One of the few complaints of the most recent bailout was that the size of the European Financial Stability Facility wasn’t increased. I was amazed at how many experts claimed that EFSF was too small, but everything else about the bailout was great. I will ignore the fact that the IIF voluntary restructuring proposal seems to have disappeared into a black hole and focus on the problems of the EFSF portion of the bailout.
People have argued that EFSF is too small to have an impact on Spanish and Italian debt if they continue to experience trouble. That part is true. An EFSF PIIGY bank of only €440 billion will not make a dent on the yields of Spain and Italy, with a combined debt of €2.2 trillion. That is only if the entire €440 billion was available for those two countries, but most of the money will be used up supporting Greece, Ireland and Portugal. So it's true that EFSF is too small to do anything material to help Italy and Spain, but that doesn’t mean it is small. In fact, the EFSF is large, and may be too large already for France and the Netherlands.
If the EFSF issued the full €440 billion, it would be one of the biggest bond issuers in the world. It would have more debt outstanding than any corporate I could find. DB has €370 billion, GS $400 billion, and GE $367 billion. The fact that EFSF would have more debt outstanding than these massive global companies puts its size in perspective. The Netherlands has only €307 billion of debt outstanding, Belgium €315 billion, Austria €194 billion, and Finland €74 billion. Do these countries, which provide 15% of the guarantees, think €440 billion is small? Fannie Mae comes with $742 billion of debt outstanding and everyone knows how well that worked out in the end.
So although the EFSF is too small to have an impact on Italy and Spain, it is actually a very large entity, and would have more debt than almost any corporation and most governments.
As EFSF has morphed from a prudent liquidity provide at times of need to specific borrowers into a PIIGY Bank that has virtually unlimited powers, the rating of EFSF is now solely based on the coverage provided by the AAA-rated governments. Earlier this year, the structure of the EFSF was changed to allow it to issue up to €440 billion of bonds. That required each government to change its “over-guarantee” to 165% from 120%. The sum of the guarantees provided by the AAA governments (Germany, France, Netherlands, Austria, Finland, and Luxembourg) total €451 billion. It is not a coincidence that EFSF debt issuance is constrained by the total guarantees provided by the AAA countries. With the expanded powers of the EFSF in the latest proposal, it is clear that you cannot rely on the assets of the EFSF to provide value.
In a rational world, someone would try and figure out the likely worst case value of the EFSF, and then only look to the guarantees to cover the losses. But if this crisis has taught people anything, it is that rating agencies don’t always live in a rational world. So once you start looking solely at the guarantees to determine the rating, you run into another one of the rating agencies’ little quirks. If any part of a potential payment was covered by only a AA-rated entity, the agencies would feel compelled to provide a AA rating for the whole amount of debt issued. That is why to get the AAA rating, the EFSF will need the AAA guarantors to cover the whole amount. It seems a bit weird, but that is how the rating agencies tend to work. Though in their defense, relying on the guarantees provided by Spain and Italy to buy their own debt is a bit convoluted, and you have to assume that in the worst case, where the EFSF has purchased bonds of those countries and they default, the guarantee provides little comfort.
So now that it is clear that the EFSF is completely dependent on the AAA guarantors, let’s put their EFSF guarantees in some perspective. The Netherlands’ guarantee is equal to 14% of its existing debt. Would the market be comfortable if the Dutch came to market and increased their debt from €307 billion to €351 billion? How comfortable would investors be if they came to market with a €44 billion issue? That is a big increase in the debt of Holland. I believe investors would get nervous, and so would the rating agencies. The EFSF guarantee mechanism and second loss protects the Netherlands, but in the worst case, this is an obligation of the Netherlands. Germany's EFSF obligation is 17% of its existing debt, and for already reluctant Finland it would be the equivalent of increasing its outstanding debt by 19%. These are big numbers. Looking at the guarantees in terms of GDP doesn’t make the numbers less daunting. Effectively these countries are taking on obligations of about 8-9% of their respective GDPs. Adding debt of almost 10% of GDP should raise some eyebrows, both for investors and the rating agencies.
The obligations created by the AAA governments are large relative to their existing debt and to their GDP, and are big enough that they could cause real problems for the guarantors if and when they are called on to meet their obligations. It may even increase their own cost of debt, as the EFSF competes with its own debt amongst bond investors.
Finally, does the EFSF really accomplish much? One of the most ballyhooed PIIGY bank features is the ability of the EFSF to buy bonds at a discount and lend money to the country to buy them back, thus decreasing the notional owed by that country. Let’s say that the EFSF buys €20 billion of Greek 5.3% March 2026 bonds at 60% of face. So the EFSF spends €12 billion. In the proposal, the EFSF would now lend Greece €12 billion so that Greece could buy these bonds and retire them. Greece would have €8 billion less debt outstanding. That is good for Greece. The EFSF would have used its guarantees to borrow the €12 billion it needs. If the EFSF lends the money to Greece for 15 years at 4%, the market value of that loan has to be less than 60% of face. That loan would be longer dated, with a lower coupon than the bond that is trading at 60% of face in the market. That loan has to have a lower valuation. Let’s say 55%. So the EFSF borrowed €12 billion and now has an asset with a mark to market of €6.6 billion. Greece benefits because it got to reduce its debt by €8 billion, but you cannot ignore that the EFSF just did a trade that cost it €5.4 billion on a mark to market basis. This scheme comes at a cost (or gift) and it is yet to be determined how much the AAA countries are willing to gift to other countries.
There is an even bigger problem with this scheme, and one that limits how much it can really do. I continue to view the sovereign bonds of each country as belonging to two categories – the “free float” or those that are held by entities that have them marked to market, and the non-marked bonds. From the data presented by the IIF, it appears that most of the Greek debt is still held in non-mark to market accounts at banks and insurance companies. The “free float” bonds can be traded around with limited consequence. The EFSF can purchase these from trading desks or hedge funds (or from hedge funds via trading desks) and not have an impact on the non-mark to market holders. Quickly, the fast money will realize who the ultimate buyer is and restrict the amount of free float bonds for sale, until they extract the maximum possible price from the EFSF. In the end, even if the EFSF was able to buy all the bonds already in mark to market accounts at a reasonable price, the potential benefit to the countries is limited. There just aren’t enough bonds readily available in the marked world. So the EFSF would need to source bonds from the great unmarked pool.
These are the same banks that the EU/ECB/IMF have been trying hard to help avoid losses. These are the banks that are potentially weak and may start a contagion amongst banks. How can these banks afford to sell the bonds and monetize the loss? They should be able to, but there is concern that they aren’t capitalized well enough to do it. If they start selling en masse, the losses have to hit the books of those institutions. Wouldn’t that trigger a potential run on the weakest banks and potentially unleash contagion?
The EFSF plan to let countries buy bonds at a discount is a true Catch-22 proposition. If they don’t source many bonds, the benefit to the country is too small to make a difference at the sovereign level, and sovereign contagion risk remains in play; if they are able to buy a meaningful amount of bonds, they will be coming from banks that had been desperately avoiding taking the mark to market hit, potentially triggering contagion amongst the banks. The narrow window where this program might stop sovereign contagion without triggering bank contagion is too small to think a bunch of politicians or economists will be able to steer the course accurately and that some other unintended consequence won’t rear its ugly head.
Given my views of how unlikely the EFSF program is to be successful, coupled with doubts about what the IIF can accomplish through volunantry submission, I continue to be bearish the market.