As momentum gathers behind the (deep breath) first loss guarantee on new issuance approach for Europe’s bailout vehicle, Gary Jenkins examines some of the pros and cons.
Leverage aside, the biggest plus point, says the Evolution analyst, is that the EFSF would not have to raise any money.
Depending on what proportion of a country’s issuance the guarantees covers (20% seems to be a favourite), the actual funds provided to the issuer is a multiple of the EFSF guarantee and private investors remain involved in primary market activity.
The weakness is the guarantee. What would it be worth if it was ever called upon?
If it was me investing my own money I would want to first look at the borrower itself and its stand-alone ability to pay. There may be good arguments why Italy is in a better position than many sovereigns; smaller deficit, lower private sector but the fact remains that earlier this year Italy’s funding costs shot up and if it wasn’t for ECB intervention funding would have been prohibitively expensive. Without outside assistance Italy could have been heading towards default.
I would then move on to analyse the strength of any outside support and in particular the EFSF as a guarantor. The possibility of an EU break-up would have to be taken into account, though a low probability event, the threat of a breakup would probably be higher in a scenario where the guarantees were called upon, thus reducing the value of the guarantee. But the main point is that you would have to consider what state the EU would be in if Italy defaulted. If a Greek situation has caused so many problems, what on earth would happen if Italy defaulted? Would there be sufficient political will to stand by the guarantees or would it be every man for himself? After all debt and sovereign debt in particular, is as much about the willingness to pay as it is about the ability. And I have no idea how you work out the ability of the rest of Europe to pay in a scenario where the world’s 3rd largest bond issuer has just defaulted. How do you analyse the political and economic impact of such an event? Would the rest of Europe be able to fund themselves, let alone pay me? Would there still be a functioning banking sector?
Even if guarantees were honoured in such a scenario we would probably be looking at a hair-cut well in excess of 20% in cases of default. In case of default Italy would most likely be dependent upon outside funding for some time. It is easy to imagine strong political pressure to force losses on bondholders in such a scenario, increasing the haircut because of the protection thus watering down any guarantee.
So, the first loss EFSF plan is a confidence trick and its real weakness is that it’s not backstopped by a superior force, such as the ECB.
Still something is better than nothing, reckons Jenkins.
As the Italian 10 year yield yesterday reached its highest level since ECB intervention started in early August it is imperative that a solution is found. There are flaws with the first loss guarantee as we have pointed out, but on the positive side it does show a commitment by euro area members to each other. We have gone from “no bail outs” to potentially guaranteeing each other’s debts (amongst other things), and that ought to give investors some confidence. Let’s hope we will never have to find out if that commitment is strong enough to deal with an Italian default…
Meanwhile, yields on Italian bonds continue to creep higher…
… and the SMP has been activated.
09:16 14Oct11 RTRS-ECB SEEN BUYING ITALIAN, SPANISH BONDS – TRADERS
A systematic approach to the eurozone CDO – FT Alphaville