Putting The Con in Confidence Part 1 – Published on naked capitalism, by Satyajit Das, November 1, 2011.
The most recent summit failed to meet even the lowest expectations. Euro-Zone leaders displayed poor understanding of the problems, confused strategies, political bickering and infighting as well as inability to take decisive steps and stick to a course of actions. This summit follows the 21 July 2011 declaration of a definitive grand plan to solve the problem. Like the ones before it, the 26 October meeting yielded a plan to have a plan to have a plan etc. There’s no reason to believe that this summit will be the last … //
… Holey Fences:
An enhanced EFSF is the cornerstone of efforts to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis.
The EFSF will provide loans to or purchase bonds in order to support market access for Euro-Zone Member States faced with market pressures and to ensure that their cost of borrowing does not rise to levels that threatens solvency.
After accounting for existing commitments to Greece, Ireland and Portugal, the fund’s available capacity is around Euro 200-250 billion. If it has to finance recapitalisation of banks in member states, then this capacity is further reduced.
The EFSF does not have adequate resources to perform its functions. The amount available can be compared to the financing requirements of beleaguered European countries.
In the period to the end of 2013, Ireland, Portugal, Spain, Italy and Belgium will need to raise about Euro 700 billion to finance their deficits and refinance maturing debt. In 2012, Spain faces maturing debt of around Euro 120 billion. Italy has debt maturities in 2012 of Euro 260 billion and another Euro 150 billion in 2013. Crucially, Italy faces debt maturities of around Euro 40 billion in February 2012.
Italy’s total debt is Euro 1.9 trillion (118% of GDP), the fourth-largest debt in the world after the United States, Japan and Germany. Spain’s total debt is above Euro 600 billion (61% of GDP).
In order to enhance the capacity of the EFSF, the EU proposes to leverage the fund.
The EU proposes provision of credit enhancement to new debt issued by member states to reduce its funding costs. In the absence of details, it is widely assumed that this will entail the EFSF guaranteeing a certain percentage of the first losses on new bonds. Promoted by German insurer Allianz, the plan would entail investors in say Ireland, Portugal, Italy and Spain being protected against losses on bond holdings, up to an unconfirmed amount of around 20%.
The plan raises several issues:
- 1. The bondholders would still look to the issuer and assess its solvency and ability to meet its obligations.
- 2. If losses turn out to be above the insured first loss amount then the investor would be at risk. Losses on sovereign bonds are variable and difficult to predict.
- 3. Technical details such as the trigger of the payment, the loss determination and payment mechanism are complex.
- 4. The insurance would apply to new issues and may create a two-tier market – one for existing bonds and another for the new insured securities.
- 5. This risk insurance would be offered to private investors as an option when buying bonds in the primary market for a price. There are uncertainties about the price. It is also not clear that it would be preferable to alternatives already commercially available such as CDS.
- 6. The legal impact of such insurance on legal provisions of existing bonds, such as the negative pledge and pari passu clause which prevents the borrower from pledging its assets to prefer a particular group of creditors or change the ranking of investors.
To address some of these problems, the EU has proposed the issue of detachable insurance certificates that can be freely traded which would be available with new bonds. The price of this insurance would be reflected in the lower interest rates on such bonds. Following a default event, the certificate would entitle the holder to claim their entitlement for the loss suffered not in cash but in EFSF bonds.
In the absence of full details, it is difficult to assess the arrangements. Their complexity may create uncertainty.
The structure introduces unnecessary problems. If the certificates are regarded as derivative contracts then many investors may not be able to purchase them. The accounting treatment of these certificates, vital to ensuring protection against losses in financial statements, is uncertain. The structure also introduces exposure to the credit standing of the EFSF itself as the insurer.
It is unlikely that the insurance scheme will achieve its intended objectives to support market access for and the lowering of borrowing costs of countries like Spain and Italy.
The enhanced EFSF plan does not address fundamental problems of its structure. The EFSF in severally guaranteed by Euro-Zone member states (up to a stated amount). Major guarantors are Germany 29.07%, France 21.83%, Italy 19.18%, Spain 12.75%, Netherlands 6.12% and Belgium 3.75%. Given that Italy and Spain as well as others may need to avail themselves of the assistance of the EFSF, the circular nature of the scheme remains an issue with weakened nations undertaking to rescue themselves and their banks.
What’s Chinese for Begging Bowl:
A second option proposed is to enhance the EFSF using resources from private and public financial institutions and investors through Special Purpose Vehicles (“SPV”). Few details are available currently …
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(Satyajit Das is derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, and of Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives, Revised Edition 2006 and 2010).
Satyajit Das’ books on amazon;
HyperInflation Survival Guide, a free Research Report from the Institute For Individual Investors IFII, Florida/USA.