Peter Tchir

European Union Document on EFSF Status (with comments)

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Here is the text of the Draft Terms and Conditions according to a Bloomberg article. After an initial read we have included our thoughts in bold into the document.


Oct. 24 (Bloomberg) — Attached is a document prepared by European Union officials on the current status of the euro region’s bailout fund. The document was distributed to German lawmakers and obtained by Bloomberg News.

23 October 2011

Draft Terms and Conditions

Maximising the lending capacity of the EFSF

The capacity of the extended EFSF can be enlarged without extending the guarantees underpinning the EFSF. This optimisation would take due account of the rules of the Treaty.

Within the terms and conditions of the endorsed framework agreement, the maximization of EFSF efficiency would support the continued market access of Euro area Member States under pressure and the proper functioning of the sovereign debt market. The mechanism will provide immediate and credible support, always linked to appropriate conditionality and seeking cooperation with the IMF, while fully preserving the high credit standing of EFSF. The credit standing of the EFSF is mentioned several times, along with rating, yet, no discussion of which Member States will have “stepped out.”

Several models exist to leverage the capacity of EFSF by several times. A more precise number on the extent of leverage can only be determined after contacts with potential investors. Two more specific options – a credit enhancement approach and the setup of an SPIV (special purpose investment vehicle) could be further pursued in order to increase the effective capacity of EFSF in implementing the instruments as described in the EFSF guidelines.

1. Objective

The effective capacity of the EFSF to assist in managing the funding requirements of Member States in the Eurozone can be enlarged based on two approaches:

– The credit enhancement approach (option 1) gives additional credit enhancement to sovereign bonds issued by Member States, thus removing concerns about the liquidity position of a Member State. A “first loss” guarantee doesn’t REMOVE liquidity concerns, it may alleviate them, but since it is only a portion of the liquidity required, it does not remove them, furthermore, it only works while the “first loss” providers are deemed to be liquid. It is designed to increase demand for new issues of Member States’ sovereign bond programmes and lower the yield thereby supporting the sustainability of public finances.

– The creation of a Special Purpose Investment Vehicle (option2) would combine public and private capital to enlarge the resources available to EFSF. The SPIV, which could be created centrally or separately centrally or separately is a very big deal and is glossed over here in a beneficiary Member States, would aim to create additional liquidity and market capacity to extend loans, for bank recapitalisation via a Member State and for buying bonds in the primary and secondary market with the intention of reducing Member States’ cost of issuance. I think you may need at least two types of SPV’s as “bank recapitalizations” are very different than “sovereign debt purchases”, and loans to whom? The loans category is very vague, it could be loans to banks?

Both options can be delivered within the existing EFSF Framework Agreement. The governance structure applied to the different EFSF instruments as described in the guidelines should apply. This is Good.

Therefore financing under option 1 and 2 would be linked to an MoU entailing policy conditionality and appropriate monitoring and surveillance procedures.

2. Mechanics

Option 1

A Member State issues a sovereign bond with credit enhancement through a partial protection certificate attached. Both items could be issued as a combined package, but would be separable and intended to be freely traded after issuance. Freely traded? Really? I would expect that they will try and control people from shorting these products. The coupon on the sovereign bond should be lower than current market yields because of the protection afforded by the attached certificate, and thereby contribute to the sustainability of financial flows. This analysis is incorrect, if the insurance is detachable, it should impact all bonds in the secondary market for that issuer. That is good in some ways, but it also means that the new issue will not trade better than the secondary market as a whole and won’t improve the coupons on new issues relative to the slightly improved overall secondary market levels. If the insurance is tied to only a specific issue, then it is fairly restrictred for trading, but the benefit would be more pronounced in the new issue. In any case, the supply of insurance will be very small relative to a country’s total outstanding debt until more and more new issues are done – so no real short term benefit to the overall market.

The mechanisms to implement this approach should be compatible with the operational model of EFSF. This could be achieved by EFSF extending a loan to a Member State in order for the Member State to acquire EFSF bonds which back the effective guarantee.

The bond would then collateralize the partial protection certificate and could be held by a Trust or SPV on behalf of the Member State. This is just crazy. EFSF loans money to a country so it can buy an EFSF bond which it then puts in trust? Just directly issue insurance against the EFSF. This seems like a bizarre and unnecessary step and should be removed – it would also remove negative pledge issues that possibly arise from this bizarre methodology to create insurance.

In the event of a default (to be defined), the investor could surrender the partial protection certificate to the Trust/SPV and receive payment in kind with an EFSF bond. Whoa, I don’t get cash when there is a default I get EFSF bonds, possibly guaranteed by the country that just defaulted???? This dramatically reduces the value of the insurance.

Option 2

One or more special purpose investment vehicles (SPIV) would be established; each dedicated SPIV would have a mandate to facilitate funding of Member States through loans, and invest in sovereign bonds of a specific country in the primary and secondary markets. Notice how bank recapitalizations has disappeared here? We still have loans and bond purchases, but no bank recap – I assume that is just sloppy, but also tells you how much thought was put into this document. This vehicle could be funded by different classes of instrument with distinctive risk/return characteristics. The instruments could include a senior debt instrument and a participation capital instrument, both of which would to be freely traded instruments. In addition there would have to be an EFSF investment which will absorb the first proportion of losses incurred by the vehicle.

The SPIV structure should be set up so as to attract a broad class of international public and private investors. For that purpose, the senior debt instrument could be credit rated and targeted at traditional fixed income investors. The participation capital instrument could be junior to the senior debt instrument but rank ahead of the EFSF investment. This might attract Sovereign Wealth Funds, risk capital investors and potentially some long-only institutional investors. This tranche will potentially share with EFSF any upside generated by the investments. This might be interesting, but will depend on risk/reward and flexibility or lack thereof, etc. In managed CDO’s, investors focus a lot on managers who have great credit skills. Say a Pimco or Blackrock. The EFSF is purposely trying to buy bonds both of these managers are either out of or underweight. They want to overpay for bonds to push prices higher. There really is limited diversity as most if not all the countries are extremely highly correlated, especially in event of default of one. So most of what the EFSF wants to accomplish would push away traditional investors and scare the rating agencies. More details need to be seen, it could be interesting, but for now, it seems the desires of a true private investor and the desires of the EFSF diverge. But there may be a price where the risk reward is subsidized enough that private investors want in – thereby increasing costs to the Member States.

3. Flexibility to deploy both options

The EFSF would benefit from the flexibility to deploy both options, which are not mutually exclusive:

Option 1 may not be appropriate or feasible in the circumstances of every Member State, because of negative pledge clauses (see below) in some Member States’ existing bonds and other financial instruments. Moreover, because Option 1 focuses on new primary issuance, it would also only be used for non-programme countries or for programme countries in an exit/post-programme period (whereas Option 2 could be used for secondary market operations in relation to programme countries). I have to admit I get a bit lost here, but I think there bizarre form of the insurance may be why Finally, a decision on which of Options 1 and 2 represents the most efficient use of EFSF resource can only be assessed after extensive dialogue with potential investors and rating agencies in any normal deal, this dialogue would have been ongoing, particularly with the rating agencies – and the answer may vary from Member State to Member State. Therefore, retaining the possibility to deploy both approaches would be beneficial. The plan to plan.

4. Timing of implementation

In both options, the technical market preparations can in principle be achieved quickly following agreement on the terms on which a particular Member State might benefit from support and once the necessary clearance is obtained for the EFSF to progress – although option 2 does require a period of some weeks after finalisation of the structure during which investors and lenders would be sought for the fund. A funded SPIV may not be so simple, since ramp-up is usually an issue. It would have to balance having negative carry while paying outside investors, or use up all the money up front, thereby reducing the ability to influence markets in the future.

5. Issues

Segmentation. The danger of segmenting the relevant sovereign bond market is reduced as neither option results in any alteration in the nature of Member States’ sovereign bonds.

Negative pledge clauses. Option 1 has the potential to trigger negative pledge clauses (i.e. existing commitments from Member States not to grant security to new creditors, or only if they grant old creditors the same security as they grant to new holders) in Member States’ outstanding financial instruments.

There would need to be an extensive due diligence exercise similar to that being operated for the Greek PSI scheme for any Member State using Option 1, to establish whether bonds or other obligations have a negative pledge clause, and if so the extent and implications of it. Option 2 does not raise this issue. Just issue a regular guarantee and avoid all this negative pledge stuff.

Impact on government debt. There is a material possibility that Option 1 could statistically increase the Member State’s gross debt, as the debt level would increase due to the loan extended by the EFSF to the Member State providing credit enhancement.

This issue will have to be assessed by Eurostat. Option 2 may not raise this issue.

Impact on EFSF rating. The current basis of EFSF’s AAA rating is that no value is assigned by the agencies to the underlying assets and that the AAA rating depends entirely on the guarantees provided by the AAA Member States. The underlying business profile of EFSF is not the driver of the rating. They say it, but don’t get it. The original AAA came from the fact that EFSF was never going to have obligations outstanding greater than the amount of AAA guarantees. Now they plan on taking more risk than is covered by the AAA members. This runs a real risk of getting something as low as weakest link, but likely gets something more like a AA- rating. They understand why they got rating in first place, but don’t seem to connect the dots to how that has changed. Again, it is not professional at all to only be re-engaging the rating agencies at this late stage. Expect negative surprises on the AAA rating.

Impact on Member States’ ratings. The rating agencies have already taken into account the guarantees given by AAA sovereigns in their rating of the respective Member State. The rating agencies will, however, have regard to a change in EFSF’s risk profile in their analysis of Member States’ own ratings.

Were any AAA Member State to suffer a downgrade, this would impact on the EFSF’s own capacity. I don’t think the EFSF is AAA anymore to begin with, but yes these guarantees place pressure on all member ratings since nothing is being done to reduce the probability of default of the borrowers.

Leverage. The capacity increase in both options is achieved by combining public and private resources in order to attain financing for Member States at sustainable prices. Option 1 achieves this capacity increase by insuring only a fraction of the actual funding requirements, while option 2 combines capital from European and non-European public and private investors. The leverage which can be achieved can only be determined after dialogue with investors and rating agencies around the new instrument, and in the light of prevailing investor appetite over time for the sovereign bonds of particular Member States.

Distribution of returns. According to the EFSF Framework Agreement all funding and operational costs of EFSF have to be covered by the beneficiary Member States. A Financial Assistance Facility Agreement will settle all profits and losses of EFSF engagement for a country.

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