Here’s an elegant, if controversial, solution to the limits of the EFSF.
The European Financial Stability Facility (EFSF), as we’ve written at length, largely resembles a giant CDO. It’s overcollateralised by 20 per cent to achieve a triple-A rating, which means the funds it’s actually able to lend out are much reduced. Indeed the €440bn headline figure disguises actual possible lending of just €250bn.
(Chart via Barclays Capital)
And remember, the EFSF is meant to cover financing needs for all of Europe’s hotspots until 2013…
So what about losing the triple-A rating, and by extension, that overcollateralisation requirement, in order to squeeze out available bail-out funds as much as possible?
It’s an idea brought up by international think tank Re-Define:
Even at the time the structure of the EFSF was being discussed we questioned the need for a AAA rating on efficiency grounds. Subsequent events have only increased our doubts about the need for the EFSF to target a AAA rating.
Seeking AAA rating was justifiable on two grounds:
1) reputational and 2) in order to lower the cost of funds. The thinking was that if the European Union, one of the most credit worthy regions in the world, could not design a multilateral vehicle that enjoyed the highest credit rating that might cause some reputational damage. This line of reasoning has some merit in it but a good case can be made that the incoherence of policy making and delayed responses to recurring crisis are far more significant. EU policy makers should be willing to consider jettisoning the AAA rating.
The second justification, of lower borrowing costs, is on even thinner ground. First, the borrowing costs increase only very slowly down the rating scale and the difference between AA and AAA is very small with the difference in borrowing costs between A and AAA larger but still close to the 1%-2% mark depending on market conditions. As the following graph shows, borrowing spreads increase rather slowly at first and then more rapidly down the rating scale. Most important, by setting the interest rate at which funds will be made available to Ireland at close to 5.8%,, the EFSF is not passing on the low cost of borrowing it is expected to enjoy because of the AAA rating to borrowers so the justification for the inefficient use of the capital structure to achieve this rating is not defensible.
If the EFSF were to agree to settle for a AA rating, its lending capacity can be instantly increased from about the current levels of €250 billion-€270 billion to more than €400 billion without any increase of commitments on behalf of Member States. This is a boost of more than 50%. We strongly believe that this is a step policy makers should instantly consider. In fact, in discussions at the next Euro group meeting the possibility of targeting not just a AA rating but an even lower rating of A should not be dismissed.
That having been said, we believe that the biggest efficiency gain for the EFSF will come from a move to a AA capital rating that would not only allow for a significant expansion of the lending capacity of the EFSF but will also allow it to borrow at spreads that are very close to the cost of funds under a AAA rating. Moreover, we firmly believe that the EFSF should on-lend to troubled Member States on a pass through basis after making deductions for operational and administrative expenses.
This would address the very pertinent objections raised by many commentators including ourselves of the logic of current high lending costs to troubled countries such as Ireland that only help exacerbate the problems being faced by these Member States.
Would Europe be comfortable with a less-than-triple-A-rated EFSF bond?
Perhaps not, though we’d note that the bonds are already classified as Category II, rather than Category I, in the European Central Bank’s collateral framework. Which means they’re looked at more like supranational debt than central government debt, and get a higher haircut when used at the ECB’s refinancing operations.
Anyway, dropping the AAA might be a quick fix for the rather lamentably structured EFSF, but there’s something to be said for forgetting the thing altogether and attempting to replace it with something much more comprehensive. Wolfgang Münchau argues in Monday’s FT that a “few hard-to-understand technical changes” could transform the EFSF into a backdoor “European bond and a fiscal union.”
But why keep flogging a dead horse?
Scrap the EFSF’s triple-A rating.
Then scrap the EFSF and replace it with something new and something better.