What the world needs, what Europe needs, is clearly another monoline.
On Tuesday, the WSJ broke the news that a proposal by Allianz for the EFSF to act as a bond insurer was gaining traction. This would enable the firepower of the bailout fund to go from €440bn to something in the region of €3,000bn. The bond-insuring EFSF looks like this (from a recent Allianz presentation — big hat-tip to Also Sprach Analyst):
Rather than continuing to issue bonds and then lend to sovereigns, banks, carmakers, insurers, Fannie, Freddie or whatever, the fund would instead become the insurer of sovereign bonds.
The diagram above shows the 40 per cent ballpark figure that Allianz give for Greece, Portugal, and Ireland. That is, they reckon that investors would be willing to swallow sovereign bonds of those nations if the EFSF took (or shared) the first 40 per cent of losses.
The equivalent scribble-in-the-footnote-of-the-Powerpoint for Italy and Spain is 25%, hence the €3,000bn figure in the WSJ article (€2,900bn in the presentation, but who’s going to argue over rounding up by a mere €100bn at this juncture?). Hence total leverage of 3.7 times.
In this scenario, the “European Sovereign Insurance Mechanism” (ESIM) could also act as the insurer for new bonds received in the current Greek debt swap.
Concerning banks, the presentation states, “Necessary support of banks still possible”, which is a little different to what Allianz chief executive Paul Achleitner said to the WSJ. Here’s an excerpt on why the proposal was initially dismissed.
Diekmann said the plan would not involve recapitalizing European banks, which he said was a matter best handled by individual governments rather than the EFSF.
When it was first proposed six months ago, Allianz’s plan was dismissed by the German government, the biggest and most influential contributor to the EFSF. At that time, people familiar with the German government’s thinking said the proposal was too unwieldy and faced legal hurdles.
But Achleitner said questions about European Union treaties that ban sovereign governments from directly guaranteeing the debt of other members have since been resolved. Exemption clauses for emergencies would get around those restrictions, he said.
Achleitner also said that they were working on the proposal with Deutsche Bank and that it already has the support of other insurers and some big French banks. (We’re getting a bit of deja vu here…)
Could we be onto a winner or are we going to get some politicians coming out of the woodwork to smack it down any second now?
Before that happens, one more quote from the WSJ that drew FT Alphaville’s attention:
And unlike the current EFSF model, which relies on the facility earning a Triple-A rating with which to raise money cheaply in world markets, “under this plan the EFFS doesn’t care about being a Triple-A rating,” he said.
Now while, we agree with that one’s rating counts for a huge amount in bond issuance, we are not so sure that it means nothing in the world of bond insurance.
Looking at the performance of EFSF bonds over German Bunds reveals a widening from around 60bps at the end of June to north of 120bps more recently. It would seem that there’s some risk being priced in, isn’t there? Is that even implied AAA at those levels?
Which leads us to wonder when the first CDS contract will be written against the EFSF, particularly if it takes the role of bond insurer.
In other words, FT Alphaville has been reminiscing about AIG this morning and about Goldman Sach’s moves to hedge against their erstwhile counterparty when things started to look ermm.. wobbly.
One key difference here though is that AIG had to post additional collateral as it experienced downgrades. Even more to the point though, AIG posted collateral. Anyone want to take bets on whether the EFSF is going to enter into a two-way CSA (and hence post collateral)?
Given that banks hedge against their individual sovereign counterparties already – particularly in the absence of such collateral arrangements – we find it hard to believe that EFSF bond insurance would warrant superior treatment.
And that’s without getting into the massive correlation risks. As a quick note though – that diagram puts the bond investors in the senior tranche. Senior tranches hate high correlation because it means that a wave of defaults could reach all the way up to their perch, causing losses.
Not that we think this proposal is a bad idea, just that we wonder about the future form of the EFSF and the instruments that may develop around it.
Let them eat EFSF equity tranches – FT Alphaville