Lest it be overshadowed — Europe’s bailout fund will finally be given an effective lending capacity of €440bn, judging by an EU summit decision. Long awaited, this…
Lest it be forgotten, however — the bond-buying feature they’ve also come up with for the EFSF and the ESM on the side. A little strange, this…
Both funds will be able to buy distressed sovereign debt in the primary market at auctions, but not on secondary markets. We confess to being confused. A quick primer from Barclays Capital:
The agreement to allow the EFSF to purchase sovereign debt in exceptional cases in the primary market came as a bit of a surprise, given that we and probably also markets had expected that EFSF bond purchases, if allowed at all, would be focusing on secondary market operations, including possibly the financing of buyback operations. Nevertheless, this agreement should be modestly positive for peripheral bond markets, as it provides a large-scale backstop facility should market appetite for periphery sovereign risk fail short of issuance needs…
Here’s the thing. The problem isn’t issuance. It’s credit risk, and liquidity risk too, you could argue.
We don’t doubt that EFSF buying at auctions will drive yields down, nor that they really do need to come down for (say) any Greek or Irish return to the market in the near future. On the other hand, yields are up in the first place because no one else wants to hold this paper on their books. Of course, they would support the EFSF taking the burden on their behalf, but we’re unconvinced that this will encourage investors to actually buy again in their own right.
After all: they now have an excellent alternative. As far as the financing works for the EFSF buying these bonds, it looks like purchases will have to be pre-financed by raising bonds well in advance. Now, if the AAA-rated EFSF raises €1bn of its bonds towards buying €1bn of a €2bn Greek issue, which €1bn would investors probably buy themselves?
The Greek remainder, or the EFSF’s highly safe bonds?
Hopefully, you can see why the EFSF buying bonds in primary markets suggests that we’re watching the next stage in the gradual collateralisation of peripheral sovereign debt. The EFSF bonds are collateralised Greek bonds. Which is pretty historic in its implications.
Next stop, we reckon — buybacks, now that the ice is broken.
But let’s not forget where the European Central Bank fits in.
The EFSF will buy in primary markets. The ECB, we guess, is going to carry on buying in secondary markets for now — which happen to be where the really severe illiquidity lies, and where government bonds just aren’t changing hands. (In fact it looks more like investors use the ECB to offload remaining holdings.)
If neither the EFSF nor investors buy, the ECB carries on, and throws normalisation of monetary policy into doubt. If the ECB stops, who knows what happens to liquidity.
There’s one silver lining we can think of — yield depression at auctions, thanks to the EFSF, stops some investors picking up issues at those auctions and then flipping them to the ECB as a buyer of last resort.
But, um, that’s using one intervention to fix the flaws of another. One thing we don’t get, either — surely using the ESM to buy up bonds will make it even more senior to investors, by owning that much more debt?
And seniority sure is a burning question at the moment.