Strong action from the European authorities is desperately needed. Proposals range from extending the EFSF (European Financial Stability Facility) to allow a Greek default and recapitalize banks. Before any options are considered, we must be sure the data is precise.
The EFSF: there has been a lot of talk about expanding the size and scope of the EFSF.
i. Scope: Since July 21st (ratification still under way), the EFSF can be used to provide funds to non-program countries to recapitalize their banks. It can also intervene in the secondary market “on the basis of an ECB analysis recognizing the existence of exceptional circumstances.”
ii. Size: The current effective lending capacity is 440 b EUR. Official and non-official talks are up to 1-2 tr EUR. What lies behind the numbers?
If you expand the EFSF size, it means that you will have to use it either for bank recapitalization or financing for countries that lost access to market funding.
The European Bank Association (EBA) provided the details of the story of the 91 bank panels to sovereign risk. We must therefore understand that all players are in the know and have access to that data. There is no surprise in any kind of losses that banks may suffer in the case of orderly/isolated or major default. What matters most are the assumptions used in carrying the test. In most cases, the calculation is based on the assumption of a default that would not affect solely Greece and Portugal, but would extend to at least Spain and Italy.
We can consider several ways to do these calculations:
i. Assume that the CDS reflects the good level of haircut that should have sovereign debt: the need for recapitalization is estimated at 50 bn Euros (avoiding rounding).
ii. If we think instead that a threshold of sustainability for a country would return to the threshold of 60% of public debt required by the Pact of Stability and Growth, the need is then 100 bn.
iii. Assess the needs in the event of a 50% haircut in the peripheral countries: capital required is 150 bn.
Most estimates of bank capital need to rely on a regulatory capital requirement of 5% (“core tier one” Basel III) while the industry has set goals of 9%. They also do not account for losses on loans to the private sector that such restructuring could happen. Hence, the anxiety of investors who might fear that the 400 bn increase in the capital of European banks since 2008 is sufficient. But sufficient for what?
That leads to our second point. Instead of estimating the potential exposure of banks, we must at least question the validity and relevance of a widespread default. A 50% haircut of Spanish and Italian debt would amount to have the EMU close to a breakup.
There is a simple criterion for distinguishing countries’ solvency crises (for which default is inevitable) and those for which the funding difficulties are primarily related to the lack of resolution of the euro crisis (liquidity crisis).
The most traditional is the primary balance—the budget balance before interest payments. If the stabilization of public debt requires a primary surplus above 4-5% of GDP, the country is insolvent. The table shows that only against the countries currently under the European Financial Stability Fund (EFSF) is a solvency crisis. The others, including Spain and Italy, mainly require short term assistance to address a liquidity crisis (distrust of the markets). The urgency is primarily to ensure that these countries are experiencing a prolonged liquidity crisis and end up excluded from the market.
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It implicitly suggests that Larry Summers is far from alone when he proposes to “triple or quadruple the size of the EFSF to prevent Italy and Spain from becoming ‘toast’.” Where are these numbers? The EFSF has a capacity for action in the form of 440 bn Euros, a sum quite inadequate to the refinancing needs of Greece, Italy, Portugal, Spain and Ireland by 2014, which need 1,200 bn Euros (see chart below for redemptions alone).
Proof? No, because such a scenario would suggest that Spain and Italy could no longer finance themselves and should appeal to the EFSF. Above all, it would mean that Germany, France and the Netherlands would shoulder all the “residual” risk in the event that these countries could return to a sustainable fiscal trajectory.
An EFSF CDO?
Advocates of an enhanced EFSF suggest to “leverage” it. Keep in mind that before an intervention, the EFSF must first issue the debt market (EFSF can pre-fund, but it cannot tap the market for a specific program until a euro member requests help). In this sense, the EFSF is not the IMF, which derives its resources from central banks when it intervenes. This process is not only lengthy, but can make investors question the willingness to acquire debt of a financial vehicle whose leverage would be huge - paid up capital should increase to 80b EUR in 2013 - if its strength strike was extended.
Leveraging the EFSF would amount to drawing funds from the ECB to grant lows and offer a monocline/equity tranche-like guarantee. This appears quite risky. Furthermore, if increasing the size of the EFSF is intended only to avoid the contagion, there is a much simpler solution: the ECB should continue to buy Treasuries on the secondary market (or via the SMP). First, as noted above, insolvency is not the current threat for Italy and Spain. Second, and most importantly, the ECB has no limits on its capacity. It can also respond quickly.
Of course, anger is growing within the ECB: purchases of public debt is done in accordance to the “transmission channel” of monetary policy criteria (the increase in the risk premium destroys the beneficial effects of low interest rates) and not in response to a possible “quid pro quo” between the States and the ECB (in essence: “I am improving my finances, and in exchange you contain my sovereign debt yields”). The President of the Bundesbank, Jens Weidmann, believes that the ECB is going beyond its mandate.
But we must look to the obvious: only the ECB can now prevent the liquidity crises that affects the “big country” devices considered “too big to save”. It's transformed into a solvency crisis (note that Spain is currently pretty good when viewed through the scope of structural reforms, the fiscal correction and the good performance of exports). At no time did the ECB members say they opposed the SMP due to losses that could make them run a default in accumulated treasury bills. A central bank can afford the luxury of negative capital (“negative equity”).
The only reason for the EFSF to be extended is:
to help recapitalize bank if need be (note that if rig-fences work well the European banks can easily absorb the loss of an isolated Greek default);
to show that it can hit hard and massively. “Threat” would matter more than action because if Spain and Italy went under the EFSF program, there would be no doubt that it would take a fortnight for the market to look at core countries and ask, “who’s next?”
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.