Before reading on — we highly recommend you read this guest post over on Self-Evident on the very subject of the risks facing Europe’s bailout funds. It’s excellent and well worth your time.
OK, done?
You know – there’s something else about the ESM term sheet even after the CDS and seniority issues. Initially we were mildly confused by the reams of callable capital financing Europe’s second try at a sovereign bailout fund, as well.
Confusion is now turning into clarity, but we remain concerned, despite what are clear advantages to this capital structure.
A quick explainer:
The European Financial Stability Facility can (finally)* lend up to €440bn, backed up by guarantees by eurozone states on specific debt instruments issued in capital markets to finance bailout loans.
The European Stabilisation Mechanism can (apparently) lend up to €500bn, backed not by debt guarantees but equity. Specifically: €700bn pledged in as capital. More specifically: €80bn of paid-in capital, €620bn of callable capital, i.e. not paid in until asked for.
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The ESM is a big bank
Those distinctions are pretty important, as it happens.
Nomura’s European rates strategists explained it really well in further detail on Wednesday, using callable capital at other big supranational lenders – multilateral development banks – as an analogy:
Under normal operation, callable capital may not be used to make loans directly, because no actual cash funds are received. Though once the structure assumes a going concern status, retained earnings accumulated from the spread on loans would act as a capital/cash buffer. This would lead to delayed recourse to shareholders and an enhancement of the structure.
Callable capital would be called upon once the risk of a country being unable to repay its loans becomes apparent, whereas guarantee comes into play after the loss occurs. The ESM structure is said to have both elements to it. Our understanding is that the guarantees that are not utilised within the EFSF structure may be ‘transferred’ to the ESM.
The idea here is that the ESM is actually starting to look like a big bank, to which you can infer leverage, capital ratios, and retained earnings. Imagine Basel III-compliant sovereign bailouts. Whether that’s a utopian or dystopian view of the financial future, we’re not sure…
But the key implication, and a big plus point for the ESM, is that callable capital is fungible.
Whereas EFSF guarantees relate to individual debts issued by the EFSF, the ESM will be able to deploy capital wherever that capital is needed within its activities. Of course, ironically, it doesn’t look like the ESM will end up having a wide range of activities anyway, given a ban on buying peripheral bonds.
Still, this appears to address a massive drawback to the EFSF, one observed in the Self-Evident post: since the guarantees on each individual EFSF bond were shared out among eurozone states, a failed guarantee by any one state (say, Spain or Belgium) would upend the structure pretty quickly. By spreading capital around, perhaps that’s solved. Perhaps.
In that case, we’d submit these two arguments:
There is no greater monument to the failure of the EFSF guarantees than the ESM callable capital structure. Their failure was to leave the EFSF and the euro wide open to the risk of correlated defaults in the guarantor states. Callable capital is an attempt to tackle this risk.
Second argument, however: it may not tackle it enough.
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The ESM is a big liability, debt or not
If (ahem, let’s be diplomatic) Ruritania’s guarantee of the EFSF was reneged upon, it’s a sovereign default for Ruritania. Imagine the attendant bond market contagion that would cause via the linked guarantees of the EFSF. Would the ESM’s capital solve this issue?
It’s a difficult but important point, so we’ll go into it a bit more.
Nomura notes this regarding the European Investment Bank (as analogy for the ESM):
Under the EIB there is a legally enforceable obligation for shareholders:
· Obligation to pay callable capital, if demanded by EIB, has highest ranking in EU legal framework and in national law of Member States
· A Member State failing to pay could be sued by a creditor (e.g. bondholders)
Additionally, if a Member State fails to meet the obligations of membership arising from this Statute, in particular the obligation to pay its share of the subscribed capital or to service its borrowings, the granting of loans or guarantees to that Member State or its nationals may be suspended by a decision of the Board of Governors, acting by a qualified majority.
As it happens — whether holders of a supranational’s bonds really could sue sovereigns for failing to commit capital is a controversial subject indeed. For a simple reason: no sovereign has ever done it before, and whenever capital has become depleted relative to the supranational’s lending, the response has been to inject yet more capital, not to call existing subscriptions.
However! The injected extra capital is itself callable.
Fitch is already concerned about an increased reliance on callable capital by supranationals, therefore, especially when you add the absence of a precedent for managing a failed capital call.
That’s a bad sign for the ESM (for which capital injections may be controversial to voters anyway – remember this is bailout lending rather than cuddly project finance), considering that many of its subscribing sovereigns will remain very weak. Ironically, they’ll struggle in part because ESM-inspired restructuring risk is set to infect their borrowing costs.
In that case, we’re still cautious on whether the ESM could really successfully call capital in a sovereign crisis (which is just when it likely would want to call capital to cover losses). It may not be as world-ending as if the EFSF blew up, but still, worrying.
Looks like one answer is to make absolutely sure there is a firm outlining of capital call obligations in the ESM, especially with no precedents here.
Another is to keep track of states’ ESM liabilities, but there’s one remaining irony here. You might remember that Eurostat placed liabilities generated by the EFSF back on to states’ balance sheets, given the EFSF is pretty flimsy vehicle at the end of the day. The EFSF doesn’t actually exist, in an important sense.
Not so if the ESM is a ‘bank’ with capital. Contingent liabilities can happily migrate there off balance sheets. Tracking them in a crisis might be another matter, of course.
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* = There is always an asterisk when it comes to EFSF guarantees. How guarantees will be increased exactly will not be decided until a meeting at the end of June, Reuters reports.
There’s kicking the can down the road, and there’s kicking the can down the road on how to kick the can down the road…
Related links:
A fresh (IMF) sovereign contingent liability – FT Alphaville
The EFSF chief executive writes in… - FT Alphaville
That tricky ESM seniority – still tricky - FT Alphaville
Parliament approves Treaty change to allow stability mechanism – European Parliament