The Spirit Is Willing, But The Flesh Is Weak

Via Peter Tchir of TF Market Advisors

I hate to go all “biblical” but that is the best way I could describe the statements and releases from this weekend.  Every politician and finance ministry employee made it very clear that they wanted to do all that they could to “fix” Europe.  The problem remains, that they can only do limited things, and those may not work.  The schemes being proposed to save Europe are getting more far-fetched by the day and are more often than not in direct odds with each other.

The ECB will continue to purchase bonds, will cut interest rates, and may start selling CDS.  YAWN!  Short term interest rates aren’t the problem in Europe.  It may help at the margin, though there is a growing chorus of market watchers who question how helpful ultra low short term rates are to the economy as a whole.  The likely outcome of ECB bond purchases is that they will increase their balance sheet at the wrong price without meaningful long term impact on the debt market.  When will CDS on the ECB start trading?  How much access to capital do they really have before their solvency is questioned?  How much capital do they require from the member countries, and when will those capital calls impact the ratings of those countries?

The market briefly rallied because the ESM was going to be put in place sooner than expected, alleviating the need for the EFSF.  When that rally faded, the new plan was to let the EFSF use leverage to increase its impact.  In the background lingers the hope of a Eurobond in spite of all evidence that the EU cannot come to agreement on financial issues much smaller than would be required to ever successfully issue Eurobonds.

While the market may go up 5% from here, or down 5%, or both, it is worth examining the details again. So far, any analysis of the details of the situation has led to the obvious conclusion that the plan doesn’t work, and that conclusion has turned out to be correct.

This is some data I was able to get last week.  Ratings were from Bloomberg and O indicates where the rating is on “outlook” and W indicates where the rating is on the more severe “watch”.  GDP came from Wikipedia and is from 2010 and Debt comes from Bloomberg. 

Eurobonds Are Unrealistic

If Europe was going to issue bonds where each country backed a portion of the debt, what would the rating of those bonds be?  We took a look at 3 reasonable ways to allocated the responsibilities – by % of GDP, by % of debt outstanding, and by % of EFSF guaranty.  If each country was responsible for paying back Eurobonds based on their proportion of GDP or EFSF guaranty, the Eurobonds would receive Baa2 ratings .  If the responsibility was based on debt outstanding, which makes the most sense, the rating would be Baa3, or almost junk!  So on a WARF basis, the outstanding debt of Europe as a whole is almost junk.  It is not surprising, but still useful to see, that a methodology where payment responsibility is tied to amount borrowed produces the lowest ratings, confirming that the weakest countries borrowed too much.  Based on rates where bonds were trading last week, a 10 year Eurobond would trade around 4.2% on a GDP based responsibility, and over 5%, on a debt based allocation.  Clearly that would be a huge burden to Germany, France, and the Netherlands, a moderate benefit for Spain and Italy, while providing almost all of the benefit to Greece, Ireland, and Portugal.

If you remove the worst offenders – Greece, Portugal, and Ireland, the Eurobond ratings would increase, but only to Aa2.  The yields should drop to 3.2% and 3.7%.  This would obviously make a Eurobond more useful, but it would probably be a hard sell where the 3 countries in the worst shape, who need 10% of the proceeds aren’t actually on the hook to pay any of the debt back.
In the end, any Eurobond solution would have to be done with a “joint and several” guarantee.  That may trick some citizens into believing that Germany and France aren’t fully responsible, but probably not enough to get it passed any time in the next few years.  Germany in particular would want a lot of rules in place to protect their guarantees.

I have read some reports about “blue” and “red” bonds.  The blue bonds would be for the entire Eurozone and only be lent up to 60% of a country’s GDP.   I am not sure how the transition period would work.  I cannot think of an obvious way to slowly replace existing bonds with “blue” or “red” bonds.  I don’t think it is worth spending much time on that, because Italy would need to issue €700 billion of subordinated debt and Greece would have to issue €200 billion of subordinated bonds (technically the much more happily named “red” bonds).  The ratings would have to be several notches below their existing debt ratings and I cannot imagine there is much appetite out there for subordinated PIIGS debt.

Eurobonds will not be created ever in my opinion, but even the best case would be several years before the framework was put in place that would allow countries (Germany) to get comfortable with a Eurobond.  What they do highlight is how problematic the debt situation in Europe is, and that any attempt to create a Eurobond will downgrade the credit of Germany and France and greatly increase their annual deficits as their funding costs will greatly increase.

Leveraged EFSF Is A Non-Starter

Which now takes us to the idea of “leveraging” the EFSF.  Letting the EFSF become a 5:1 leveraged vehicle would turn it into something with €2 trillion of buying power.  I can see Rehn and Schaeubly singing their “Happy Happy Joy Joy” song.  But let’s just think about this for a moment.  How would this actually work.

The original construct of EFSF required a total of €780 billion in guarantees to be able to issue €440 billion of debt.  The reality is that the AAA entities provide just over €440 billion of guarantees.  The entire AAA rating of the EFSF notes depends on their being enough AAA guarantees to cover the entire issue amount.  That is consistent with either a WARF or Weakest Link methodology.  By ensuring that the AAA entities provide more than enough support for the funded notes, the other guarantors became irrelevant.  The view, at least originally, was that these guarantees wouldn’t affect the ratings of the countries.  EFSF v 1.0 was supposed to lend money to weak countries, but on highly negotiated terms.  That has been expanded in the proposed EFSF v 2.0 to include bond purchases.  I can see how the rating agencies would keep the AAA rating if EFSF had some expanded powers, such as buying bonds in the secondary market at market prices in addition to some direct lending, again on reasonably commercial terms.  As the potential for EFSF to provide equity infusions for banks and to provide off-market funding or to drastically overpay to buy bonds from the ECB at their cost, the risk of actually needing to draw down on those guarantees has increased.  The rating agencies, and more importantly, investors, cannot just ignore the guarantees these countries have made to the EFSF.  France’s €158 billion guarantee is not trivial.  It wasn’t trivial in the original simple EFSF.  Under the proposed EFSF 2.0, it is somewhat plausible that investors could close their eyes and pretend it’s not really the debt of France.  But when that guarantee becomes a 20% first loss component, is that realistic?

If the EFSF takes the capital (guarantees) provided by the AAA countries and leverages them 5:1, investors and rating agencies would be prudent to consider those guarantees as debt of the issuing country.  Is it possible that not a single one of those AAA countries would experience a downgrade on that basis alone?  Then think about the intangibles.  These countries are basically showing that they are willing to throw out all the prudence that made them AAA and a safe haven for investors, in a last ditch effort to save the PIIGS.  The credibility of these countries would have to be questioned, and as the U.S. learned the hard way, rating agencies in particular aren’t afraid to look at changes in the political situation as an excuse to downgrade.  The US downgrade didn’t have a material impact on rates, because we can print money and many investors didn’t really agree with the rationale.  A country that is willing to take first loss risks in a vehicle that not only can make investments in a broad range of assets, but is planning on making its investments in assets that the market has determined to be deficient and at prices above what the market would pay does dramatically reduce the credibility of those countries.

I would be surprised if EFSF can sell the “first loss” notes to the market.  They might have to be classified as subordinated debt, or possible even equity.  That would have an impact of the regulatory capital requirements of the buyers of those “AAA” notes.  But that can be fixed.  The EFSF could create a 1% “first loss” tranche that they sell to the ECB, so the notes are no longer first loss.  The 1% “equity” stake purchased by the ECB would likely be worthless from a valuation standpoint, but being able to “honestly” say that the EFSF notes are senior and AAA would make it more plausible when they accepted them as 0% risk weighted assets.  It is ironic how all the politicians who hated “financial engineering” will hop into bed with it as soon as it’s helpful to their current agenda.  Even with these tricks, I think the risk of EFSF losing its AAA rating would scare investors.  It would scare me.  What would scare me more is that in a year, when I need to collect on the EFSF guarantees, new governments in some of the countries fight payment.  They would argue that the guarantees made by the prior government are unconstitutional or illegal.  Guarantees, like many forms of insurance, sound great until you go to collect payment.

If my analysis is correct, then EFSF may have to get money directly from the guarantors.  That is what the plan is for ESM so it’s not an outrageous suggestion.  But who will actually provide the funds?  EFSF does have guarantees from the non AAA countries.  Those were largely for show so that it would look like there was responsibility across EU members, even though investors were looking primarily to Germany and France.  Germany’s “over” guarantee is €211 billion.  Germany may argue they should only post €128 billion of cash into the vehicle and every other country should post their appropriate amount.  Why should Germany put up the full amount of its guarantee exposure if they are now investing in a potentially non rated first loss?  But then Italy would need to put up €84 billion and Spain would put up €56 billion.  Since the EFSF could just lend them the money, that would be the best solution, because then Germany could pretend other countries are putting up their “fair” share.  But would the markets see through this scheme?  Would the rating agencies see if for the joke that it is?

Where would the EFSF be able to fund the second loss tranche?  Where would it raise €1.6 trillion of senior debt money? China and Russia are obvious candidates.  Will they demand more than 20% subordination to take this over?  Will they argue that EFSF can do too many things and they want further credit support?  Where does it end, but I am not sure that with 20% only below them in a vehicle pretty much designed to lose money, that investors will flock to these notes.  Maybe they can create a mezz tranche?  Maybe, they can get AIG to write some super senior protection so they can sell the senior notes on a wrapped basis?  Once they get enough subordination then China and Russia can sell treasuries to the Fed so that they can buy the second loss notes.  At that point the EU/ECB would be the largest holder of risk on European bonds (via a first loss position) and the Fed would be the largest holder of Treasuries.  Something about that makes my head hurt.

Look at what they are talking about doing.  Look at how unsuccessful any of the previous, poorly thought out plans have worked.   Contagion has spread.  European bank shares are down 50% from a year ago.  European stock indices are down 20% from a year ago.  Portugal and Ireland are in deep trouble, and Italy and Spain are on the cusp of trouble.  Will more bogus plans that don’t really ever get implemented, that fix nothing, but make the system more convoluted really do anything?  Wouldn’t we be better off letting some defaults occur and picking up the pieces.  Maybe more time and energy should be spent on how to pick up the pieces while some are still independent, rather than further linking everyone to the anchor?   Maybe more time should be spent determining if Lehman was “solely” responsible for the problems in late 2008 and early 2009?  Maybe the problem wasn’t Lehman defaulting and it was just another piece of a bigger uglier puzzle and we are so busy trying to avoid another “Lehman Moment” that we have lost sight of whether it is that important to avoid a default?


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