The €440 euro EFSF facility does not come close to covering the needs of all of the PIIGS that need assistance. Thus, it is imperative to expand the impact of the facility. But since it will be politically impossible to raise any more money via European parliaments, it is clear to all involved that something “creative” must be done.
As outlined here, the best – and, in my opinion – the only way to have leveraged the EFSF funds effectively would have been to have used the available funds as a “reserve” or “equity tranche” of a leveraged vehicle that would have been funded by the ECB.
This idea was favored by the French. However, this proposal has been completely and publicly discarded by the Germans and by the ECB itself.
According to various news outlets, having discarded the French proposal, the “best” idea to come out of the brainstorming sessions leading up to the EU summit this weekend is to use the European Financial Stability Fund (EFSF) as a “first-loss insurance” mechanism to guarantee the first 20% of any eventual losses on the sovereign bonds issued by troubled countries.
Although the proposal seems plausible at first blush, there are any number of reasons why this idea will ultimately not work. In this article I will only discuss one of those reasons: The proposed bonds with an EFSF first-loss guarantee are like Brady bonds, but without any of the credibility.
Fake Brady Bonds
The proposal apparently being discussed in European corridors is somewhat reminiscent of the Brady Plan that was implemented to rescue Latin American Countries and their creditors in the 1980s.
At the heart of the Brady Plan was the issuance of what were denominated as “Brady Bonds.” The salient characteristic of these bonds was that a certain portion of the principal and/or interest was guaranteed by the U.S. Treasury in the form of U.S. Treasury Bonds that were used as collateral.
The Brady Bonds were quite successful in the 1980s and 1990s in helping to restore the credit of Latin American basket cases in global sovereign bond markets. Couldn’t the same concept work for the European PIIGS?
Unfortunately, the plan currently being discussed is unlikely to be successful in rescuing European basket cases. There are two main reasons to be skeptical:
1. The lame leading the lame. The guarantee of the bonds issued by basket cases is partially issued by the basket cases themselves. After all, the EFSF will presumably be funded by all of the member countries, including the PIIGS themselves.
The question is: Why would anybody believe in a guarantee that is backed by unwieldy conglomerate nation-states, some of which are near-insolvent? Indeed, many of the nations backing the fund are precisely the ones that need guarantees because they are considered un-creditworthy. This is not a riddle that can be solved. It is plain illogic.
This glaring flaw clearly distinguishes this scheme from the Brady Plan in that the guarantees embedded in Brady Bonds came from a single source that was highly credible at that time.
2. If no restructuring, what’s the point? One of the factors that made Brady Bonds credible is that virtually all of the outstanding sovereign debt and debt service of Latin American nations was reduced (through hair-cuts) and restructured prior to issuance of the new Brady Bonds that replaced the old debt.
One of the biggest problems with the current proposals is that it does not contemplate a prior restructuring in order to make the new issues credible. The sovereign debt and debt service of the issuers will be exactly the same as before – only larger.
Many investors may conclude: What’s the point? If the reason why PIIGS sovereign bonds are currently trading at low values is that the level of debt of the PIIGS is too high, then the current proposal does absolutely NOTHING to lower PIIGS debt.
3. Terrible signaling. Brady-type bonds are like big fat signs that say: “Un-creditworthy.” The program is scheduled to last until the middle of 2013. What in the world would cause anybody to think that the PIIGS will be able to get off of life support in 2013? Their debt will not have been reduced. Their economies will be equally uncompetitive due to accumulated PPP imbalances. Thus, labeling PIIGS sovereign debt as “un-creditworthy” today essentially puts a big “bulls eye” on all of the sovereign debt of these nations maturing after mid 2013. Thus, the yields on long-term debt are likely to go sky-high.
4. Multiple classes of sovereign bonds. The Brady Plan consolidated all of the sovereign debt of the countries that participated, which was then reissued in the form of Brady Bonds. The current plan being contemplated by the Europeans will not consolidate debt – it will create two classes of bonds: The new guaranteed bonds, and the old un-guaranteed bonds. At how much of a yield premium do you think that the old un-guaranteed is going to trade? It will likely be very substantial. Those extremely high yields will then become the reference yield for the entire structure of interest rates in the country involved. Note also that the market is not dumb. In the 1980s and 1990s, the relevant sovereign yields quoted for nations under the Brady Plan were “stripped yields.” In other words, bond traders calculated the theoretical yield of the underlying security as if the guarantee was “stripped” out of the bond. The stripped yield was obviously much higher than the conventionally calculated yield.
Conclusion
The new bonds that would be issued with the EFSF guarantee will enjoy none of the credibility that the U.S. Treasury guarantee was able to confer upon Latin American Brady Bonds in the 1980s and 1990s. Furthermore, creating dual classes of sovereign bonds will do nothing to lower the reference yield on the sovereign debt of the PIIGS.
Issuing debt with guarantees does absolutely nothing to improve the stand-alone creditworthiness of the issuer. If the issuer was un-creditworthy before the guarantee, without restructuring, the issue will be just as un-creditworthy. The only difference is that 20% of the losses will presumably be covered by a paper tiger called the EFSF that is ironically backed by some of the same countries that are so un-creditworthy that they need guarantees. Again, the fact that eventual losses may be reimbursed by some entity does not improve the underlying creditworthiness of the issuer. The economic fundamentals remain exactly the same as they were before – high debt, low competitiveness and no growth prospects. Thus, if investors did not want to buy the sovereign bonds of these countries before (unless enticed by extremely high yields), there is no reason to think that they will want to now.
This is one case in which putting lipstick on a pig makes it look no better. Quite possibly it makes PIIGS look even worse.
I doubt whether Nicholas F. Brady, the 68th Secretary of the Treasury of the United States who oversaw the successful implementation of the original Brady Plan, would want his name associated with this turkey of an idea.
Hold off on the purchase of stocks (SPY, DIA, QQQ) until and if the Europeans can come up with something more credible than is being discussed right now. Indeed, if the Europeans do not come up with something more credible by this weekend, I expect U.S. indices such as the S&P 500 (^GSPC), Dow (^DJIA), Nasdaq (^IXIC) to trade much lower. Quality stocks such as Apple (AAPL), Microsoft (MSFT), Intel (INTC) and AT&T (T) will be available for purchase at much lower levels.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long puts on SPX, DBC, and XLB.
