Peter Tchir

You Can’t Spell Tooth Faeries Without EFSF

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Well, actually you can, but I guess that is my point. We have been reacting so much to headlines there has been no focus on details. Even the political farce in Greece drew attention away from the real problems.

If anyone had told me that by the end of the G-20 meeting all we would have is a vague concept of a 3 pronged EFSF where none of the prongs have been explained, an IIF “haircut” plan that is still being developed, no strong commitment from the G-20, and some extremely bizarre politics in Greece, I would have laughed – and I am bearish! I didn’t think they would have a workable plan, because I don’t think anything other than printing money or default will work, but I thought they would have something concrete on the table by now.

The EFSF reminds me of the tooth fairy – there are those who believe because they are told it will work, and those who try to figure out how it will work, and come out on the non-believer side. This week, we are supposed to start seeing some real details, although they are already down-playing that.

The prong that lends money to Greece, Ireland, and Portugal, so that they can pay back the people who lent them money in the first place, should be pretty straightforward. Borrow money in the markets, lend it to those countries, those countries pay the banks that own their debt, so that those banks can buy more EFSF bonds, the next time EFSF has to lend money to the PIGs to pay back the banks to free capacity to buy EFSF bonds – straightforward doesn’t mean it isn’t bizarre.

The prong that is going be used to “recapitalize” the banks is somewhat irrelevant. They will be embarrassed to admit what great terms they are willing to buy equity stakes in banks. Regardless of how good the terms are, the banks will only use it as a last resort, in the hopes that the ensuing rally eliminates the need. If this money is ever used, it will be only in a panic, as the crisis gets worse, and the banks then come to “demand” the money that was set aside for them at the worst possible time for the countries. They won’t take this money while we are in rally mode, or even if the markets are just stable, or so long as they hope another bailout package is coming, because why dilute your deferred comp when you have a free put.

The leveraged EFSF is the best part of the “story”. They have no clue how to execute this part. As we wrote the other day, they can’t do a CDO because there is no diversity in assets. They can’t do a proper “wrap” because if there is a loss on an underlying bond, it will almost certainly be greater than 25% thus causing the “wrapped” bond to have a loss regardless of whether the “wrapper” honors their commitment – which isn’t certain. The leveraged EFSF is not a €1 trillion bazooka, it is €250 billion of binary CDS, that someone (Regling? Merkozy?) hopes the market will hoover up. I wouldn’t be surprised if they try and revert back to the bank plan later this week, as they realize the “wrap” doesn’t do much. Only then will credit investors, if not the politicians, see that the EFSF as a bank strategy has just as many problems.

So the EFSF is offering €250 billion of binary CDS in some form to entice the market to buy €1 trillion of Spitaly paper. I think Greece, Ireland, and Portugal are too far gone (the bonds trade at such a low % of face) that first loss protection does little to help them get new deals done. The first prong will have to suffice for them. While the bulls are all eagerly anticipating this tide of liquidity they are ignoring the fact that the EFSF pulled a deal this week! They were supposed to do €5 billion of 15 year bonds, which became €5 billion of 10 year bonds, which became €3 billion of 10 year bonds, which because a statement saying the deal was pulled because of market conditions. For clarity, these are straightforward, non-leveraged, EFSF bonds, where 3 similar issues already exist, and the deal was pulled! I am sure it was a matter of price, but still, how well does that bode for their bigger and far more convoluted scheme?

If it was over price, what price or yield does the EFSF think it should get? The Dec. 2016 bond yields 2.63%. French 5 year paper is trading at 1.97%, so it is a spread to France of 66 bps. That is a bit more than I would have expected, but doesn’t seem irrational. Germany yields less than 1% in 5 years. Does the EFSF expect to trade like Germany? Germany covers less than half of the useful (AAA) guarantees. The average should, trade more in line with France, but even then, there is always a haircut for structure. Is France more likely to default on French government bonds they issued, or EFSF notes? Without a doubt, the actual bonds issued by the country should trade tighter than something backed by a complex guarantee. The EFSF has massive amounts of new issue to do as well, so that will impact the price or yield they should expect. I think France + some spread is where EFSF will trade for now, 66 bps might be a bit much given how wide France is to Germany, but I think it’s in the ballpark. I have this feeling EFSF and the EU have completely unrealistic expectations where EFSF bonds should price. The EFSF 10 year bond yields 3.4%, compared to 3.04% for France and 1.8% for Germany. Again, that doesn’t seem an unreasonable price (and even the GS CFO, when complaining about the price of their CDS on their earnings call, mentioned that you can’t argue with the market price).

I think the EFSF and EU got it completely wrong on where the EFSF bonds should trade. Wait until they see how little benefit they get on a partial loss wrap on Spanish and Italian new issues. In my view, for the EFSF to be truly successful, it should focus on the 10 year maturity. If they shift to 5 year financing, it is helpful and is at least in the “sweet spot” of credit trading. Resorting to 2 year funding smells of desperation. There is now even talk about creating some EFSF money market paper. By heading down the path of short term funding with constant rolls, the EFSF would be adding a liquidity problem to the solvency problem. The market may cheer the reduced costs of borrowing in the short term paper, but that is a desperate act and a horrible solution in a world where there is no backstop beyond them. If they cannot roll the debt, then what? To “solve” the problem, or at least kick the can down the road, the EFSF needs to be helping countries extend maturities. Lending long and borrowing short is a time proven strategy for disaster, especially for leveraged entities!

I really do believe that the 5 year point is where they should focus. The markets are too choppy, that developing policy around 10 year financing is too hard right now. Shifting to 2 year, or even worse, to the money markets, is a recipe for disaster.


Just focusing on 5 year yields, shows how much work is yet to be done. Since the end of September, stocks have staged a great rally, yet, from a credit standpoint, the problem has gotten worse. EFSF, Italian and Spanish yields are significantly higher. The ECB has been buying and that has failed to staunch the bleeding. The ECB cut rates, and that too failed to solve the problem. The Italian 5 year bond started the week at 5.73%. It was trading at 6.13% right before the ECB rate cut, it dropped to as good as 5.82% (picking up the rate cut and more), but failed to hold that level (in spite of alleged ECB buying) and finished the week at 6.19% (just below the highs of 6.26%). This is a clear signal that Italian 5 year bonds are not rate instruments, but credit instruments. The ECB can continue to employ policy tools that help countries that trade as rates – Germany, France, Holland, etc., but it is not affecting Spain and Italy, because the credit risk is real, and 25 bps (or even 100 bps) on the short end ECB financing rate, is not enough to offset the fear of default and the losses from that.

We saw it in Greece, we saw it in Ireland and Portugal, and now we are seeing it in Spitaly. Outright yields are going higher, and are not responding to traditional interest rate policy tools. The curves are flattening. The Italian 2 year hit a yield of 5.4%. That is extremely high for 2 years, and is actually relatively flat to the 5 years considering the overall rate levels. It is also higher than it was Thursday prior to the rate cut. If the 2 year bond of a country is not a transmission mechanism for central bank rate cuts, than what is?

The rate cuts should at least affect the good countries, and that should translate into a savings for EFSF. In principle that would work, except German 2 year yields are already only 0.4%. Clearly they are not trading at 0.4% because of some carry trade with ECB rates at 1.25%. That is the problem, the good countries already trade inside of the ECB overnight rates, so the benefit is marginal, and the bad countries are no longer responding to interest rate policies because they are credit products. EFSF gets no real benefit, and as the complexity and self-referencing financing nature of the whole program gains attention and the potential political problems when it comes time to pay become more apparent, the premium of EFSF to France will increase.

Lost in the shuffle this week is the fact that there still is no IIF plan. No definition of what an NPV haircut is, or how much EFSF support is going to the banks as part of this “haircut” and which prong of EFSF money this will come from. Merkozy can complain about Papandreou backing out of “the plan” but honestly, don’t you think he should have been given a plan? A vague promise by bankers of a 50% NPV haircut so that Greece can achieve 120% debt to GDP in 9 years, doesn’t sound that great. I don’t believe Greece was on board with any plan, and probably haven’t even seen what it will look like. Once the IIF comes up with their plan, I suspect some people will be disappointed – Greeks and the taxpayers of countries that see more money going to banks, rank right up there as candidates to be disappointed.

What I have finally seen, is some actual discussion of what default would mean. For all the talk about “Greek Default” very little serious work has been done on it. The instant reaction is “horrible for Greece”, “stone ages”, “togas and sandals”, “hyperinflation”, etc., yet as some analysis starts to come out, more and more is showing that Greece could have a much better debt burden while retaining core state assets if they head down the path of default or repudiation. After the initial nasty comments that came out of European leaders forced Greece back on the “path”, more reasoned voices are coming out – slowly, but at least starting to come out. If Greece defaults, would they even have to give up the Euro? Important leaders have said they would, yet there is no mechanism to force them, and would be a great way for Greece to wipe out its debt and not experience hyperinflation. If Greece left the Euro, could it remain in the EU? There are 17 countries that use the Euro, but 27 in the EU, so it would seem possible that they could leave the Euro but remain in the EU. That too is only starting to be discussed. The initial headlines were all about – don’t pay and get kicked out and starve, but the reality is likely much different and probably much better for Greece.

The EU leaders may be able to stop this line of thinking, but as people get over the initial “shock and awe” of the word “default” they are realizing it is not the end of the world for Greece and may in fact be the fresh beginning they need – Argentina and Russia might be better examples than Zimbabwe.

I am not sure what exactly has happened to the Greek government. So far, it is being interpreted as positive because they will go along with the plan. I guess that is the case, but I find it hard to believe that the people will be pleased that the referendum was taken away. I think as they also start seeing proper and reasoned arguments against accepting the terms being forced on them, the level of dissent will grow. There were no tanks rolling into town squares to send the people back to their homes in fear, but enough has potentially been done to turn the tide of the people against the politicians. I don’t think we have seen the end of dissent in Greece, and if anything, I would expect it to become more vocal, and supported by more facts about what Greece could do, rather than just fear mongering of default and fewer summit invitations.

Copyright © 2011 · Peter Tchir

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