Goldman's 10 Unanswered Questions On The European Bail Out And The Revised EFSF

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Buying stocks with the confidence that all has been resolved and all open questions have been answered? Or just doing it because everyone else is doing it, and there is "career risk" for those who actually sit to think what the events over the past 24 hours mean? It's ok if it is the latter: everyone else is in the same boat. After all the whole purpose of today's rally is to get everyone exposed the same way, so when it all crashes again, nobody can be singled out for having been contrarian. Why are we so sure? Because when even Goldman Sachs has at least 10 outstanding questions on not only the structure of the European bailout, but the layout of the revised EFSF, it is safe to assume that few have the answers (which, incidentally, don't exist). So in between chasing VWAP ever higher, it may be worthwhile to read these 10 questions which nobody has the definitive answer to. At least not yet. And whose answer is assumed will be a satisfactory one...

From Goldman Sachs

Last night’s announcement following the EU and Euro area summits was broadly in line with expectations. While progress in key areas was made, specific details are yet to be determined and further concrete measures are needed to address the Euro area’s economic challenges in a lasting way. With the PMIs now suggesting a Q4 GDP contraction, successful implementation of the summit agreement is needed to get the Euro area recovery back on track.

Our expectations leading up to the summit on Greece were largely met, with the announcement of a 50% haircut on Greek privately held sovereign debt within the PSI framework. So was the decision to recapitalise European banks.

The summit produced a positive surprise with the agreement to set up an SPV alongside the EFSF, as well as in proposing to have public guarantees to support bank term funding.

On the negative side, implementation risks surround some of the summit’s main conclusions. In particular, there are few details on how the EFSF will be leveraged. What we do know is that the leverage will be in the order of four to five times, and that it will occur through an SPV.
This week’s focus answers some key questions on the revamped EFSF, including its options for leverage. While the July 21 agreement has now been ratified, the details of the measures proposed last night have yet to be revealed, making the potential ‘firepower’ of the EFSF uncertain. In part as a result, we continue to expect the ECB to continue to backstop the Euro area financial system and keep the SMP active to the extent it is needed.

Euro-zone governments decided this Thursday to amend the EFSF through additional measures that will increase its scope to contain the Euro-zone debt crisis. How effective these measures will ultimately prove to be, and whether sufficient lending capacity can be raised to cover Italy also, remains unclear at this point. Given these uncertainties, we remain of the view that the ECB will continue to act as a final backstop for the financial system. Following the recent ratification of the July 21 agreement and the latest announcement of measures to leverage the EFSF, we address some key questions on the revamped EFSF in a Q&A format.

1. What is the EFSF, how big are its guarantees and who is liable?

The EFSF was set up in May 2010 to provide temporary financial assistance to Euro-zone countries facing difficulties accessing funding in the debt market due to “exceptional circumstances beyond such euro-area Member States’ control”. By providing this support, the EFSF aims to “safeguard the financial stability of the euro-area”. The EFSF is a temporary facility and, under current plans, will be replaced by the European Stability Mechanism (ESM) by July 2013. The EFSF was set up to relieve the ECB of the burden of purchasing sovereign debt through its Securities Markets Programme (SMP).

Each country’s share of the EFSF’s capital guarantees is determined by the ECB’s capital subscription key (the capital share of non-EMU member countries is ignored). Table 1 shows each country’s guarantee, incorporating the size increase agreed at the July 21 EU summit. The EFSF funds itself through the issuance of bonds backed by these guarantees, which are “irrevocable and unconditional”.

These are joint (but not several) guarantees for an amount up to the maximum guaranteed by each country. This means that each country is never liable for more than the maximum amount it has pledged. As an example, if the EFSF were to face losses on loans of, say, €100bn, Germany would, for example, guarantee all of the €100bn in the event all other countries were unable to honour their guarantees (not just €27bn of the €100bn, which would be Germany’s relative share in the EFSF guarantees). If the EFSF were facing loan write-downs of €300bn, and no other country were able to honour their guarantee, Germany would only be liable for its maximum pledge, €211bn.

2. What is the EFSF’s actual lending capacity and what happens if a country ‘steps out’?

While the amount of guarantees stands at around €780bn, the actual lending capacity of the EFSF is about €440bn. This is because in order to obtain the highest possible rating from rating agencies the amount of money spent is limited to the amount of guarantees given by AAA-rated countries.

In the event a country requires financial support from the EFSF, it can ask the other countries to “suspend its commitment to provide further Guarantees”, making it a ‘stepping-out guarantor’. Greece, Ireland and Portugal are already deemed ‘stepping-out guarantors’. The relative contributing share of the remaining countries is then adjusted accordingly, but the absolute amount of guarantees of each country remains unchanged. The overall size of EFSF guarantees decreases accordingly from the €780bn figure (and is about €726bn when Greece, Ireland and Portugal’s guarantees are deducted). However, unless the country seeking financial assistance is AAA-rated, the ‘effective’ capacity remains unchanged at €440bn.

3. What are the new powers of the EFSF following ratification of the July 21 agreement?

The EU government decided on July 21 to increase the “effectiveness” and “flexibility” of the EFSF, thereby allowing it to become active outside a specific loan facility agreement (i.e., a multi-year programme). This additional financial help can be provided under the so-called Financial Assistance Facility Agreements. The financial assistance can be used to recapitalise banks (although via a loan to a government rather than directly), and purchase government debt in the primary or secondary market, based on an analysis of the ECB.

The support provided under the Financial Assistance Agreements will still be conditional (although different from a full multi-year programme such as those to which Greece, Ireland and Portugal are subject), and the country requesting the help will have to enter into a memoranda of understanding (MoU) with the European Commission (in liaison with the ECB and the IMF). For those countries already covered by a programme (Greece, Ireland and Portugal), no new MoU need be negotiated and provisions to recapitalise banks are already included in their programmes.

4. How are EFSF decisions taken and what role do parliaments play?

All relevant decisions at the EFSF are taken by the board of directors. Each country will have one representative on the board—usually its finance minister. The board has to approve unanimously any decision that concerns any funding activity of the EFSF, as well as any change to the EFSF’s framework agreement. This includes any decision to intervene in debt markets.

In some cases, the board member will need the approval of parliament before casting his/her vote on the EFSF board. In Germany, for example, the Bundestag needs to be involved in any relevant decision. This can mean either that the approval of the budget committee is needed, or a full vote of the whole parliament.

5. What is the scope for extending an EFSF loan programme to Italy and Spain?

Of the €440bn in actual lending capacity, around €119bn have already been pledged (of which around €9bn has been disbursed, Table 2) to Greece (via its second bailout package), Ireland and Portugal, along with money coming from the IMF and the EFSM. While the size of the second Greek programme may still change, this means that about €320bn remain to finance other loan programmes, bank recapitalisations or government bond purchases.

If a similar loan programme to those agreed with Ireland and Portugal (which takes those countries out of the market for around three years) were to be extended to Italy and Spain, more than an additional €1trn in loans would be needed (Italy’s financing needs up to and including 2014 are about €650bn, while the equivalent amount for Spain is around €450bn). While the IMF would likely provide an additional 50% to the European commitments, the combined funds would still only amount to around half of the requirement, leaving no available funds for bank recapitalisations, for example.

6. How will the EFSF be ‘leveraged’?

Governments decided earlier today to “maximise the available resources” of the EFSF by introducing two different schemes that would allow the available guarantees to be leveraged, thereby increasing the overall amount of debt issuance that can be supported by the EFSF. Many of the concrete details are lacking, but the early announcement states that both schemes could be levered in the order of four or five times.

The first scheme would provide insurance for bond investors, such that the EFSF will take on a certain amount of the losses that investors would face in the event of a sovereign default. The insurance would apply to newly issued debt. Assuming, for example, that some €250bn of actual lending capacity is available, an insurance of 20% (increasing the EFSF funds’ scope fivefold) would imply that €1.25trn of peripheral debt issuance could be supported through this scheme. This would be sufficient to cover debt newly issued by Italy and Spain until the end of 2014. While insuring only newly issued debt would result in a two-tier market, if both Italy and Spain are perceived as fundamentally solvent (as we have previously argued), and the current high spreads in their secondary sovereign debt markets mainly reflect roll-over concerns, insuring newly issued debt should mitigate this concern, thus lowering the credit risk on currently outstanding debt.

The second scheme provides for the setting-up of a Special Purpose Vehicle (SPV) to invest in peripheral sovereign debt. The SVP will be funded through investments by the EFSF in combination with public and private financial institutions (e.g., sovereign wealth funds and the IMF). In order to make investing in the SPV attractive for investors, the EFSF would again be first in line in the event of a sovereign default.
The key implication of this leverage is that the EFSF would use more of its funds. While the current loan arrangements would yield some kind of recovery rate for the EFSF in the event of a programme-country default, the ‘leveraged’ EFSF would likely have a recovery value of its claims at close to zero. This makes the EFSF more risky for the guarantee countries, but extends the scope of the facility.

Yesterday’s summit did not specify the size of the insurance to be provided to investors, although the scope of the leverage suggests it would be around 20%-30%. While a higher insurance rate would make investing in newly issued debt by insured countries more attractive, it would also narrow the scope of the EFSF. It is likely that a critical level of the insurance percentage exists at which the demand for insured debt would be material. This critical level would likely be inversely related to a recovery rate of this debt. The lower degree of ‘leverage’ of insuring, say, 40% of newly issued debt rather than 20%, for example, could be countered by attracting more private investments through the SPV. And a smaller effective 40% insurance scheme would be preferable to a larger, but ineffective, 20% insurance scheme.

7. Will there be enough buyers for credit enhanced peripheral debt?

This remains to be seen and the effective appetite of investors will depend on several variables, not just the size of the insurance provided. We mention here just one example of potential practical problems: for some investors, the credit enhancement provided by the EFSF implies that the underlying sovereign debt will become a credit derivative from a regulatory point of view. However, the regulatory guidelines with respect to credit derivatives make it more difficult for potential investors to allocate capital towards these instruments. While this might only be a minor factor, it nonetheless exemplifies the difficulties in estimating ex ante the demand for these credit-enhanced bonds.

8. What are the implications of a leveraged EFSF for government ratings?

While the insurance scheme does not change the overall amount of guarantees provided, it does change the risk profile of these guarantees, given the likely smaller recovery value. Consequently, the increased credit risk will weigh on the underlying credit rating of guarantor countries. Recent statements suggest that rating agencies will take a fresh look at sovereign ratings once all the details are available.
While a downgrade of any of the AAA-rated countries is anything but a given, this nonetheless poses a risk to the whole scheme. A potential downgrade of France, for example, would reduce—all else equal—the effective lending capacity by France’s share of EFSF guarantees.

9. What other options exist to increase the EFSF’s lending capacity?

At least in theory, there are several other ways to increase the lending capacity of the EFSF even further if this should become necessary:

  • More guarantees. Countries could be asked to increase the size of the guarantees they provide to the EFSF. Such an increase in guarantees would, however, be politically very difficult. Moreover, an increase in the implicit guarantees would weigh on the rating of guarantor countries.
  • Guaranteeing maximum interest rate. The EFSF could guarantee countries a maximum interest rate level that they would need to pay on newly issued debt. Such a scheme would pay investors the market interest rate but the respective peripheral government would need to pay only the lower guaranteed yield. This would imply that the debt dynamics of that country would, at least as far as interest payments are concerned, be decoupled from market movements.
  • A lower EFSF rating. The actual lending capacity could be increased by accepting a lower rating for EFSF bonds. A lower rating would imply that the guarantees provided by most the non-AAA-rated countries would also become ‘effective’ as a backstop for EFSF bonds. However, a reduced rating would imply higher funding cost for the EFSF, thus raising the interest rate charged to programme countries and reducing the overall benefit of the programme.

Non-AAA-rated countries are the most likely recipients of EFSF funds. In the event Italy and Spain were in need of funds, this would result in a reduction in the overall size of the EFSF of around 30%, thus significantly reducing the benefit of using non-AAA-rated guarantees.

•  Bank licence and ECB funding. Providing the EFSF with a bank licence and allowing it to repo its bond purchases at the ECB would increase the size of the EFSF’s lending capacity significantly. In fact, a banking licence would not be very different from the ECB’s current SMP, implying—at least in theory—a non-inflationary lending capacity that could easily cover all of the periphery for many years.

While funding the EFSF through the ECB would certainly be an effective way to end all questions about the EFSF lending capacity, the ECB has rejected this idea and Euro-zone governments have decided, at least for the time being, not to pursue this route further.

10. Will the ECB continue to backstop the financial system?

Whether the increase in the EFSF’s indirect lending capacity will lead to a stabilisation of the situation depends on several factors, and there is no guarantee that the revamped EFSF will instil sufficient confidence among investors. We therefore think it will be crucial for the ECB to continue to play its role as fall-back option in order to prevent a systemic event. The expanded EFSF is now the first line of defence, but its success also depends on the implicit understanding that the ECB act as a final backstop for the financial system through its various non-conventional measures. We continue to think that the ECB will remain active in containing financial market uncertainty, in particular by remaining active in the bond market through the SMP (although the size of its interventions may vary).