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.