Submitted by Peter Tchir of TF Market Advisors
ESFS - Has Europe Finally Discovered Alchemy
Markets are better this morning, at least in part because there is renewed hope that Europe will band together and create a new and improved EFSF. This EFSF V3.0 will, allegedly, finally solve the European debt problem. It sounds great on the surface, but is it possible? I think there are problems with virtually every step in the process. The ability for EFSF to retain a AAA rating is dubious, and the willingness of investors to buy an expanded mandate EFSF may not be as great as the politicians believe. Here is a quick summary of many of the problems facing the new EFSF in reality as opposed to in a quick and optimistic press release. Just like the “rollovers” that were announced, the details will prove to be unworkable and will not provide the benefits expected.
The last round of EFSF had the Over-Guarantee Percentage increase from 120% to 165%. Italy is the 3rd largest guarantor at 18%, just below France’s 20%. Italy is Aa2 on negative watch at Moody’s and negative outlook at S&P. Spain is the 4th largest guarantor at 12%. It is Aa2/AA on negative outlook at both agencies. So 30% of the guarantees are coming from 2 countries that are rated less than AAA, are on negative outlook, and will likely draw on the EFSF funds? Even the rating agencies must be scratching their head wondering how to let AA entities guarantee themselves and still provide a AAA rating.
Guarantees that will never be provided
The latest version still includes Ireland, Portugal, and Greece as Stepping-Out Guarantors totaling 7% of guarantees. Ever since EFSF V1.0 I have been confused by the insistence of the EFSF to include in the list of Guarantors, those that have already said they won’t provide guarantees. So for anyone keeping score, only 93% of the guarantee amount is available in the first place, and 30% comes from 2 countries that will likely use the facility. At some point the ability of Germany and France to carry the AAA rating by themselves becomes doubtful.
The EFSF will be guaranteeing far worse assets than previously planned
Under the original terms, the EFSF was going to lend money to sovereign nations. The terms were very strict. Money would be withheld in escrow to cover the spread payments and other amounts deemed necessary for the safety of the EFSF. The loans were structured in such a way that the EFSF loans were structurally senior to existing debt of that nation. The move to open bond purchases was one reason the Over-Guarantee had to increase. These bonds were not as well protected as the original EFSF loans. They do not have additional covenants and there is no initial hold back, so the rating agencies had grown more concerned about giving the EFSF the AAA rating. Now, there is talk about lending to banks directly, not just sovereigns. That is a massive move down the credit curve. Not only do banks actually have a much higher risk of default, the severity of loss in default is usually very high. Recovery rates vary widely for corporations that default, but for banks, the recovery is usually very low. This higher risk of default, coupled with lower recoveries has to be taken into account. It was one thing for EFSF to go ahead and fund a couple of select sovereigns, but opening it up to banks increases the risk dramatically.
Who will sell bonds to the EFSF
There seems to be so much hope that the EFSF will be able to buy bonds cheaply on the open market. I just don’t see how this happens. The weak banks that hold these assets in non mark to market accounts have demonstrated that they are not willing to sell their PIIGS bonds. They have had ample opportunities over the past 18 months to sell their bonds at much higher prices than where they currently trade and have not sold. You can only assume they didn’t sell because they didn’t want to take the loss, so nothing has changed and they still won’t sell. If anything, this new round of government capitulation will only encourage them to hold onto their PIIGS debt because of their belief that the EU and ECB will eventually take them out at par as the debt matures. So the banks won’t sell, which leaves only the hedge funds and mutual funds and bank trading desks. They already trade these bonds so that won’t change much, but with knowledge that there is a deep pocketed buyer with no trading skills out there will likely lead to a short term surge in the prices of these bonds. The fast money/mark to market accounts will reap a nice profit as they sell the bonds to the EFSF at inflated prices. Briefly, the market may even believe the problem is solved, as bond prices increase, but once funds are out, who represent only a small portion of PIIGS debt, we will be right back to where we are. Nothing about EFSF open market purchases will have a meaningful long term impact on the market, though it will give some funds a nice monthly gain. It would be ironic (and par for the course) if funds used those gains to place shorts on other sovereigns or even the EFSF itself.
EFSF helping sovereigns buy back their own debt
The most intriguing aspect, on the surface, is the willingness of the ECB to let sovereigns buy back their own debt at a discount to par. As mentioned above, I don’t think the ECB will be able to accumulate large positions at deep discounts. The “free float”, or those bonds that are held in mark to market accounts represent only a small portion of PIIGS debt outstanding. The free float holders are likely to be able to use the knowledge that the EFSF is buying to drive the prices substantially higher, eliminating a big portion of the benefit. But let’s pretend for a moment that the EFSF accumulates blocks of bonds at a discount. They will then lend money to the sovereign nation to buy back debt? Let’s say that they bought €50 billion of Greek 10 year bonds at 60% of face. The EFSF spent €30 billion and owns assets valued at €30 billion. So far, so good, but what happens if they lend Greece €30 billion to buy the bonds back? If the new loans only have a €30 billion par amount, where would those loans be valued? If the loans have the same maturity and same interest rate and same seniority as the bonds they sold back to Greece, the EFSF loan to Greece would only have a value of €18 billion (60% of 30). Greece would be in better shape as €20 billion of debt would have been forgiven, but the EFSF would have lost €12 billion on the transaction. How long do investors lend money to EFSF to do that? How long can they throw away money and keep the AAA rating? How likely is it that hedge funds drive the price of PIIGS bonds up knowing that the EFSF is a dumb buyer and then turn around and use those excess proceeds to short EFSF bonds?
Just like the proposed ‘rollovers’ that were going to save Europe, once the smoke clears the room and the politicians and finance ministers are done patting themselves on the back, the markets will realize there is nothing workable in practice about this new EFSF solution. Some will profit from the new proposal, but likely not the people the government wants to support.