EFSF "Guidelines"

From Peter Tchir of TF Market Advisors

EFSF "Guidelines"

The EFSF released (source):

  • EFSF Guideline on Primary Market Purchases
  • EFSF Guideline on interventions in the secondary market
  • EFSF Guideline on Precautionary Programmes
  • Maximising the capacity of the EFSF

(capitalization and spelling direct from the EFSF).

If the crisis could be ended by the creation of acronyms and the use of the word “modality” then we are saved.  The number of 3 and 4 letter acronyms is mind boggling, but let’s see what these proposals all mean.

In the preamble to each of the “Guideline” papers, the increased flexibility of roles of the EFSF are laid out

i)    Act on the basis of a precautionary programme
ii)    Finance recapitalization of financial institutions through loans to governments including in non-programme countries
iii)    Intervene in the secondary markets on the basis of an ECB analysis that financial stability is at risk

So point i seems fine. 

Point ii strikes me as disappointing.  I certainly had the perception that the EFSF was going to be involved in the recapitalization of banks.  Now they are going to lend money to countries that will use that money to recapitalize their banks.  I suspect the rating agencies were very uncomfortable letting the EFSF take equity stakes and the Member States also probably wanted more direct control.  I don’t really understand why the EFSF should be lending money to countries to recapitalize their banks.  Shouldn’t they be able to do that themselves or use money from a general bond issue for that?  In spite of all the talk about “more Europe” this would be a step back to national policies.  It also makes it unlikely much gets done because the banks in each country will want to ensure they get the best terms.  The fact that there was no specific “Guideline” sheet for the recapitalization process makes me believe that the EFSF and the rating agencies and the Member States couldn’t agree on anything and decided to include this loans to countries provision to calm markets.  But that is all it is there for, to keep you the investor calm.  The whole deal of the EFSF is to provide loans to Member States, so why differentiate ones that are meant for recapitalizing the banks?  Because the market expected the EFSF to be involved, and although they failed to reach agreement, they are pretending that they did something.  Not a good sign as that has been their modus operandi since the beginning and it hasn’t fooled anyone for long.

Point iii is also a negative for the market once you think about it.  Clearly the EFSF is branching into SMP’s (Secondary Market Purchases) which may seem to be a good thing, but they seem to be going out of their way to indicate that they are effectively going to take over purchases that used to be done by the ECB.  The ECB will be very involved in helping the EFSF manage their secondary market purchases.  All of that, is unfortunately for the market, consistent with the stated goals of transferring this responsibility from the ECB to the EFSF.  With so many people long risk assets waiting for the ECB to turn on the printing spigot, this should be a concern.  The ECB may really be about to take a step back from market intervention, the exact opposite of what the market is clamoring for.  Given how small the EFSF is, and its multiple mandates, that should be a real concern.

Why there are so many roles, and ultimately so many facilities and programs under the EFSF, is beyond me.  They have made it incredibly complex and it seems that there will be layer upon layer of approval, which is not what the market needs.

EFSF Guideline on Primary Market Purchases

This program is dedicated to helping Member Countries “as a complement to regular loans under a macroeconomic adjustment programme or to draw-downs of funds under a precautionary programme”.  As far as I can tell, this means that in addition to the other programs, the EFSF can mess around in the primary market auction process.  They want to be “limits the risk that ‘out of the market’ prices are posted by opportunistic primary dealers to test the needs from the country”.  The idea that the markets are wrong is a prevailing theme throughout the documents.  That should concern people in the market as well.  If you start all your actions with the premise that the market is wrong, you are unlikely to be successful or keep your capital for long.  I would be far more comfortable if there were fewer mentions of  how the market could be wrong and the EFSF is only stepping in to put the market at “right” or “correct” prices. 

The PMP “would address liquidity requirements from investors and reduce undesirable price effects”.  They intend to do careful market analysis to decide on any intervention.  They go on to discuss some of the potential ramifications, but frankly, I doubt they will use their capital wisely in this case.  It is hard enough to do at a firm that is purely profit driven, let alone at an institution that has no proifit motive whatsoever.

They go on to discuss concerns about not wanting to have undue influence on any particular auction.  I was impressed until it turned out that their idea was not to be more than 50% of an auction.  That seems like a very high number, not to expect undue influence.  There is a brief paragraph that given the complexity they may choose a “rules based mechanism”.  Again that scares me.  I don’t trust their judgement, but I don’t like a rules based mechanism that is also likely to be overturned whenever their judgement tells them to.  There is also a discussion of whether they would participate at an RFR (Reference Funding Rate) or at an average clearing price.

In the end, they will just be a big buyer in a new issue.  There is no mention of how they will get the money to buy the bonds and certainly no talk about leverage.  Right, no leverage mentioned in the whole PMP program.  But don’t worry, the leverage comes in the ECCL+ program. 

The “Management of the portfolio” section is worth a quick glance.  It discusses 4 strategies for the EFSF’s PMP facility.  It could sell bonds back to the market when the demand is restored, which would be good because it would let them recycle the money, but it does rely on demand returning and the EFSF seems concerned about the potential negative impacts on the market.  They could hold to maturity, which “limits the market risk” and is consistent with the ECB policy.  This seems like a bad idea, because they really should be trying to sell when they can so they have fresh capital – there is no concept of “leverage” in the PMP program.  They could sell the bonds back to the country as an option, but this strikes me as the most far fetched and none of the countries participating will be in position to do so for a long time – selling back to the market would be far more useful.  They also mention using “bonds for repos with commercial banks to support the liquidity management of the EFSF”.  I am not sure that is a 4th option.  That could be used with any of the prior 3 options and is either an attempt at leverage or admission they don’t think they can raise the money to actually purchase the bonds outright. 

The repo option being considered should concern potential EFSF investors.  They are either planning on leveraging this with commercial banks (not the ECB).  So someone is taking the leverage risk – either the banks if it is non-recourse, or the EFSF if it is with recourse.  So the mark to market risk is either shifted to banks, nullifying the use of the EFSF, or the EFSF is taking leveraged risk with mark to market triggers, meaning they can erode their capital far faster than anyone thought.  If leverage isn’t the reason this is included, then it has to be because the EFSF is concerned about its own ability to fund itself so wants to use its assets for funding.  There is NOTHING about option 4 that is portfolio management, it is all about leverage and funding.  Investors should be very worried that this is being discussed as it increases the risk of EFSF or the banks dramatically, especially in conjunction for their disdain of the market’s ability to price assets correctly.

EFSF Guideline on interventions in the secondary market

This program looks like an attempt to take over the ECB’s current activities.  It would rely heavily on the ECB to help make decisions, another signal that the EU is trying to take the responsibility of buying bonds in the secondary market away from the ECB.  There are various conditions for a Member State to have access to the SMP.  The EFSF seems to have overly high expectations of what it can accomplish, I found their belief that “EFSF intervention serves the purpose of a market making to ensure some liquidity in debt markets” as a reach.  They seem very cavalier about how easy and successful this program will be – and all they have to do is look at the unrealized losses on the ECB’s book and know that secondary market purchases have been a miserable failure.

The procedures and conditions and “modalities” run the risk of making the program far less effective and timely than the already dismal performance demonstrated by the ECB.  There are too many acronyms here to go through in detail (and many don’t even seem to have been defined).  I have to admit MoU is cute with the lower case but I couldn’t figure out what EWG is nor remember what an EIP is. There is also something called the ESCB but I think that might just be a typo, but wouldn’t bet on it.

They do take the time to say that a Financial Assistance Facility Agreement (which I assume is a “FAFA”) “will specify how any profits and losses will be settled between the beneficiary Member State and the EFSF”.  Really, profit and losses on something that they don’t know what it will be and may or may not be to the maturity of the bond and may or may not be leveraged?  They are already dividing up the spoils before they have taken a single action.  They also, once again, seem to be creating interconnectivity, when the purpose is meant to be to stop contagion. 

They go through the same 4 options of how to manage the portfolio.  Once again, I think trying to sell when they can (even at a slight loss) is the best choice because capital is truly scarce for the EFSF, and I remain concerned about what they are planning on the repo side.

EFSF Guideline on Precautionary Programmes

There are “Precautionary conditioned credit lines” (PCCL’s) and “Enhanced condtions credit lines” (ECCL’s).  They appear to be “benchmarked” against the IMF’s FCL and PCL programs.  These are loans that would be available to countries and would come with IMF monitoring, or monitoring done very much like the IMF would do, and done by IMF employees.  There is no leverage for these programs.   These are straight loans, with some stated maturity, that can be rolled over for a certain number of periods, though the reality is they will be outstanding until default if nothing improves. 

The programs are meant to be 2% to 10% of GDP for a country, but without leverage and subject to the overall limited amount of EFSF funds, I don’t see how either the PCCL nor the ECCL do much.  They aren’t bad, but seem a bit unnecessary and are just a backdoor way to enforce controls on Member States that other EFSF programs don’t.  Complexity, particularly unnecessary complexity makes me doubt that this was well thought out, or can even be implemented.

So the first true mention of leverage comes with the “enhanced conditions credit line with sovereign partial risk protection” (ECCL+).  This section mentions the issuance of PPC’s (Partial Protection Certificates) for Member States who have signed MoU’s.  This section though seems to be limited, it is for PPC’s in connection with a relatively short term loan with rollover features (ECCL’s).  The duration of this will actually be “set in the Financial Facility Assistance Agreement” (FFAA, or FFA for short, and not to be confused with the Financial Assistance Facility Agreement that is part of the secondary market programme).  Though if you continue to read the document you will find that for rapid activation, the Member State will need a MoU and a FFA (which is the official acronym for a Financial Assistant Facility Agreement, and confirms the earlier mess was an accidental re-arranging of the words, based on the fact that it is all made up and not even the lawyers have a clue what this will all mean if it is even actually implemented).   Though as you read through conditions a through g, you realize that there is a Eurogroup Working Group, which I assume is what the never defined EWG is.  If nothing else, there are going to be lots of good paying jobs, with great benefits that are going to be created out of this bailout.

The Accompanying enhanced surveillance for “a Member State receiving an ECCL,, ECCL+ or drawing a PCCL” is similar to having the IMF looking over your shoulder.  It may be useful, but undermines the believe that any country that qualifies will actually receive the benefits.  They have not learned the lessons from Greece.  If there are contingencies, the market will begin to believe that the contingencies won’t be met and the country will never receive the benefits promised.

Maximising the capacity of the EFSF

This document is split into two sections, the PPC and the CIF (Co-Investment Funds).  It is easier to start with the CIF section.  It is basically what every summer intern knows about CDO’s and tries to explain to their mentor in an effort to look smart.  It is just as vague as before.  No details are offered, and in some ways, it is more vague than the original document that was sent around.  I can only assume that it is still in there because people think it might work (and I wrote that this is better than the PPC program), but they have toned it down because every potential investor laughed them out of the room.  The investors laughed them out of the room because there was no plan.  There still isn’t.  I think if they focused on the CIF’s they would have some shot of achieving some level of financing.  I am no longer thinking about much leverage, just actually meeting their fully funded 440 billion Euros.  In the end they seem to be distancing themselves from this option.  It is almost like they have given up, aren’t willing to do the work, but hope someone might come to them with a deal.  2 months ago I would have laughed at myself for writing that, but now, I think I’m actually being kind.  The CIF’s have the best potential to combine some tiny amount of outside money with all the various national and supranational programs, but they clearly missed it, and are giving up on it, at least for now.

So what about the PPC’s?  Each PPC will be issued by a separate SPV.  So not only will each country be guaranteed, not by the EFSF, but by an entity supported the EFSF, but each individual bond will have its own support SPV.  That strikes me as bizarre.  It is convenient that the SPV’s will be from Luxembourg.  That is straight “cut and paste” from a typical pitchbook, but makes you wonder why the EFSF would use the easy Luxembourg route?  It is an improvement from their first attempt where they issue EFSF bonds that are then used as collateral, but still makes you wonder what game they are up to, or they just ran out of time and picked some standard terms and conditions from any pitchbook they could find? 

I may sound facetious, but didn’t people expect the EFSF to provide the insurance?  Having this SPV provide the insurance is certainly a concern for me.  But it all becomes clear later on.  “The SPV shall finance the payments due by receipt of drawings made under a financial assistance facility agreement [not capitalized] (“FFA”).  The SPV will settle the claim by deliver cash or EFSF bonds.  Under this route, the claim is unfunded until the time of a call”.   So they are hoping to create all these unfunded SPV’s.  Then if the bond one of them is PPC’ing defaults, will they bother to get money.  That to me, is insane.  The correlation is incredibly high to begin with.  Who would want to buy a PPC from an SPV and only once a protected bond defaults, would that SPV try and get money.  I wouldn’t take that risk.  By the time Italy or Spain is defaulting, Germany and France will do everything in their power to walk away and fail to this Luxembourg SPV.  That they would even try to incorporate this into the document strikes me as complete folly.  And why would they need to?  Is it so they can guarantee more debt?  The rating agencies wouldn’t allow that.  Once their SPV’s have guaranteed 440 billion Euro (or used it in the PMP or SMP or loans to recapitalize) they are no longer AAA.  If it isn’t to leverage, it is because they now know there is almost no demand for the paper of the AAA guarantors.  If you want cheap German or French paper, you already have EIB, of EBRD, or existing EFSF paper (in a separate note the EFSF effectively verifies that the first EFSF bonds retain their superior credit seniority structure) so the EFSF is trying to avoid funding anything.  The EFSF is concerned about the ability of it, or its core guarantee providers to raise money (ESM is ultimately going to be DELAYED, not accelerated, because the countries there don’t provide guarantees like the EFSF, but are committed to providing cash!)  Trying not to fund is bad enough, but thinking that after not funding, they could provide EFSF bonds in lieu of cash is beyond comical.  Hey, one of our big members defaulted, we are getting downgraded faster than we can call the agencies and tell them they are wrong, but take some new EFSF bonds instead of cash!  That tells me that they do NOT get it.  Not one bit.

Even they must realize this, as they add a line “Upon investors’ request it could be considered, that claims would be funded at the outset”.  So yes, they will have to be funded.  No one in their right mind is buying protection on an entity from itself, that not only doesn’t escrow cash, but actually just plans on issuing another IOU on itself.  This is so wrong, that you have to be very concerned.  All the people drafting this care about is creating a 4-5 times leveraged EFSF headline and don’t care or worse, don’t understand why it doesn’t work.  Don’t fall for their trap.

Assuming it is fully funded, in cash, it is worth looking at a bit more.  Each PPC would come with a new issue and would have a maturity the same as the new issue.  It can be split up and used against other bonds.  So, for a country like Italy, there are plenty of bonds trading below 85% of par, so there will be big demand for a 20% first loss certificate (at least one that is fully funded up front).  If they offer that with each new issue, it is a drop in the bucket so it won’t impact secondary market prices much.  If they only use it on short dated bonds to get the lowest coupon to the Member State, then it will have no impact on longer dated bonds in the secondary market, or on all the funding that is priced as a spread to that.

Unless they swamp the market with PPC’s up front, it won’t have a big impact on the secondary market.  If they swap the market with PPC’s, they will have used up all their firepower while it is still a mess.  As we have said before, there is no good option, but since banks price off the unsecured risk, and they lend to corporations based on their cost of funds, this is NOT going to help the broader economy.  Way too little, way too late, and the market has already determined Italy with a 20% first loss is not risk free.

They plan on using the ISDA Credit Events – please hold the laughter, that a group that has done everything in their power to avoid triggering an ISDA CDS Credit Event is choosing those definitions. 
They have added something about voluntary restructuring as a credit event.  That sounded promising, except it went on to discuss “Collective Action Clauses being adopted by the euro area Member States”.  I have no clue what that means, but asides from being another attempt to make the PPC seem more useful than it is, it is a clear warning sign to Greece, Portugal, and Ireland that you should default while you can and before the lenders have any power against you. 

The PPC’s will also be denominated in Euros.  That limits their usefulness as a real short.  Sovereign CDS doesn’t trade in the currency of the country that it is referencing because currency devaluation destroys the value of the protection.  All European Sovereign CDS trades in $’s for this exact reason.  For non European banks, that will diminish the value of the protection.  The plan is for the PPC’s to be tradable, but when you go to collect you have to own sovereign bonds against it.  They don’t include any provision that you can’t own the PPC’s at some point in time without holding bonds, so after all their efforts to stymie the CDS markets, they have gone and potentially created another way to short sovereign risk.

Buy the rumor, sell the news?  Investors bought the rumor, then sold the lack of news, I think you are supposed to sell the news again, as there is nothing in this document that provides evidence that they get it, or that any scale can ever be achieved, and if anything, it makes you wonder if they will even get to the 440 billion of support the market thought they had back in July.