Markets Rally On EFSF, But Don't Get The Math

by: Carlos X. Alexandre

Before we get into the topic, MarketWatch reported on Ben Bernanke’s speech “The Effects of the Great Recession on Central Bank Doctrine and Practice" delivered Tuesday at the Federal Reserve Bank's 56th Economic Conference, in Boston.

The Federal Reserve might one day have to hike interest rates to pop an emerging bubble, Federal Reserve Board Chairman Ben Bernanke said Tuesday. The comment by Bernanke, restrained as it was, goes against past proclamations. Before the 2008 financial crisis, Fed officials - notably Alan Greenspan, the former chairman - argued that monetary policy was too blunt a tool to combat possible bubbles.

In addition, the speech covered financial stability.

“So the possibility that monetary policy could be used directly to support financial stability goals, at least on the margin, should not be ruled out,” Bernanke said.

The market listened, smelled dollar flooding - QE3 or whatever number - and took away the following meaning: The Fed will do whatever it takes to save the banking system and the stock market. In my corner, the meaning was a bit different, and what I understood was that Mr. Bernanke was way off topic, added nothing to current issues, and simply provided some logic as to why the Federal Reserve is still relevant.

Regarding the EFSF – European Financial Stability Facility – and according to MarketWatch, rumors were that Germany and France had agreed on a larger fund.

France and Germany have agreed to boost the eurozone's rescue fund to 2 trillion euros, The Guardian reported Tuesday on its online edition, citing European officials. Under part of a comprehensive plan, the European Financial Stability Facility will be increased to 2 trillion euros from 440 billion euros, turning the fund into an insurer rather than a bank, according to the Guardian.

And the KBW Bank Index (NYSEARCA:KBE) took off like a rocket, rising a whopping 5% in short notice. Later in the day the Wall Street Journal reported that the rumor above was “wrong.”

DJ: Report EFSF Firepower To Reach EUR2T “Totally Wrong”-Source

But even if the end result is truly a 2 trillion euro war chest, while borrowing Timothy Geithner’s much hated “leverage,” the idea is to turn the EFSF into an insurance policy, paying 20% to 30% of first losses. How does the 440 billion magically turn into 2 trillion euros? The fund, or insurance policy, would represent the first 22% of losses, while carrying a 78% deductible considering the worst case scenario.

However, the call recently has been for investors to take a 50% haircut on Greek debt. If that becomes the case across the board, and considering that Greece is not the end of line, there’s at least another 28% that is not covered. And that amounts to another 560 billion euros in losses that someone has to swallow just based on a 2 trillion euro fund. That bill will come due down the road.

We can play around all we want, but the writing is on the wall, and painting over it doesn't change the message.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.