EFSF leverage explained

Unless you have been living under a rock you have probably heard by now that “Europe is going to leverage the EFSF”. The stock market certainly seems to have read the headline but I wonder exactly how many people reading those words actually understand what it means, and more importantly how many of the eurocrats that who just enacted it do?

But before anyone can understand how the European Financial Stability Facility or the EFSF could be “leveraged” they need to understand exactly what it is.

According to the funds website the EFSF was:

… created by the euro area Member States following the decisions taken on 9 May 2010 within the framework of the Ecofin Council. The EFSF’s mandate is to safeguard financial stability in Europe by providing financial assistance to euro area Member States.

EFSF is authorised to use the following instruments linked to appropriate conditionality:

  • Provide loans to countries in financial difficulties
  • Intervene in the debt primary and secondary markets. Intervention in the secondary market will be only on the basis of an ECB analysis recognising the existence of exceptional financial market circumstances and risks to financial stability
  • Act on the basis of a precautionary programme
  • Finance recapitalisations of financial institutions through loans to governments

To fulfill its mission, EFSF issues bonds or other debt instruments on the capital markets. EFSF is backed by guarantee commitments from the euro area Member States for a total of €780 billion and has a lending capacity of €440 billion.

EFSF has been assigned the best possible credit rating; AAA by Standard & Poor’s and Fitch Ratings, Aaa by Moody’s.

EFSF is a Luxembourg-registered company owned by Euro Area Member States. It is headed by Klaus Regling, former Director-General for economic and financial affairs at the European Commission.

So at its most basic level the EFSF is like a bank. It was originally designed to provide loans to eurozone nations who ran into economic difficulty. The point is, however, that the fund has no money up-front. Euro nations have “pledged” money to fund in case of default on a loan issued by the fund to a struggling nation, but the basis of the fund is that it will raise money from investors by issuing bonds. This is a critical point that I think many people have missed. Investors must be found who are willing to purchase EFSF bonds backed by loans to euro nations at precisely the time the markets has decided that those countries (or nationally backed institutions) aren’t credit worthy.

In fact if you look at the details of the fund’s mechanism you realise that EFSF funding comes with special conditions that look as if they were written by the Troika:

Any financial assistance to a country in need is linked to very strict policy conditions which are set out in a Memorandum of Understanding (MoU) between the country in need and the European Commission. For example, conditions for the Irish programme include strengthening and overhaul of the banking sector, fiscal adjustment including correction of excessive deficit by 2015 and growth enhancing reforms, in particular of the labour market.

Sounds familiar doesn’t it ?

It is also important to understand that the EFSF is not a charity. It issues loans to struggling nations that must be paid back with interest and these loans are the collateral for the EFSF bonds. As the EFSF is guaranteed by other participating European nations, at a time of default it is up to those nations to meet the obligations of those bonds including ALL interest payments. It is that last point that shocked the Finns who seemed to have neglected to read the fine print on the legislation that they ratified.

So now you understand what the EFSF is, what does it mean to “leverage” it ?

Well there are a couple of ways this could occur but at this point are still waiting on the details. However the most likely at this point, given that Sarkozy and the EFSF’s Regling are currently smoozing China, is that the fund will become some form of giant collateralised debt obligation (CDO) based fund. If this is correct then basically this means that EFSF will have the ability to issue notes up to €1 trillion, but there would be some sort of tiered structure where a tranche of the notes up to a certain value would be backed by the euro nations while lower grade tranches would not be. The idea being that due to the guarantee on the senior tranches investors would be still be willing to participate in lower tranches due to the perceived “first loss” guarantees. This would theoretically mean that the fund could raise much larger amounts of capital without additional risk to euro nations, but it isn’t actually that simple.

The trouble with the EFSF is that it is backed by sovereign nations that have already been locked out of conventional markets. This obviously assumes that they are under significant financial stress and there is the high likelihood of default. This has been the case of Greece which has been under instruction from the IMF to implement economic adjustments very similar to the ones specified in the EFSF charter. For highly indebted non-export driven nations such as Italy, Portugal and Spain these measures are likely to make their underlying economies worse while they are attempting to meet their obligations to the EFSF loan. Under these circumstance there is a fair chance that something will eventually go wrong, and if recent history is anything to go by CDOs have a funny habit of under-performing, leading to the requirement for re-capitalisation and more incentives from guarantors to stop the funds from imploding. Just imagine if Greece had been under an EFSF loan over the last 12 months… Now imagine if that was Italy.

The chart below shows of the spread between the first five-year €5bn EFSF bond, used in the bailout of Ireland, versus those of AAA euro-nations. The fact that the EFSF bonds are slowly drifting apart from the guarantor AAA rated nations implies that there is already some concern that the EFSF guarantee is not an acceptable risk mitigator. It must also be noted that particular bonds are collateralised against loans to Ireland, a nation that is on the mend due to its export status, and  this is while the fund has only issued bonds totalling less than 5% of the euro-nations back-stop guarantee under a perceived 100% insurance obligation.

So can a leveraged EFSF save Europe? Potentially yes, but only if we see Europe address some of its other macro-economic issues.

We already know that Europe has set itself a course of deflation via austerity budgeting and bank re-capitalisation. I have been predicting for over a year that Greece would end up defaulting due to its macroeconomic metrics and I have little doubt that Portugal and Spain will eventually join it due to their own unless something is done to address competitiveness differentials across Europe.

If this does occur then the EFSF will attempt to seek capital via bond issuance to support a loan program while pushing further austerity based economics on the recipient country. If successful this would initially lower funding costs for the nation, however the mix of austerity on the public budget and high private sector debt in the absence of exports will inevitably lead to default as it did for Greece. At this point the AAA rated countries would be called upon to meet their obligations but by this time it is likely that the entire instrument would have been rendered useless leaving them holding the entire obligation.

Obviously this is a all hypothetical at this point, and we haven’t even seen  technical details of how the fund will actually be leveraged, but you can see there is the potential that Europe has just signed itself up to something far more worrying than a default by a small nation like Greece. You may also have realised now why France is on downgrade watch.

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  1. and the maket is going gangbuster : “if you have alot of people not paying their mortgage, imagine the amount of purchasing power you have in the country”.

    not mine

  2. unless something is done to address competitiveness differentials across Europe

    And how can that be done without the PIIGS exiting the Euro?

    however the mix of austerity and high public sector debt in the absence of exports will inevitably lead to default as it did for Greece.


    How do the PIIGS grow their way out of this without exporting? The Euro is rallying on all this “good news”, so its making it harder to export outside Europe, and they can only compete within Europe by cutting labour costs.

    And if the Euro were to weaken again the main beneficiaries would be the Germans.

  3. rob barrattMEMBER

    Forgive me if this sounds cynical, but with the certainty of a Greek default, impossible targets for the other PIIGS austerity measures etc you have to ask the question ‘why concoct an unworkable, patently dishonest solution?’.

    When apparently absurd policies are being formulated you have to ask ‘who profits from all this?’. Contract fees, advance percentages on all this paper, time for bank executives to jump ship etc etc has to be the answer. What IMO is happening is that the powers that be are extracting the last few drops of juice from the fruit before heading for the yacht. I converted all my Dutch partner’s (euro) savings to gold about 6 months ago. I found I had 300 euros in cash left from a European visit last year and cashed them out at Brisbane airport last night. I don’t intend going down with the ship.

    • Some Yanis gold:

      The only good thing one can say about our politicians is that they’ve created such low expectations in the markets over the last weeks and months that it’s very hard to surprise negatively the markets now. So, even if the news is bad as opposed to atrocious, the markets are going to receive a little bit of a boost today.

      But I think that once investors pore over the details of what’s happening, they will realise that nothing much has happened, so it would be back to business as usual as of the – in the next two or three days.

      I wonder how correct he will be on that call ?

  4. Great post DE. Maybe I’m misunderstanding things, but doesn’t this seem like the whole subprime mess all over again?

    Admittedly there are differences, like this time we’re lending to countries. But if, as you point out, the conditions lead to default, then the bonds end up relying on the guarantees of whoever is insuring them (the rest of Europe). In this case it’s not too hard to imagine an AIG-type situation, except this time instead of the insurer being unable to pay, the insurers simply refuse to pay due to massive political backlash.

  5. So correct me if I’m wrong but… The AAA rated EFSF requires the contributing states to be AAA. France is 1/5 of the EFSF. France is getting near the downgrade threshold – all it needs is another bank failure with associated bail-out from the govt and they will most likely get a downgrade. French banks have a big exposure to Greek debt. These French banks are among those taking a “voluntary” 50% haircut. These French banks are also the ones who refuse to disclose the amount of red ink all over their balance sheets.

    Where can I buy some CDS on the top-rated tranches of the EFSF??? Oh wait, they won’t honour them anyway…

  6. Nice summary.

    What is the latest on whether CDS events will be triggered by any of this?

    Has the 50% haircut number been devised based on what it would take to get Greece viable or what the banks will swallow?

    • They’ve been “asked” to accept the 50%. But I don’t see them having an option now….but this is the EU so anything is possible. I’m just wondering when it will all unravel.

  7. Thanks DE. I will have to read this a few
    times to let it all sink in.

    It is common knowledge that there is not enough existing money in Europe to bail out Spain and Italy.

    So today the markets are celebrating the AGREEMENT yesterday from eurozone leaders that investors from IMF, BRICs and Norway (I suspect) will fund the leverage and the next PLAN is to get those investors involved! Now it makes sense why we’ve had all those rumours circulating about Eurozone courting the BRICs in the past months.

    Fantastic! /sarc

  8. DE.

    Great post. I think you’ve nailed the main flaws in the EFSF, and they are big ones.

    The EFSF is too small, and the wrong treatment for a misdiagnosed disease. And now they’ve levered it up, potentially blowing the whole show a mile higher when it comes undone.

    Changing topic slightly, if anyone on MB could comment on the implications of the eurocrats successful neutering of the CDS market (assuming they can pull it off), I’d be much obliged. My shit-detectors smell a stinking pile of unintended consequences if they manage to avoid triggering a credit event. Why anyone in their right mind would trust a CDS contract if the eurozone avoids a credit event on a 50% “voluntary” (my ass!) haircut is beyond me. And what about all the other CDS contracts currently out there? What does this mean for them?

    • rob barrattMEMBER

      Britannia (at least in that the pound aint the Euro..)rules the waves, but the Troika waves the rules.

  9. Thanks for putting an understandable analysis around what for most is an unfathomable structure.

    You are correct that it is doomed to failure and its just an effort in can kicking which if that’s what markets want, fine. Turn debt into capital and then eventually into losses.

    Governments should not get involved in structure finance. Some bunch of banksters will be getting paid very well for very poor advice.

    All the sovereign risk in the EFSF is corelated so no amount of trying to reduce risk by pooling works. This also means that the AAA rating is incorrect. Even if the largest guarantor states are AAA. If the structure had to come down to just those states to pay, they have neither the capacity or the will. Its just another flawed opinion of a credit rating agency that suddenly suits the governments of the EU. Which an eye blink ago have been trying to decrease the rating agency powers in the banking markets. Nothin like getting into bed with the devil when it suits.


    • Thanks Deep T.

      So I’m not going crazy thinking the latest leveraged EFSF plan is actually multiplying an earlier disastrous idea.

      I thought the US mortgage market had already schooled even the half-bright people of the world that if you fill a bag with 10% prime rib and 90% sawdust and sell it as Class A prime rib, the outcome won’t taste very good?

  10. Not to mention that Spain and Italy have to roll over nearly a trillion of debt themselves in the next 2 years, so that’s pretty much all the EFSF money gone, and that’s before Portugal puts it’s hand up for more money in the next few weeks… FAIL!

  11. On what basis is the EFSF rated AAA? It can only be that Germany and France are back stops. As others have pointed out, France already has a question mark.

    The ratings agencies are on the front foot this time around, once bitten twice shy following their subprime incompetence. How long before the EFSF rating is reviewed / downgraded? Particularly in light of its newly acquired leverage and partial insurance?

    This is all smoke and mirrors and a massive exercise in manipulation of market psychology. Germany may as well have just issued bailout bonds. Why didn’t they? Well, apart from the legitimate response of ‘why should they?’, the fact is several European nations have unsustainable debt levels and this burden needs to be relieved via default. How does one learn without being given a lesson?

    This is all just papering over cracks.

  12. “It must also be noted that particular bonds are collateralised against loans to Ireland”

    I disagree. The bonds are pari passu, unsecured. You are also in trouble if something goes wrong with loans to Portugal..

    I have another worry with the EFSF. Let’s imagine something goes wrong and cash from guarantors is needed. Well, most – if not all – of the guarantors would need to sell bonds for the funds. Since something has gone wrong, market sentiment would be a little shaky, I suppose. Some of the weaker guarantors might not be able to pull it.

  13. EFSF Stands for European Financial Stability Facility. ‘Fund’ wouldn’t have been obfuscating enough.