Tranched EFSF - Or TARP Lite

Tyler Durden's picture

Via Peter Tchir of TF Market Advisors

The EU is getting closer to having two actual alternatives for EFSF on the table. 

Partial Protection Certificate (PPC)

The PPC approach is included as one of the two proposals.  They came up with a name so that is progress.  It looks like payout would be linked to events that are very similar to CDS Credit Events.  It seems that the PPC’s would be issued in conjunction with a bond issue.  The goal would be to reduce the coupon on that issue.  They got rid of all the awkward mechanics of EFSF issuing bonds to be used as collateral – but we assumed that would never happen since it made no sense.

Everything else seems still up for debate – detachable or not, what the actual payout definitions are, the form of the payout (immediate or regularly scheduled), etc.

They make it clear that you would need to own bonds in order to collect on the PPC if they are detachable.  I assume they will change that to something where you need to own the bonds if you own the PPC, otherwise “speculators” will buy the PPC as a short and only buy the bonds when they go to collect.

The First Loss EFSF detailed analysis  from last week still applies, but my sense is the EU is backing away from this proposal since it wasn’t that well received and offers the least flexibility.

Co-Investment Funds (CIF)

I think CIF’s are the way they are heading, partly because they are extremely flexible and partly because the PPC didn’t seem to do well when it was the only option on the table.

Multiple CIF’s could be established.  Each would be able to buy in the primary or secondary.  Each could be for one country or for multiple countries.  Each could have its own bespoke “tranching” to suit each investor’s needs.  It is clear that they are trying to create something that is a cross between a CDO and TALF. I think it has a better chance of succeeding than the PPC does, but there are still a lot of issues to be addressed.

Each CIF would have some standard features.  It would have “nominal equity capital”.  This is usually a very small sliver of risk, often sold to charitable trusts, so that the rest of the capital structure can be considered debt, and only the small charitable trust has to consolidate the assets of the CIF.

The EFSF would provide the first loss risk (or at least a portion of it).  With this structure, the EFSF would have to deliver cash into the CIF.  It couldn’t work based on just guarantees.  Whether it is more efficient for member states to issue bonds and deliver cash into the CIF or to have the EFSF issue bonds and deliver the cash into the CIF is yet to be determined.  I suspect the cost would be lower if individual countries did it, but that would force those countries to recognize debt, and remove the fiction that all the countries are participating in the EFSF.  In the end, the EFSF will likely issue bonds to fund their portion of the CIF’s because the accounting and headlines sound better and that will offset the extra costs.

How appealing will the CIF be to investors?  What can be done to make it attractive?

Tranching a Single Asset – The problem of low expected recoveries

Creating tranches for a single asset is difficult.  The only way to create value is to create a “senior” tranche that should be covered in event of default.  Basically the risky tranche(s) need to cover down to a likely recovery rate.

Mortgages are one example.  In a “normal” mortgage market, banks liked to lend when the homeowner had a 20% first loss.  The homeowner could achieve that by putting down more equity or buying insurance from PMI (yes they are now in default).  It was the fact that banks had a buffer on home value that made them comfortable lending at cheap rates.

The same principle applies to corporate credit.  By pledging collateral against certain debt, the company can achieve a lower cost of capital, because that investor can look to the assets in the event of default.  The more fungible the assets pledged, the better.

The issue with a single sovereign credit (or unsecured credit in general) is that the expected recovery in event of default will be 40% or lower.  An investor would need at least 60% first loss protection before they would consider themselves isolated from the risk of default.  The reality is, they would probably want to be protected down to a recovery of 30% if not 20% (the rating agencies would likely assume a 20% recovery when providing ratings).

Let’s assume that with enough political pressure and a bit of greed, that a “senior” investor could be found.  A realistic assumption is they would want 70% first loss, so they are providing 30% of the funds to the CIF.  I think they would want to earn what they could make by buying French debt.  So in 5 years, it would be 2%.  German 5 year debt trades at 1%, but I think with only 70% subordination on a single issuer (Spain or Italy) the investor would consider it reasonably safe, but wouldn’t take the risk for less yield than they could get by investing in France.  “Mid-swaps” for 5 years are at 1.90% so in line with the thinking that decently safe investments in Europe would yield 2% for 5 years.

If the goal of the structure is to get a 4.5% cost of funds for 5 years to the issuer, which seems a reasonable goal as it would balance a reasonably low coupon with a decent tenor.  The EFSF will likely want to earn their own cost of funds on their first loss portion.  If they have negative carry, it would complicate things for the EFSF as they would have potential capital calls in the future and they would have to restrict how much debt they could issue now, to account for those future capital calls.  In the end it is just so much simpler for them to charge the CIF their cost of funds, that I think that is what they would do.  Let’s assume they issue where France is trading (mid-swaps + 10) for a cost of 2%.  This is a bit aggressive versus where their 10 year deal priced the other day, but I’m trying to make CIF’s work.

So CIF’s would have to pay 2% on 55% of its capital structure (the first loss is heavily subsidized by the EFSF and the senior debt is priced fairly).  So for every €100 of debt that the CIF buys yielding 4.5%, it would earn €4.50.  It would pay out a total of €1.10 for the first loss and senior debt.  That would leave €3.40 for the €45 of “mezz” debt.  That is a yield of 7.6%.  The mezz debt would need to trade at 7.6% for this strategy to work.

Is that a “good” price for that risk?  It clearly depends on where the underlying bonds trade outright.  If the straight debt is trading at 5% is this good risk/reward?  What if the straight debt is at 6.5%?

It will depend on your assumptions about default and recovery.  If the straight debt was yielding 7.6%, the “mezz” tranche would be a bad investment.  You would get the same return in a no default scenario, but likely do better under any reasonable recovery assumption.  The breakeven recovery would be about 54%.  If you bought outright debt, you would lose 46% of your investment.  If you bought the “mezz” tranche, you would lose 21 points (75 – 54) because the first loss tranche would absorb the first 25 points.  That would be 46.7% of your investment.  A recovery about 54% would favor the “mezz” investment, but reasonable recovery assumptions (40% and below) favor an outright investment.

When you factor in a lack of liquidity and lack of control of the CIF, the yield required to make the mezz attractive has to be even higher.  So, as “straight debt” yields increase, or the cost of capital of senior debt or EFSF debt increases, the ability to get a “good” coupon to the issuing country decreases.   The “mezz” tranche only offers attractive yields to outside investors when the underlying bonds don’t need the structure – why would you go through all of this if you could issue bonds at 5%?  You wouldn’t. 

This analysis also ignores initial price of the bonds.  If the CIF is buying “discount” bonds that is helpful, but then it does nothing for the new issues and the roll risk countries are facing.  Investors can buy Italian bonds in the 4-6 year maturity range at 90% of par in many cases.  That already provides a “first loss” protection of 10%.  How exactly the market will respond is unknown, but the more bonds that trade at a discount in the secondary market, the less useful the “first loss” protection is.  The CIF’s could be structured to focus on secondary market discount bonds, but that may do little for the new issue market which is clearly what needs to be helped the most.

The structure is more compelling than the PPC’s but it is hard to determine whether a real senior note provider will step up and whether the yields would be compelling to a “mezz” investor relative to an outright bond investment.  To the extent the participants in CIF’s are just shifting how they purchase Italian or Spanish bonds, then most of the perceived benefit will be reduced by this cannibalization.

Using Multiple Assets to Increase diversification

Having more than one asset in a CIF would help.  There is some probability that the different issuers won’t default at the same time.  So let’s use Spain and Italy together.  The ratio should be about 3:1 which is about in line with their debt outstanding.  The CIF would own €25 of Spanish bonds and €75 of Italian bonds.

The senior investor has more protection now as both countries would have to default and both would have to have the same low recovery rate.  In the real world, an investor might not give much benefit to the idea that if Italy defaults Spain wouldn’t, or that both wouldn’t have low recoveries.  But since we live in a government pressured market, let’s assume that the senior investor now only demands 60% of first loss protection (they are willing to reduce their subordination by 10%).  I think this is a stretch, but if it happens, it has a big impact on the “mezz” tranche.

Now the cost of first loss and senior debt is €1.30 (2% on 65).  Since the mezz tranche is now only €35, its yield would be 9.1%, a significant improvement.  If somehow only 1 country defaulted (especially if it was Spain) then the “mezz” tranche wouldn’t have a loss.  These numbers are more compelling, but hinge on finding the “senior investor”.  I don’t think there is a real world investor who takes that risk at that price.  I would much rather own French bonds at 2% than 60% subordination risk on a pool of 25% Spanish bonds and 75% Italian bonds.  I don’t think even BRIC’s would be keen on that risk.  They will buy the EFSF bonds to fund the CIF’s but the second loss portion seems too risky on those terms.  The only likely home for those senior bonds (on these terms) would be a government controlled entity.  Either the ECB or some French or German pension funds are the likely “stuffee”.

A couple of months ago, I would have doubted that the leaders of these countries would purposely saddle their pension plans with bad investments. That they wouldn’t risk more of their citizens future on a plan to keep together a debt riddled zone of countries that is getting worse rather than better.  Now, I have to admit that not only would they be willing to do it, but they might be eager to do it, to “prove” that their plan worked.

CIF are better than PPC’s but still no TALF

CIF’s seem to have a better chance of working, though they will require not only cheap EFSF money at the first loss part of the capital structure, but also some “dumb” money at the senior part of the capital structure.  If they get enough of that, they can create some compelling value for “mezz” investors.  These would then be Wall Street firms or hedge funds (angel investors when buying CIF’s, evil speculators when buying CDS to short).  It would be a big shift of funds from taxpayers to money managers, but that is about par for the course.  The value of the mezz relative to an outright investment decreases as yields on the underlying go up.  This makes the deal easy to sell when underlying yields are under 5%, but not much help as yields go well above 6%.  So it will be trillions in could times and “crickets” in bad times.  Not exactly what you want out of a bailout fund.  They will have to be careful, once again, to conserve their limited resources.  Using too much up front, in relatively stable times, could be a big problem down the road.

This is not TALF.  TALF was a much better deal for outside investors.  The range of assets the investor could choose from was broad.  Most fund managers believed they were “cheap” but couldn’t come up with the capital to invest, or handle the downside.  The assets themselves were good for “tranching” in that they were diversified pools.  In TALF, the government (fed/treasury) provided both the senior financing and the co-invested first loss financing.  TALF was a great opportunity.  CIF’s may create some interesting opportunities, and are at the very least flexible enough, that investors could have a discussion, but they are nowhere near as appealing as TALF was.

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HelluvaEngineer's picture

Either way, I'm sure it's incredibly Bullish.

lizzy36's picture

So they rebranded the EFSF from a SIV to a CIF/PPC. 

Still can't raise the money can they?

Good luck with that.

HelluvaEngineer's picture

It's not about raising money.  It's about delaying the inevitable a few more days/weeks until the looting is complete.

hedgeless_horseman's picture






No matter the acronym, the meaning is debt slavery.

"I will never live for the sake of my parent's debts, nor ask my children to live for mine."

Who of us can truthfully say this? 

Who will dare to break this heritage of debt slavery?

Who is waiting for the master to set you and your children free, eventhough he has invested so much in your service?

Who is hoping for some crumbs from the master's table?

Who is fighting?

Who is alive and who is already dead?

GMadScientist's picture

More like an STD, specifically Syph.

Symptoms of neurosyphilis include:

  • Blindness
  • Confusion
  • Dementia
  • Depression
  • Headache
  • Irritability
  • Numbness in the extremities (Greece?)
  • Poor concentration
  • Retardation
semperfi's picture

What part of "You can't solve a debt problem with more debt" don't they get?  When was the last time anyone put out a house fire with a flamethrower?

Dapper Dan's picture

You forgot about the insurance on the house, problem solved.

Hint:  credit default swap

topcallingtroll's picture


The value of the cds goes to zero as the original debt is extinguished.

Watch cds pricing. It will tell us if or when the plan is credible.

mess nonster's picture

God, please deliver us from the curse of the acronyms! Or, should I say, GPDUFTCOTA!!!!!!!!!!

oogs66's picture

the french and germans love their acronyms...and more and more the whole world is run by kids will grow up hating 3 letter acronyms....let them swear, no one ever went broke from saying fuck!  but letting IMF, ECB, IIF, SIV, CIF, PPC, PPT, FED, rule the world will

topcallingtroll's picture

They are having to use three letter words cuz all the good four letter words are taken.

Mercury's picture

So let me get this straight -  by putting a bunch of subprime but geographically diversified sovereign loans (which historically have a very low default rate) together into a pool and then dividing that pool into senior and subordinate tranches....shine can in effect be created from shit.

Why does this sound familiar?

LawsofPhysics's picture

Apparently inflation is not the only thing America is good at exporting.

Killer the Buzzard's picture

This whole scheme sounds like a single-property CMBS, but instead of, say, securitizing Rockefeller Center, it is some ghetto tenement in Jersey City.

LawsofPhysics's picture

Equities rallying hard, but without gold.  This is a change, but how to interpret it.

Captain Benny's picture

CIFs sound like the equivelent of lubricant that you'd want to rub on your wanker prior to screwing a dry granny vagine.  No matter how much lube you put on, the sandpaper is still going to rub you raw and you'll still be the one getting monetarily f'cked.

Josh Randall's picture

I've lost track of all of this - I will need the cartoon Bears to explain it to me

topcallingtroll's picture

They could do it.

You could follow a moneybag from the taxpayers as it exchanges hands several times and then ends up in the hands of the big bindholders, banks and pensions.

Hilarity ensues as they try to confuse the first guy handing over the money bag as to where it ultimately goes.

slaughterer's picture

The strategies being used to rescue the ESFS are a reduplication, on the level of government debt, of the pre-2008 MBS structured finance revolution that led to the finance crisis in the first place.   Then it was "slice and dice" mortgages, now it is "slice and dice" government debt.   I would say the CIF will take 2-3 years to blow up, and blow up it will, taking all the mezz dumb money with it, and perhaps some of the senior. 

oogs66's picture

yes, if they manage to avert problems now, the problems will be bigger and even more convoluted and dangerous next time around...though i think 6 mths to a year is the right timeframe

Mercury's picture

A couple of months ago, I would have doubted that the leaders of these countries would purposely saddle their pension plans with bad investments. That they wouldn’t risk more of their citizens future on a plan to keep together a debt riddled zone of countries that is getting worse rather than better. 

Of course they will because when the S inevitably HTF the appeal to taxpayers/private wealth  becomes save the pensioners not save the wasteful and bloated government.

I am a Man I am Forty's picture

they are trying so hard to figure out a way to fuck investors over, who in their right mind would buy a lower tranche on the CDO, "hey here's some extra yield for ya for taking on that extra risk..." POOF, investment gone to zero prior to them making a single payment

lapedochild's picture

Remind me again... why do countries not just pony up more actual money?

They could issue a special tax on their citizens. They will gladly pay because noone wants to see the EZ tear appart and northern countries are more than happy to pay for southern countries, right?

No? There's your answer to the long term succes of this integration

topcallingtroll's picture


That is why they must hide the subsidy in financial gimmickry.

It would be far more efficient just to auction off the bonds and send the efsf money directly to sellers up to a specified limit to make up the losses.

But everyone could understand that.

chubbar's picture

It's just one big money shuffle in an attempt to dupe the population into thinking this problem of too much debt is solved.

I don't know two people who understand what is happening and the consequences the world faces when this debt scheme collapses. Everyone knows something isn't quite right but has no idea other than it is a recession, or possible recession depending on the channel they get their news from.

I'm sure they'll be convinced that it is the next false flag that is the culprit. Im seeing the same war drums beating for a war against Iran as I did for the first gulf war. Perhaps that is the plan for the next "big diversion"? I guess we will all see shortly.

semperfi's picture


topcallingtroll's picture

Hmmm.... so complicated financial engineering is bad....unless governments do it then it is good.

Monedas's picture

Reminds me of a 1930 B&W "B" movie where the bad guys are squabbling over dividing up the loot from a bank heist ! Monedas 2011 Comedy Jihad put a TARP over it !

Bansters-in-my- feces's picture

Long story made short.they need a SuperPonzi.

These regular old Ponzi's are not working so well.

spanish inquisition's picture

I think I get it.. Its like factory second condom insurance, it is cheap, instills confidence to have more "protected" sex and you can get your money back you spent on the condom. Sounds safe to me, am I missing anything?

topcallingtroll's picture


Now we know who the second loss bagholder in a CIF structure would be, the ECB.

Will the Germans somehow find that more palatable than the ECB monetizing individual country bonds? Only if they are dimwitted and suffer from mental accounting.

LongSoupLine's picture

Call it what you want, name it something else daily, ramp it with shadow banking fiat, back it all up with rumors, mis- and dis-information and you get what we have yet again this morning...a huge pile of growing shit and surging futures.

f16hoser's picture

A "Turd" by any other name is still a "Turd!"


Yancey Ward's picture

Well, there is lots and lots of dumb money in pension plans.  Hell, the governments could even require it be invested in the CIF.

taraxias's picture

Who said you can't turn shit into gold ?!

Dorky's picture

This PPC/CIF plan looks so much like "how to manage default" than "how to manage recovery".

Well, I guess this plan is good enough to buy some more time.

Buy some more time for what?

Buy some more time for the TBTF bank to completely liquidate their positions in the EU before letting everything collapse.

The market is not driven by economic fundamentals.

Rather it is driven by politics, corruption and manipulation.

slewie the pi-rat's picture

  <=== yes

  <=== no

Q:  want the planet earth to function properly?

liquidate the bad debt and maybe all debt, and give peace a chance, BiCheZ!