Monday, 31 October 2011

Leveraging the EFSF

Although there are no definite details of how and when the EFSF would be leveraged there are some hints that allow us to make some initial points (EFSF website, EU statement). In a strange quirk of fate, the EU is now seriously contemplating using almost exactly identical financial gimmicks and structures that it accused of bringing the world economy to the brink of extinction. i.e. SPV’s, CDS’s, CDO’s, leveraging toxic mortgages and credit slicing. Instead of mortgages, we now have peripheral debt and instead of CDS we have EFSF certificates, and EFSF controlled SPV’s.

EFSF Pool of money
The initial pool of money allocated to the EFSF was 440bln. However, as more countries are raised to the pig status this has come down. Current estimates are around 250-290bln. The uncertainty comes from the fact that the EFSF would be called to recapitalise Banks if the respective Bank and country fails to raise it.
EFSF leverage
According to the not so clear EU communiqué the EFSF would be allowed to leverage the remaining amount of cash 4 to 5 times and this is how the 1trl figure is achieved. This leverage is going to be achieved using two different options:

Option 1. Credit Certificate
This is how we presume it is supposed to work (see EFSF website). Investors would have the option when buying a NEW issue to ask for an EFSF guarantee certificate to be attached to it. This certificate would offer a 20% (the exact amount has not been fixed) protection given default. This would be the EFSF guarantee. Subsequently, one could detach the certificate from the body and sell it thus creating a new parallel to the CDS insurance market. We do not know whether one could, for example, buy in the open market 5 of these and claim full insurance against the bonds but it seems that these certificates are going to be country specific.
The idea behind the proposal is that investor would lower their demands for yield once they know that they are partially protected. It is not known whether Eurostat would use this fact to lower the debt of a country or increase the one to the selling county. As the markets are efficient, this drop in the yield presumably would be compensated by an equivalent increase in yield of those we sell the protection, namely the EFSF countries.
This brings us to the next few points.
Correlation Risk. Since the EFSF is composed by all countries including the ones that the protection is aimed at, it would be very hard to price it. This is also known as correlation risk. Simply put, it is imprudent to buy protection insurance against someone from that someone. We therefore conjecture that the market is going to price it solely as German risk.
Concentration Risk. Greece, Eire and Portugal already have their share of the bailout from EFSF and hence this is aimed at Italy and possibly Spain and Belgium. However, the sheer size of Italian debt would make it a purely German risk. In other words, there is a single point failure in the whole scheme and that is called Italy (some may call it Berlusconi).
Credit Event. The EFSF website tells us that the certificate would be paid if ISDA determines that there is a credit event. I don’t see how this can be reassuring to prospective investors given the lengths the EU has gone the past few months in order to avoid calling the Greek bankruptcy a Credit event worth triggering the CDS. Could the EU engineer something similar in the case of Italy in order not to pay the insurance as it has done for Greece? Would voluntary restructurings become credit events?
CDS. One cannot help being cynical when it comes to the CDS market. The EU leaders did their best to badmouth the CDS market and now they are trying to create a parallel one themselves. Is this a way to corner or even manipulate the sovereign CDS market? We do not know. Why not buy CDS outright instead of the complex certificate process. EFSF claims that since it is a 3-A entity it would offer superior protection to investors (see points above on correlation and concentration risk). Is there going to be an arbitrage between the certificate and the CDS? Maybe, but the devil is in the documentation and pricing risks properly.
Negative Pledge. A rather minor point but one that should not be overlooked is the issue of negative pledge. As was the case of Greece with Finland, many Italian and other periphery bonds have a prohibition on giving security unless it is done to everyone. We believe that this would be dealt with effectively (given the right amount of legal fees to lawyers).

Option2. The SPV approach
The SPV approach aims to create a vehicle that investors from across the world would be able to invest in. It would be structured so as to be attractive to SWF and other international investors. Although they have not mentioned it, they could also be one suitable for Islamic banking. There would be one SPV per country and its purpose would be to buy in the Primary or Secondary market bonds of the country in need. So, how are the investors in this SPV would be protected? The idea is that there would be a 3-tier capital structure with the EFSF taking the first loss.
Senior Tranche. There would be a Senior tranche that would pay a fixed coupon. This would be a freely tradable bond.
Participation Capital Instrument. This would be junior to the Senior tranche but rank higher than the EFSF investment. It would carry a small coupon and it would take a cut from the appreciation or full redemption of a bond. For example, if a Greek bond now trading at 50% is bought and is redeemed in full, there would be a 50% of the nominal gain. This would be distributed (we don’t know how much) to the holders of this participation instrument.
EFSF Investment. This money would be used as a cushion against any losses given default. The exact amount has not being revealed.
It would be interested to see if the SPV would be able to buy not just new issues but already existing ones, as these are precisely the ones that would give the Participation trance its biggest gains. If that is the case, then we have another possibility of a grand Free Rider alongside the ECB. According to the EFSF website, the setting up of these SPV could only take few weeks and this may coincide with the PSI.

EU Politics
The sole purpose of both options is to attract investment from the private sector to the rescue of the periphery. This however, has to be done in accordance to the fortress Europe principle which does not allow foreigners laying their hands on real assets in Europe. Only Europeans (Germans) have that privilege. In other words, Europe is not only trying to raise cash but also to control the amount and where it is going. On the other hand, it would be very hard to play that sleight of hand to the most likely investors to this scheme, the Chinese. We would therefore expect them to be less enthusiastic or to demand in parallel other more “physical” concessions.