Singularity's  Instablog

September 27th

European markets seem to be excited about prospect of leveraging EFSF resources. 

As this is ultimately a sovereign (Periphery) solvency problem  intermediated by banks I see two possible solutions to the problem:
1. Debt restructuring and bank recapitalization
2. Further fiscal transfer of periphery debts by the core.

Although restructuring/recapitalization is much cleaner, it is more painful short term. As politicians are not willing to take any pain, they have been pursuing fiscal transfer solution so far. However fiscal transfer solution can only work if it reaches the size where entire periphery debt is refinanced by the core. This does not seem possible as core's electorate is unwilling to take any more obligations on. This is best evidenced by consistent losses by Merkel's party in regional elections.

Leveraging EFSF resources seemingly overcomes that problem, as it increases resources available to purchase the periphery debt without asking the core to commit more capital. However it does not change the amount of potential write-offs the market has to take. From this point of view collateralization ratio becomes the key to obtaining AAA rating. My initial assessment is that it will be hard to leverage it more than 2x. So it is not obvious that solution by itself will materially change the situation.

It is worth noting that original TARP plan in the US similarly was focused on purchasing "toxic" assets from the market. However the market only reached the bottom once TARP was re-oriented on capital provision to the banks.

So the room for failure and disappointment is quite high here. However for now it seems that the market is following tried and tested "by the rumour" strategy. We would like to join in, as each "expansion" of the bailout program increases the likelihood that the "target" amount will be reached.

The best way to express this view is via short Bunds, as they have much better risk/reward ratio vs. Eurostoxx in our opinion. Eurostoxx will become a buy when and if the European banking sector is properly re-capitalized.