phased in with a maximum of five installments.
Under current agreements, the consolidated lending capacity of the EFSF and ESM cannot exceed EUR500bn. But the authorities are actively discussing whether this limit can be increased by combining resources, even though it may not be for the entire capacity of the two funds (EUR940bn). One possibility could be that EUR500bn from the ESM will be added to the existing commitments of the EFSF (EUR17bn for Ireland, EUR26bn for Portugal and EUR102bn for the second Greek package), or to the EUR241bn the EFSF has already been authorized to issue. A decision is expected at the Finance Ministers’ meeting on March 30.
Increasing the total amount of the combined EFSF and ESM fund could have positive effects on the valuation of EFSF bonds, as a greater potential for sovereign credit risk syndication can lower the yield differential between constituents—in practice, German bonds would lose value, while those of Italy and Spain would increase in value. However, a number of issues that could affect the liquidity of the EFSF bond market still need to be addressed. Also, EFSF bonds will be close, but not perfect, substitutes of ESM bonds, because the two facilities enjoy different creditor status.
On the first issue, it is not yet clear what the EFSF’s role will be after July 2012. The EFSF will remain in place until the last bond issued matures. But it has not yet been decided whether new lending programs starting after July will come under the ESM, or whether the EFSF will be able to continue issuing bonds of existing programs. This decision will affect the depth of the EFSF bond market.
On the second issue, both EFSF and ESM loans are junior to IMF loans. However, while EFSF loans have the same creditor status as other sovereign claims on a country basis (pari passu), ESM loans enjoy preferred creditor status over other sovereign claims. This clause does not apply to ESM loans relating to a financial assistance program that came into existence before February 2, 2012, when the new ESM treaty was signed. Hence, while in theory ESM bonds have a better credit status than those issued by the EFSF, in practice this will depend on whether or not lending programs to countries other than Ireland, Portugal and Greece will be activated.
4. Too Much Combustible Material Still Around
The Euro area is a financially closed region, with more than 85% of sovereign bonds held by residents of the area. If we add to this the fact that most claims against governments are held by financial institutions domiciled in the area, the risk of ‘financial fires’ spreading is high. The prevailing policy view that bigger ‘firewalls’ would make investors more comfortable about purchasing sovereign bonds of EMU countries. This is predicated on the idea that the existence of a funding backstop would prevent credit shocks in one of the EMU members from spreading to other issuers. That said, we doubt the current infrastructure can produce the same effects on markets as the ECB’s long-term liquidity injections (LTROs). Our view is based on the following considerations.
- Size: Even if we combine the full uncommitted capacity of the EFSF and the ESM (EUR700bn), the total would not be sufficient to backstop the bigger markets of Spain and Italy. The former’s borrowing requirement (amortization plus deficit) over the next two years is EUR305bn, while the latter’s amounts to EUR525bn.
- Seniority: The ESM holds ‘preferred creditor status’ over existing bondholders (art.13 of the Treaty establishing the ESM). In practice, this means that if the facility is used to provide an EMU member country under conditionality, it would subordinate existing bondholders (twice, if the IMF also participates in a bailout). Given that investors are aware of this, they would require compensation to bear such risk. This could exacerbate, rather than mitigate, a crisis.
- Governance: The existing vehicles cannot intervene pre-emptively in markets at signs of tension. Rather, they would be activated only after a full crisis has erupted. The procedure envisages that the ECB would ring an alarm bell should tensions threaten the stability of the Euro area. The sovereigns experiencing tensions would need to formally ask for help, and sign a memorandum of understanding, before any financial support can provided. Admittedly, a ‘fast track’ option is also available, based on ‘light conditionality’ and allowing the EFSF to intervene in secondary markets. Still, the fixed size of resources could raise questions on the effectiveness of the operations.
5. What Could Help?
As we have indicated in previous research, based on relationships with relative macro and fiscal factors prevailing over the past 20 years, Italian government bonds should currently trade around 130bp over their German counterparts, and Spain at 200bp over Bunds. These spread levels are well below the 320-350bp prevailing at the time of writing. By reinforcing the notion of a ‘conditional mutualization’ of sovereign EMU debt, the expected increase in the size of the firewalls could help stabilize inter-country spreads. But for the reasons mentioned above, we doubt this would lead to a more sustained realignment of rate differentials with their macro underpinnings, particularly at the long end of the curve where uncertainties surrounding subordination are particularly acute.
We would therefore advance two ‘normative’ considerations:
- At this juncture, Spain remains under close scrutiny because of the interplay between the recapitalization of the non-listed banks (saddled with exposure to the housing sector, which has deteriorated on the back of the increase in unemployment) and the challenging fiscal targets that it needs to meet in 2012/2013. On 30 March, the Spanish government will announce the 2012 budget, which should remove part of the uncertainty around the size and quality of the fiscal measures. But concerns about the recapitalization of the non-listed banks are unlikely to diminish any time soon. We have long been of the view that an agreement between the Spanish government and the EFSF to support the recapitalization of the banking sector would be a productive use of pooled fiscal resources. It would avoid an increase in the funding needs and borrowing costs that Spain would face if it had to recapitalize banks using funds from the FROB. In this way, Spain could take advantage of EFSF funds, avoiding the ‘stigma’ of a macro-economic adjustment program, while the planned restructuring/recapitalization would be reinforced by external incentives and controls, and EMU-wide resources would be directed at one of the obvious sources of weakness of the common currency area.
- More broadly, we continue to think that a more direct approach to the ‘debt overhang’ problem affecting the Euro area would remove ‘combustible material’ and speed up the recovery. In this context, the proposal advanced by the German Council of Economic Advisors to set up a Euro area wide Redemption Fund appears to be one of the most promising. We plan to elaborate on this solution in forthcoming research, but the outline is fairly straightforward. The Council suggests creating a fund that would be jointly and severally guaranteed by EMU member countries, in which each participant would transfer government debt (ideally across the maturity structure, and in parallel with ongoing market access) in excess of 60% of GDP. Countries would pledge collateral to the fund, earmark revenues of a specific tax, and commit to repaying their liabilities over a long period (20-25 years). Alongside the fiscal compact and debt brake rules, this initiative has the merit of finally establishing a liquid security (the expected float is in the region of EUR2.5trn) which would reflect the Euro area’s comparatively high aggregate credit quality and thus represent a sound ‘store of value’.
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