Peter Tchir

The Evolution of EFSF

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It seems so long ago, but it was just over a year ago the EFSF was first created.

The first iteration was set up in a way that although the headline number seemed relatively large, the amount that would ever be lent was under 300 billion euros as there were various holdbacks and other mechanisms to ensure as little money as possible went out the door. The deals were also going to be structured as customized loans that if not outright senior to bonds, were at least structurally senior. It seemed that a bad case scenario would be losses totalling 120 billion (about 40% of the maximum that could be lent out).

For awhile, nothing really changed, other than Ireland and Portugal made it clear that they would not be participating as guarantors, further reducing the potential size, and potential loss of EFSF.

As the crisis got worse this year, a couple of changes were made to EFSF. The guarantees were increased so that the total amount of money that the EFSF could raise was about 450 billion euro. That was the size of the guarantees of the AAA countries. If not the only way to get a AAA, it was a relatively easy one as no fancy CDO mechanics were involved. The 450 billion of potential issuance was backed by 726 billion of guarantees (no point counting Greece, Portugal, and Ireland), of which 450 billion of the guarantees were provided by AAA countries. The plan seemed to change from EFSF making loans to also buying bonds. So now the realistic loss was higher. Lets say it could now realistically lose 60% of 450 billion, so 270 billion was likely at risk.

Then, before that was ever approved, the idea of injecting capital into banks was created. Now, realistically, the loss rate could be higher. Not all capital injections would be paid, so a realistic downside is an 80% loss on this mix of equity investments and bonds, a total potential loss of 360 billion. Certainly no longer a small number.

But that wasn’t enough. Now we have a new plan. EFSF would take first loss on the full guarantee amount of 726 billion. Given everything that EFSF can now invest in, and the fact that it is taking first loss risk, the potential loss is 726 billion.

So in a little over a year, the risk of loss transfer from private companies to sovereign nations has increased from 120 billion, to 270 billion, to 360 billion, to the possibility of 726 billion!

That seems bad enough, but the situation is worse than that. At each turn, Greece has underperformed and been found to have bigger needs than previously thought, but the latest IMF decision to go ahead with the next tranche anyways, sends a clear signal to Greece that they are in the drivers seat. Why do more now when IMF will keep picking up the tab until you finally decide that drachma’s suit you better.

Portugal cannot be blind. It sees where Greece has failed but still gotten money, and that Italy barely goes through the motions of pretending to try, so why should they?

Countries caught in the middle will want to tap the facility so at least it is a breakeven proposition for them (if that is even possible).

Ratings of all the PIIGS and some other countries have been downgraded over the course of the past year.

Robust economic growth has turned to mediocre performance at best.

Politicians have limited support at home to provide bailouts or to accept the terms that go with them, yet they continue to approve each bailout. I wonder what will happen when these ones get thrown out?

There was one brief moment where Europe looked like they were ready to let Greece default, let some weak banks go, and deal with the consequences. They flinched and are now in the process of creating a bigger mess.

If this Allianz proposal goes through, it will be curious to see what the structure actually looks like. Nothing that I can think of gives even the senior tranches a particularly high rating, and certainly the rating agencies won’t ignore the 726 billion of real risk being taken on by the guarantors. On the other hand, DB is probably willing to structure it for 1% and S&P and Moody’s would probably charge similar amounts so there should be about 22 billion of fees to encourage everyone to work hard. 22 billion seems cheap to save the world. Though in the end, DB will probably likely only be lead as France would want some French banks to make money of the structuring fees in order to participate. And that ignores placement fees and per annum fees.

It is truly scary how much loss the sovereigns have to take to kick this can a few months further. And that is likely all we get as everything will truly be correlated in Europe if this new approach is done, and any global slowdown will put immense pressure on the system. Remember, nothing, not a single thing mentioned above does anything to address that people and banks and countries borrowed more than they can pay back, and people lent to them on terms making it difficult to extract any value if they don’t pay the debt back.

Copyright © 2011 · Peter Tchir

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