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Leverage: Yesterday's Problems, Today's Solution
Via Peter Tchir of TF Market Advisors
All the markets continue to bask in the glow of the new improved EFSF. From a low of 1115, the S&P futures are now trading at 1175. A pretty impressive 5% move. Stocks in Europe are doing even better and credit is following along. By now I would have hoped to see some details of this alleged new beast that EFSF has morphed into. While I search for detail all I could see, so far, are denials by Germany and Spain, some support from Austria, and additional rumors of what is to come. Every European politician outside of Germany can say this is a great idea, but if the money man doesn’t go along, is there really a deal? This isn’t a democracy, and only Germany controls German money. There was a brief headline that this new plan could cause S&P to downgrade Germany and France. As a back-up plan, there is talk about letting the EIB do the heavy lifting. Just in case the world wasn’t already controlled by enough 3 letter entities, welcome the EIB to the IMF, ECB, and FED party.
The market is clearly in rally mode, but we have been there before. After the July bailout the S&P got as high as 1345 and the DAX got as high as 7350. I guess you could view those as targets that could be reached if the bailout is finally successful. Given all that has gone on in the market and the economy, I don’t think a successful bailout would send us anywhere close to those levels. More importantly, I think the point to take away from that is how wrong the markets have been in the past in response to bailout rumors.
I felt we were so close to ending this charade of kick the can. The bad countries and banks were going to be allowed to fail, and the process of rebuilding a stronger, better financial system was upon us. I’m scared that I am wrong. That the politicians are flinching and will make this far worse, far sooner, than even the “doomiest” of the” doomers” predicted.
Let’s take a moment and figure out why we are here. Why is EFSF just not being expanded? Wouldn’t it be easier to just increase the size of the EFSF? It would be, but there is no support to get that done. So the group of bankers and politicians who do not have the courage to attempt to draw a line in the sand and attempt to fix the existing problem have embarked on a new crusade. The crusade is to come up a €2 trillion plan that will for once and all make Europe safe again. They have their goal and after being told, in no uncertain terms, that they wouldn’t get that much money, they put their thinking caps on. They started to figure out creative ways to turn the €440 billion they think they can get their hands on, and turn it into €2 trillion.
There are several ways to accomplish this “miracle of finance”. There are a couple of ways that the EFSF could be used to create leverage. The potential to provide “equity” capital to the EIB would be another way. We will start with the EFSF.
The EFSF Cannot be a Cash Flow CDO
Using the EFSF construct, one option would be to create a true CDO. Let the EFSF be the “first loss” tranche, and raise actual senior debt. In an ideal world, the EU would want to create a Cash Flow CDO. On a cash flow CDO, there is no trigger mechanism for the senior debt, other than defaults in the underlying portfolio. A cash flow deal is unlikely to get approved, since the range of assets the EFSF wants to purchase isn’t diversified enough. They won’t have a complete portfolio on Day 1, which is also an impediment to the Cash Flow CDO rating methodology. The rating agencies would also be too restrictive on what the EFSF could purchase. Providing equity to banks would cause too many problems for the methodology. In the end, the EFSF would have to go down the path of a Market Value CDO.
A Market Value CDO or SIV “Solution” for EFSF Likely Ends in Disaster – Sooner Rather Than Later
Market Value CDO’s and SIV’s allow a vehicle to have the most flexibility. There are very few restrictions on what the vehicle can purchase – which would suit the new EFSF well. The amount of leverage is controlled by what is being purchased – more leverage for higher quality assets, and less leverage for weaker assets. That is workable as the EFSF would need more leverage to buy lots of relatively high rated Italian debt, and less leverage for direct capital infusions into banks. So far, so good. The problem with Market Value CDO’s and SIV’s is that they require capital infusions or risk reduction when market values decline. The ECB can ignore the fact that its purchases are all under water, but a Market Value CDO cannot ignore that. We have seen over and over again what forced selling does – SIV’s, Bear Stearns Credit Hedge Funds, Leveraged Super Senior, CPDO, etc. This is a recipe for ultimate disaster. If the CDO gets set up and purchases assets, it will be at risk of another downturn. Any time the portfolio declines in value, the “first loss” holders could top up their tranche, or they could sell. Since the EFSF would be so large, any forced selling would cause pandemonium in the market. The “only” viable option would be for the EU members to put more money into the “first loss” tranche. This would spiral until either those countries couldn’t raise any more money or the currency is so devalued that it is all pointless anyways to the ordinary citizen as inflation runs rampant. This propensity to “top up” will certainly be taken into account by the rating agencies – and not in a good way.
But let’s assume they decide to go ahead with the methodology. That the EU “knows” this is as bad as it can get, and if they just create this, the shorts will panic and Europe will be okay. Not that any prior plan that viewed the problem as something caused by pesky shorts or lack of liquidity has worked, but yeah, let’s pretend that they can convince themselves this time is different.
Who would buy the AAAA+ senior notes? One possibility is that European banks would buy the senior debt. That is a bit too circular, and the only way banks could do it and earn positive carry, is to take interest rate risk. They could buy longer dated, fixed rate assets, and fund them short term. That would only add to the misery, if and when, the vehicle had a deleveraging event and/or inflation hit. In an ideal world the BRIC’s would be big buyers of the second loss notes. On the surface, it seems like a good deal for them. They would get diversified exposure to the Eurozone with 20% subordination. The problem with that analysis, is that everything in the vehicle is 100% correlated (creating the vehicle increase the correlation within Europe). Normally a second loss investor in a market value CDO is comfortable, because they can take over the assets and manage them to control their risk once enough of the “first loss” is wiped out. That works well when the assets are not highly correlated and are not directly correlated with the first loss providers. What would the BRIC’s do, take over all the bonds in the CDO and try and collect on them? They know that by the time they get control of the assets, they will be worthless. This is like a CMO of BBB tranches of other CMO’s. They seemed diversified, but in fact weren’t, because all the BBB tranches got in trouble at exactly the same time. That is why AAA rated tranches of CMO^2 (CMO Squared) deals like ABX went from par to zero so quickly. It is how hedge funds made fortunes. I think selling the second loss tranche will be more difficult than people realize, because the safety of being second loss is an illusion. If there ever was an unwind event, it would be because the EU wasn’t willing to top up the first loss, ensuring the value of the bond portfolio has no value. Unlike corporate CDO’s, the second loss holder would have no one to suit to fight for rights they don’t have.
Ignoring the potential difficulties in selling the second loss notes (notice how easy it is to move forward if you just decide to ignore potential pitfalls) who would buy the first loss notes? Would any investor buy the notes based on the guarantees? Would the notes still get a AAA rating? The best case would be that investors believe the “first loss” tranche is likely to experience no losses. Since the stated purpose is more political than economic, that would be a bad assumption to make. You have to assume, to be prudent, that the EFSF will make some bad purchases. It will pay too much for assets (possibly on purpose). It will make some equity injections that lose value. You have to assume that you will need to rely on the guarantees. You cannot assume that the investment will return par, without the guarantees. Do you want to rely on the guarantees? I wouldn’t. By the time you are trying to collect on the guarantees, given the 100% correlation of the assets and the guarantors, you have to assume, you will struggle to collect. Unless you can get equity like returns from this investment, you shouldn’t buy the new “first loss” notes. Paying that sort of return would defeat the purposes, so ultimately, the countries will have to fund the EFSF directly. €440 billion of money will have to come from the countries backing the EFSF. That reduces the leverage right there. In the original construct, they planned on using guarantees to raise money from outside sources, in order to buy bonds. Now that first loss has to be funded, it is only the second loss money that provides new money to buy bonds.
So, bond investors and the rating agencies, will just applaud this action? No! The rating agencies in particular will be forced to downgrade some of the biggest countries. They will use draconian assumptions (or just realistic ones) and assume the funds that go into the EFSF will be lost. They will count them against the debt outstanding of each country. In most cases, depending on who actually puts up money, that will increase the Debt to GDP ratio by 10% to 20% for each country. For France and Austria, that assumption alone could cost them their coveted AAA rating. The rating agencies also need to take into account what this means going forward. They have to reach the conclusion that the countries are throwing away prudence. The agencies will figure out that they cannot analyze even Germany as a standalone country because it is willing to fund the weakest countries at any cost. The rating agencies are always big fans of “weakest link”. How can they really say that French or German budgets are okay, when they are willing to throw money at Greece, Portugal, and Ireland at the drop of a hat. Until now, there was at least a pretense that they were being careful.
If the AAA countries get downgraded once the plan if formalized, how long before we are hitting the unwind triggers? The agencies couldn’t take down the AAA countries only, they would also ratchet down the ratings on other countries. That could start the downward price action that trigger the unwind spiral. This plan relies on so many assumptions to work that it is unlikely to get done, but if it does, I think it will actually accelerate the demise of the entire Eurozone rather than protect it. I find it easier to see many ways that the “defensive perimeter” and “ring fence” strategy can lead to ultimate long term solutions; whereas, the CDO methodology leads to ruin much easier than people realize and doesn’t provide a long term fix.
Repo Agreements create the Same risks, they just shift who holds those Risks
If the CDO methodologies don’t work, what about having the EFSF just repo bonds to create leverage? So the EFSF buys €440 billion of Eurozone bonds. Then it goes to the ECB (who always has money?) to repo the bonds. The ECB provides say 5:1 leverage, so gives the EFSF €350 billion (440 * 80%d). The EFSF then spends that €350 billion to buy more bonds, which it also repos with the ECB. You can probably get a portfolio of about €1.6 trillion by repeating the process 5 times. Problem solved, right? Well, not exactly. Any repo agreement I ever heard of requires additional margin to be posted if the portfolio has losses. So it would look just like the market value CDO described above. They would either have to unwind as the portfolio lost value or the countries would have to post more money to the EFSF. The “repo” methodology is definitely simpler, but ultimately the risk/reward is the same as a SIV and I don’t think that works long term. It certainly triggers rating actions. With the ECB holding the entire second loss portion, I would expect the Euro to weaken and gold and commodities to do well, as fear that the ECB would have to print its way out of any problem take hold. If the ECB holds the second loss, that is the endgame. The timing may be uncertain, but no way around it.
Alternatively, the ECB could provide “non recourse” repo agreements. Then the ECB would take the losses. The EFSF wouldn’t have to sell into a weakening market. The EFSF wouldn’t have to post additional money to keep the trade on. Once again, this seems clever, but the reality is the same, just all of the losses and risk have been pushed on to the ECB. The ECB does seem to have the ability to hold assets that aren’t marked. But how does it actually fund these assets? If it’s not just printing money, then who do they borrow from? Right now they have lots of cash as companies and banks have been putting money on deposit with them. That money, unfortunately, is all short term money. If the ECB plans on running a large, long dated, non recourse repo facility, they had better have locked in some long term funding. Since that would defeat the goal of the exercise, they won’t. So now instead of forced selling in and sort of Market Value CDO solution, you will have forced printing by the ECB. When the market for Eurozone bonds declines again, the ECB will have to print money to maintain their massively underwater portfolio, or make a capital call on the member countries. The capital call is identical to what would have occurred in a SIV solution. Nothing has changed. The problems are the same, it is just the names of the entities that bear the risk that has changed, and the different accounting and legal tricks they can use to obscure the risk from the market.
Other than creating a further layer of obfuscation, the EIB solution changes nothing
Which leaves us with the EIB solution. Who doesn’t want to run an investment bank? It’s sexy and fun and pays a lot and has great perks. Sending the money to the EIB would great one of the best political patronage opportunities in a lifetime. Who wouldn’t want an investment banking job where making money isn’t even part of the job description? Since 2007, more time and effort has been spent extolling the virtues of the “bad” bank, and yet none has ever been created on any scale. I highly doubt this time will be different, and in the end, the EIB will face all of the problems mentioned above. Leverage does not come without risk or without cost.
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I was hoping for a one line explanation of leveraging up an expanded EFSF
As an example Karl Case just explained the good news of his just released Case Shiller index "very encouraging as long as sales go up and inventories continue to fall"
You ever work with X3 leveraged ETFs?
It's like that except there is no sell button and the leveraged captial decay is measured in seconds instead of minutes.
But we'll all pretend that doesn't happen, until they build the badder bank.
The LiesMan Plan - from Macro Man - not one line but one chart
http://1.bp.blogspot.com/-cWpEWnV0CvQ/ToGjELGxNpI/AAAAAAAAAtA/HuEfulkqPq...
Analysing the latest battle plan3 month old news now drives todays markets.
Their idea is that they will create a "Bad Bank" with any money given to the ECB bail out fund.
This "Bad Bank" will then use its original bail out funds asking the ECB to lend more in order to lever 55% to 75% of its holdings to create additional "firepower".All guaranteed by the ECB and its members.
Basically it would be a repetition of Obama's TARP.
This would put German taxpayers in a very happy mood.
In addition they would need a banking license for this move which will be hard to come by.
I do not think that this could pass the German supreme court let alone parliament without setting a curfew and arresting thousands of people.
same mistakes over and over, time to pluck a pidgeon.
http://expose2.wordpress.com
Now look, S&P will review Germanys AAA if they say yes to the EFSF expansion. Euro-Bonds anyone? Muahahha.
If only the 2008 TARP had been used for Good instead of Corruption
I agree, there was so much potential for that capital in the real economy, too bad it all got sucked into the liquidity trap of the kleptocrats and now the average taxpayer is stuck paying for it.
Anagrammatical truth in advertising, that.
Well now that markets have priced-in 5% gains on this 'New Miracle Plan' can we see ONE detail of it please??
LOL what a crack-up.
Here's the one and only detail: Hopium
(Actually the finmin said, there's no plan to leverage EFSF, but (german) traders say: "but we hope, that it might come true, anyway!)
Printing 101:
1) Create a lot of dodgy subprime debt.
2) Bundle the debt into a CDO/MBS/EFSF structure
3) Sell the snake oil as an "innovative solution", "European Solidarity" to the bad debt problem
4) When it crashes down claim systemic risk
5) Print
So basically, the EFSF is 440 billion euros of borrowed money from the Eurozone countries. They now want to take that borrowed money and issue bonds that the banks would purchase. And then, the EFSF takes that new money and floods the financial system with it?
Does I have this right?
sadly i think you do, and it has added a trillion to global stock markets?
So everyone gets the same relative downgrade and hence nothing changes. Can kicked-winning!
If wishes were horses then beggars would ride...
Hey I GOT it!
What you got, man?
Well, remember that thing that caused it all to crash last time? That 'leverage' of everything under the sun?
Oh right I remember, I heard Hank Paulson before congress talking about how we REALLY learned our lesson this time, and would certainly NEVER do that again.
Well, I got an idea, lets do THAT again, except this time....WAY BIGGER!
Oh yea, BRILLIANT!!
So fucking sick of the rumors and games. So later this week efsf is declared Doa and the markets crash only o have them come back and speed same rumors to pump it again?
Thats what it looks like to me!
Just let the IMF do to Europe what Europe did to Korea back in 1998 and everything will be just fine.
A higher gold price fixes this mess by giving greece an asset to balance its debt. But let the morons try everything else first. Fucking simpletons trying to warp economic law out of petty bias.
Gold is king. Accept or perish from your own stupidity.
The rumors and games are for end of year bonuses...no more... no less...
Let No Man stand between a banker and his bonus less he be put asunder!
Theres ALWAYS a present reason for market games, daily reports, electioneering season, options expiration day, 'Its Monday'...'Its Friday', Its a day between Monday and Friday.
Indeed. There is always a really scary reason for the dip you should be buying.
Because the only thing better than failing is failing even biggererest!
Just a Market going through death spasms is all.
Like that trader guy on BBC yesterday said, no one believes in this crap everyone knows the markets are dead, plan for it.
My Lord, these guys will stop at nothing if it extends the politically half-life by 1 to 2 years.
Every day I pray for a miracle market crash, something to come out of left field to reset this entire mess. Nothing will fix these problems by layering more debt upon debt.
Why don't we just give all this money to Africa? $2 trillion buys a lot of food and water and would get more use than going into some investment bankers' bonus checks.
Except maybe they dont need another 1 or 2 years, and this is just for this week.
Because they're black.
Ha. Junked myself.
Germany's "outrage" about EFSF is like when Congress says they're "outraged" about hiking the debt ceiling. They know they're going to do it, they need it, their jobs depend on it and ultimately it enriches themselves. They can pretend.....so can I
Yea got to love the mouth foaming 'outrage' politicians always have about placing more debt on americans, right before the vote themselves the standard $20,000 pay raise as well as raising the debt limit.
trillions of monies, monies for me, trillions of monies, monies for free!!!!
Even the talking heads on CNBC asked the question, Where will the Eurozone get the money, thin air? I think we all need to start playing by the big bank rules. If you have $10k that means you can buy $1 million worth of stuff. When the bill comes you use legal zoom to create a corporation and use it as an SPV to purchase all your debt. The corporation holds the debt but you get to keep the stuff.
To end this farce every single person needs to stop paying their credit cards and stop paying bills. Before you do that though each person should run them all to the limit. Leave the banks with billions of debt just as they took our money to fund their deals gone bad. Everyone with a mortgage needs to stop paying it as well. That is the solution.
The banks broke their contracts so we have permission to break ours.
This sounds like a "spread the misery" plan.
So this means the Germans are Timmay's bitchez?
Alternatively, they try and resist the melt down of their sovereign debt bonds which would ruin their economies. Is this a Maginot line, outmoded construct that cannot be sustained against the market? Or is this political will that will be backed up by strong measures to break those instruments that are considered cancerous, as used in these manipulated markets by the hegemonic Oligarchs : naked CDS type derivatives, Short plays, separating deposit banking from investment banking, imposing more transparency less off balance sheet accounting, forbidding dark pools and HFT with PENAL measures. enforcing penal action for past scams. In brief, breaking down the casino economy world wide. If they achieve this collectively to reform world finance they'll have a chance.
The ONLY REAL problem is that Timmy and Ben are both sellers of this grand scheme as well as surrogates to the Oligarchs who speculate in dark pools through HFs. Best proof : Timmy and ALL WS brass does not want the Tobin TAx on financial transactions that could cool down the speculation and allow wealth transfers from banks and Oligarchs to sovereigns. They want to have their cake and to eat it.
You dont need an IQ of 145 to understand that its the casino economy which is the cancer today, not FDR's or JMK's ghosts! Clean out the markets and you'll have done more than half the job. This includes cleaning out private banks to the nth degree using legal measures for their scams (foreclosures and market manipulations).
Same could be said for Low Mortgage rates: Yesterdays' Problem, Today's Solution?
p.tchir writes: If the CDO methodologies don’t work, what about having the EFSF just repo bonds to create leverage? So the EFSF buys €440 billion of Eurozone bonds. Then it goes to the ECB (who always has money?) to repo the bonds. The ECB provides say 5:1 leverage, so gives the EFSF €350 billion (440 * 80%d).
slewie asks: does p.t. understand the laws governing the EBC?