Reflections on the latest Eurozone tape bomb | FT Alphaville

Reflections on the latest Eurozone tape bomb


For Tuesday, the market received a jolt higher in the final hour of trading after the Guardian reported France and Germany agreed to increase the size of Europe’s rescue package to more than €2 trillion ($2.7 trillion). The Dow rose as high as 255.74 points on an intraday basis – WSJ

Some €2,000bn. That’s a big number. A number Europe’s bailout facility can only dream about, according to Willem Buiter.

In a sobering report on the EFSF, Citigroup’s chief economist concludes the maximum amount of bond purchases the facility can support is €1,500bn and in reality just €1,000bn.

The way Buiter sees it, the maximum size, and therefore effectiveness of the first loss guaranteed scheme, has been exaggerated by some proponents.

They have failed to take into account things like existing and likely EFSF commitments…

First, a bond insurer version of the EFSF will not provide more ‘bang for the buck’ than other schemes to leverage the EFSF. As we will show below, we do not think the EFSF can realistically provide €726bn of guarantees while maintaining anything like a triple-A credit rating. If, as we believe is more likely, the EFSF could at most take on a first loss exposure of around €300bn, we ascertain the maximum amount of sovereign debt purchases that could be supported by the insurance facility would be €1.5 trillion (still assuming that the EFSF guaranteed the first 20 percent of losses on the eligible sovereign debt). A plausible loss guarantee exposure of €200bn would result in a total envelope of maybe one trillion euro.

… and the ratings implications.

Second, using the EFSF as an insurer would have very similar rating implications for EA sovereigns compared with other proposals to leverage the EFSF that imply that it assumes first loss exposure on EA sovereign bonds.

That’s not to say the insurance plan doesn’t have its merits: it does not require a new round of parliamentary approvals, for example; it does not require pre-funding; and it can be focused on the flow of eurozone sovereign borrowing. (Whereas the ECB’s current bond-buying in the secondary market is focused on supporting the stock of current debt.)

But it’s probably not the big bazooka everyone seems to be expecting. It’s more of a blunderbuss.

Here’s why:

To get to the €3 trillion worth of debt touted in some of the proposals, we estimate the EFSF would, with an average first-loss guarantee of 20 percent, have to make available for its insurance activities nearly all of its notional €726bn worth of non-stepping-out member state guarantees, and these resources would have to be viewed by wouldbe insurance purchasers as being of triple-A quality. This would mean (1) that the EFSF would have to renege on all its outstanding and pending commitments other than insurance, (2) that Spain and Italy would effectively be insuring themselves, and (3) that a triple-A guarantee capacity of €440bn is miraculously transformed into one of €726bn.

Second, the insurance mechanism is not fool-proof or disaster-proof. There is no guarantee that, in a panic, the most generous terms on which the insurance could be offered (say, for free) would be attractive enough to bring in sufficient private buyers of the insured sovereign debt. Failed auctions and sovereign default are not ruled out. A standby purchaser of last resort for sovereign debt is required. This standby purchaser of last resort would have to be either an official entity or a private entity created, funded and directed by the official sector.

In other words the ECB.  Why does it always comes back to the ECB?

For Buiter the only way the ECB can be involved is by granting eligible counterpary status to the EFSF or an SPV relation.

It could be the EFSF, which can operate in the primary issue market, even without the EFSF being granted eligible counterparty or ‘bank’ status allowing it to borrow from the Eurosystem against collateral. That would, however, restrict the volume of such purchases to the uncommitted part of the EFSF’s own resources. To have a bigger standby bazooka, either the EFSF, or some special purpose vehicle created by the EFSF (possibly in conjunction with the European Investment Bank, which has eligible counterparty status with the Eurosystem) would have to be granted eligible counterparty status for collateralised borrowing from the Eurosystem. The remaining resources of the EFSF could be used to provide capital for this ‘Bazooka Bank’, and/or to guarantee the loans from the ECB to the Bazooka Bank, which would in any case be secured with the sovereign debt purchased in the primary market by the Bazooka Bank.

Whether that’s acceptable to JCT or his Italian replacement is open to question.

Update: 9.24am (London time)
Here are some of Buiter’s workings.

The ‘stepping out’ calculation:

From that number, we here subtract i) guarantees by the current set of countries with ‘stepping-out’ status (all of which are out of the primary sovereign debt markets for the time being), ii) guarantees provided by Italy and Spain, as these two countries are not credible guarantors because they are highly likely to default themselves (on their own sovereign debt and on the guarantees they provide to the EFSF) whenever there is a call on the guarantees provided by EFSF to any of the non-stepping out sovereigns, iii) other countries that, like Spain and Italy today, could potentially benefit in the future from EFSF guarantees of their sovereign debt, or are likely to ask for ‘stepping-out’ status, iv) existing and likely imminent EFSF commitments.

Then subtract:

EFSF commitments for Ireland and Portugal sum to €43.7bn of which €9.1bnhave been disbursed so far.

EFSF contribution to the 2nd Greek programme could be up to €72.6bn even if the IMF finances one third; EFSF contribution to remaining 1st Greek programme could be €27b.

EFSF is likely to contribute to the recapitalisation of the EA/EU banking sector – a conservative estimate of its contribution would be €50bn.

Which gives a figure of around €300bn, depending what happens to France and the bank recap plan.

Both sets of calculations arrive at rather similar estimates for the maximum amount the EFSF could insure, i.e. around €310bn if France remains among the insured and no banking sector support is provided by the EFSF, around €260bn with a €50bn provision for banking sector support, and less than half that if France were to join the insured.

Related link:
Eventually, French Spreads Fail (E.F.S.F.) — redux
EFSF leverage ahoy – FT Alphaville