One would think that judging by all the frequency of lies about Europe's latest CDO knight in shining armor, also known as the EFSF, that bond spreads would be rushing headlong to zero as yet another form of perpetual taxpayer backstop is implemented. One would be wrong. Spreads on the Portuguese and Spanish 10 Years are now back to their widest levels in history. It is fairly complicated to reconcile this stickiness with the daily barrage of mendacity from all ECB apparatchiks. Basically, the market, unlike Goldman (see below), is fairly unconvinced that any of the currently planned rescue plans have any chance of being successful.
Elsewhere, the Koolaid farmers at Goldman issued the following pamphlet on why the EFSF is just swell:
Using the EFSF to Buy Sovereign Bonds: Some Reflections
Concerns over solvency for countries such as Greece, Ireland and Portugal, and the resulting sharp increase in their funding costs, has ultimately precipitated a sudden shift in the demand schedule for government bonds (beyond a certain interest level, the supply of credit can become ‘backward-sloping’ in the presence of information asymmetries).
Since May, the ECB has intermittently intervened to stabilize demand for government bonds in Greece, Ireland and Portugal, cumulatively purchasing around €75bn of their medium/long-term bonds (corresponding to around a quarter of the respective debt stock). Given their scale, these interventions have arguably gone beyond the stabilization objective they were originally intended to achieve. Like others, we have argued that they may conflict with the governance the central bank (loss-sharing in case of a credit event) and, eventually, the public’s perception of its ‘independence’. Ongoing purchases may also create distortions in the allocation of credit.
In light of this, proposals have been put forward to change the statute of the EFSF to allow it to take a market stabilization role by purchasing government bonds in the secondary market, and conceivably also the primary market (which the ECB is forbidden to do). A larger commitment of resources from the AAA-rated countries would be instrumental to make the exercise work, presumably alongside more flexible funding structure (and the ability to use derivatives to reduce duration risk). Such structure could be the forebear of a European Debt Agency.
Whether this would change market dynamics by inducing private buyers to return to the market is contentious. These are some of the arguments that need to balanced out. At the margin, we think it may lead to a tightening of spreads.
- The creditworthiness of the peripheral countries is unlikely to be meaningfully affected whether it’s the ECB or the EFSF (or China, for that matter) taking up a share of government bond demand. Further, the credit risk borne by the ECB in making bond purchases is ultimately taken by its shareholders, the majority of which are also the backers of the EFSF. Just as for the ECB, or any other buyer, the EFSF could turn out to have made a good investment, or a bad one. The transfer of roles would probably be accompanied by greater transparency on the rules governing which bonds are purchased (the ECB does not disclose its own, and this unpredictability enhances the effectiveness of the policy) and a higher cost of funds (the EFSF borrowing levels are a credit-enhanced weighted average of EMU sovereigns, while the ECB sterilizes its purchases at a 1% rate). The EFSF would also have a fixed capacity to buy, while the ECB’s is theoretically boundless, subject to the governance constraints (most importantly, whether the ECB has the legitimacy to address solvency issues, in addition to liquidity problems).
- But the credibility of the commitment to purchase each other’s sovereign bonds would be enhanced if it were left in the hands of the fiscal authorities, given the inherent dilemma between price and financial stability faced by the ECB. Moreover, one adverse consequence of the ECB’s purchasing program is the potential distortion the relative credit risks embedded in peripheral bonds –why purchase Portugal and not, say, Belgium or Spain? Not coincidentally, several ECB Board members (including Trichet, Bini Smaghi, Orphanides among others) have publicly endorsed the idea of having the EFSF replace the central bank’s Securities Purchase Program.
- As the inaugural issuance this week shows, EFSF securities are palatable to investors outside the Euro area as they allow a ‘bloc trade’ in a portfolio of EMU members’ sovereign risk, reducing the liquidity risk associated with the smaller countries. Only around 20% of Euro-area public debt is held by non-EMU residents, and mostly in Germany and France. Besides responding to a common interest in preserving global financial stability, greater demand from the Far East would be consistent with the FX and rate risk diversification objectives of investors in that region. By signaling greater commitment by member states to share each other’s credit risk, EFSF purchases could reduce the information asymmetries which have precipitated the collapse in demand.
Whether the EFSF could play an active part in a liability management exercise for sovereign (or senior bank) debt, as some have suggested, is more contentious. As we commented in the past, it would probably facilitate further fiscal transfers to the distressed issuer, should these be required, without triggering CDS events. Given a chunk of bonds has been purchased by the ECB, and some liabilities replaced by IMF loans, arranging a restructuring between the EFSF –essentially the other member states- and the distressed country appears simpler than trying to corral a large group of bondholders. But there are several outstanding issues:
- The key question, considering the complex logistics and mechanics, is: is it worth it? The average market value of outstanding bonds for Greece, Ireland and Portugal is currently around 70, 80 and 85 cents, respectively. With debt-to-GDP ratios projected to stand at 144%, 104% and 91% (latest IMF estimates for 2013), whether a 15-30% par ‘haircut’ is sufficient will likely remain open until there is more visibility on the growth trend and the sustainable primary balance. Consider also that the launch of a tender/purchase program would lead to an increase in market prices, depressing the upfront capital realization. A lengthening of maturities of the emergency loans appears more effective in the near term.
- Sovereign bonds have been issued under national law with no provisions to amend contractual terms. A debt restructuring would therefore need to be voluntary, and may require changes in the local laws (see Buchheit and Gulati, How to Restructure Greek Debt, May 2010 for a discussion). The marketable debt stock of these three sovereigns (net of the funds pledged from the IMF/EU and the portion owned by the ECB) is in the region of EUR 450bn. It seems a tall order for the EFSF to grab a sufficient share (probably around 66-75%) to drive the restructuring process. Admittedly, the upcoming round of bank stress tests may provide a way of ‘bailing in’ institutional investors (the low turnover in Greek bonds may suggest that what is still in the hands of private investors has not been marked-to-market).
- A debt buyback at market prices will still involve negotiations between the issuer and its creditors on ‘burden sharing’. Assume, for example, that the EFSF were to purchase in the secondary market the 2016 3.6% GGBs priced at 66c (yielding around 12%), and ask Greece to pay back only 66c at maturity. The private investor who sold the security to the EFSF would crystallize capital losses, compared to the status quo where emergency funds are being also used to make good existing bond holders. But the Stabilization Fund would still implicitly subsidize Greece depending on the difference between the cost of funds it would charge (currently 2.9% for a 5-yr maturity plus 400bp) compared to 12% (assuming Greece can actually fund at this level). Related to this, given the fixed amount of resources available, is it more opportune to lend funds (under strict conditionality) to sovereigns with little to no market access to pay back the existing bond holders (who underestimated credit risk) at par, or participating in a restructuring of liabilities? As it stands, this seems to be largely a political choice.
In market terms, such choice will strongly influence expected returns and the volatility of investments in Eurozone securities. On a tactical basis, we continue to recommend owning 30-yr Greek bonds (opened last September), which already discount a substantial premium.