28 October 2011

Douglas J Elliott: Levering Europe - alternatives for the European Financial Stability Facility

There is no doubt that European leaders made significant progress on key issues necessary to solve the euro crisis. However, they also left us with many intriguing questions, especially how they intend to lever up the European Financial Stability Facility (EFSF).

At the end of the day, European leaders want €250 billion of usable funds at the EFSF to provide at least €1 trillion of support for eurozone debt issuances. As a result, the leaders indicated that “four to five times” leverage will need to be achieved. How can this be done? The leaders have delegated this to their finance ministers and the appropriate European technical experts, so we do not know the ultimate answer yet. However, there are several logical alternatives, of which at least two appear to be under consideration.

Provide insurance or a guaranty of a portion of each sovereign bond

The leaders explicitly indicated that this is one option. The mechanism is fairly straightforward. Buyers of new bonds issued by troubled eurozone countries could purchase protection from the EFSF on the first portion of any losses incurred on those bonds. If the EFSF guarantees losses up to the first 20 per cent of the face value on such bonds, then its resources could support €5 of issuance for every €1 of risk that it takes. (Whether the protection is provided as insurance or as a credit guaranty is a relatively technical issue that does not affect the basic economics.)

Alternatively, the EFSF could choose to operate more like an insurer, providing aggregate guarantees greater than its maximum funds, on the assumption that not all guarantees would be called upon. This approach appears unlikely, though, for several reasons. First, and most basically, there is almost certainly a high correlation between the probability of default of, say, Portugal and Italy. This is different from insuring a large number of houses in different locales which are unlikely to all burn at the same time. Second, the EFSF is currently constructed so that it borrows funds from the market to cover its activities, using the national commitments to reassure investors of its creditworthiness. Thus, taking on risk greater than those commitments could cause a ratings downgrade, raising its costs. Third, the politics of taking on still more risk could be very tricky. The case of the TARP in the US highlights how voters tend to assume that all the funds committed will be lost in these crisis times.

Non-recourse financing

Several of the emergency credit programmes used in the financial crisis in the US took another approach to luring investors to buy securities that were perceived as high risk. They offered cheap non-recourse financing.

This approach would not provide the EFSF with significant leverage. It is best suited to situations where the government has access to large volumes of funds at relatively low rates. Nonetheless, it could still be more attractive for investors than a straight guarantee, if structured appropriately. For example, a Special Purpose Vehicle (SPV) could be established that would be funded 20 per cent by the EFSF and 80 per cent by the investor. The EFSF would buy subordinated debt of the SPV that would take the first loss. This approach would allow investors to have the economic benefit of the guarantee while also reducing their funding costs by the difference between the rate charged by the EFSF on its junior piece and the rate they would normally pay for funding. This becomes relatively more attractive at higher levels of guarantee/funding, but would have value for wholesale investors even at the 20 per cent level.

The guarantee or insurance approach could be implemented using credit default swaps, but there appears to be no particular advantage to doing so. European leaders will have to make some significant choices about how to implement either of the main alternatives. Unless they discover technical problems, they will presumably offer both the guaranty and the SPV alternatives. Presumably the EFSF will not try to use up its total capacity up-front, especially since investors may become more interested in participating after the first offering or two succeeds.

Moral hazard

There is a real risk that investors, particularly foreign investors, may believe that the level of protection that the EFSF chooses to provide is an unofficial guarantee that restructurings will not be larger than that level. This is not an unreasonable assumption, although it is clearly not the intent and could easily be wrong in practice. Nonetheless, the nations backing the EFSF will likely be in a position to essentially determine whether there is a restructuring and how big a haircut is employed. One can imagine the pressure that the Chinese, for example, might bring to bear if it looked as if a future restructuring were going to produce a haircut exceeding the protection level.

Conclusions

There are several ways in which the EFSF’s own funds could be levered through a partnership with external investors, whether from the private sector or official sources. Each of these, however, has potentially serious limitations and risks as compared to the commitment of greater funds by the national governments. It will not be clear for some time as to whether the eurozone will be able to design an approach that is effective and brings in the needed level of external investment.

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