EFSF: Dramatically Exaggerated Headline and Slippery Slope Funding Mechanism

The markets greeted news of the eurozone stability measures in May exactly how the EU ministers and the IMF undoubtedly had hoped for – with huge equity rallies across Europe and the US driven by confidence inspired by the eurozone countries working together and big headline numbers. Neither is really what it seemed.

The headline number for the European Financial Stability Facility (“EFSF”) is €440bn. In reality less than €300bn could ever be available. And the very mechanism of borrowing, with borrowers dropping out of guaranteeing further loans, is likely to force “every country for itself” mentality among the weaker ESFS signatories (and perhaps even among the stronger ones after today’s news from Austria and Finland).

EFSF received little additional fanfare in August when it became operational and received the conditional “AAA” ratings, as by that time the world was already deemed a better place with spreads compressing across the board and QE2 on its way. With Ireland being pressured to ask for a bailout and Portugal not far behind, and with news that Austria is balking at funding next tranche of payments to Greece because of failure to satisfy agreed conditions, it is worth examining the EFSF more closely with a particular focus on the most plausible scenarios.

A Manufactured Headline Number to Dazzle the Markets 

The headline number for EFSF of €440bn sounds great. With the €60bn from European Financial Stabilisation Mechanism (EFSM) and a €250bn commitment from IMF, it makes for an impressive €750bn total. But how much of that €440bn would (and can) be there if needed?

• Greece -- The headline number included a “commitment” from Greece, even though Greece was explicitly excluded, making the real number €427.6bn. It is unclear why Greece was included to create a headline number, but immediately excluded from providing any support? That might have fooled the trading robots initially, but surely if some country tries to draw down on the facility this will get widespread press/ridicule.
• 120% -- Perhaps the most obvious of the inflated headline number maneuvers, the guarantees have to be 120% of the loan amount. This requirement probably originates from the balancing act of trying to manufacture the highest possible headline number vs obtaining the “AAA” rating and minimizing the actual amount that can be financed. Not much to be said about it except that after its application the maximum possible loan amount is only €356.3bn.
• Borrowers -- Since the very countries that can request EFSF loans are also the guarantors of the facility, they can ask to be excluded from future guarantees. And, of course, guaranteeing your own loan is meaningless. So if Ireland were to request a loan, the headline would have a slight reduction down to €350.5bn. On the other hand, if Spain were to drawdown, the haircut is a machete-like chop to €312.7bn.
• Cumulative Effects -- So despite the €440bn, the actual available amounts are much less. The best realistic case is €350.5bn for Ireland and €312.7bn for Spain. Ironically, the smaller the country that needs money, the larger the potential available pool. And this is cumulative. So if Ireland draws, and then Portugal draws, the amount left for Spain would be significantly lower than €312.7bn. It would be reduced by the amounts that Ireland and Portugal would have guaranteed AND by the amount used up by Ireland and Portugal when they tapped the facility. It is easy to see that less than €200bn could be even available for Spain.

Amount Actually Available To Borrowers is Even Less

Not that the shell game is over yet. This is still NOT the number that is available for the actual loans. The funds provided to a country requesting a loan are further reduced by an up-front service fee (50bps on the notional) and the NPV of spread charged on the loan, “together with such other amounts as EFSF decides to retain as an additional cash buffer”.

Assuming a 4-year bullet loan with 400bps spread, and the needy borrower gets another quick 15% haircut! And that’s before any additional cash buffer that EFSF will require. The loan is for the full amount “requested” even though it might only receive funding of 75-85% of the amount requested. That certainly increases the cost (perhaps a purposeful deterrent to borrowing?). So if you need €40bn of cash, you would like have to ask for at least €50bn and have the privilege of paying interest on all the money you don’t actually get. This both reduces the potential cash available to borrowers significantly and makes the cost to tap the facility more than it appears on the surface.

Finally, the rating agency letters seem to imply that they are looking to the “AAA” ESFS guarantors plus the total cash buffer (up front fee, NPV and additional cash buffer required) to enable the “AAA” rating of the ESFS facility. Basically it looks like they are unwilling to give any rating benefit to the structure from the non-AAA guarantors. If so, effectively, amount guaranteed by the “AAA” ESFS guarantors is an absolute ceiling on the amount that can be disbursed under the ESFS (since by definition, the borrower does not receive any amount held back in the cash buffer).

The maximum possible loan to the first Borrower could not exceed €255.4bn. In reality, of course, EFSF will not be used up all in one shot on the first borrower but will conserved to have some dry powder to permit help to other potential borrowers.

Falling Dominoes or Death Spiral?

Multiple countries are in potential need of funds from the EFSF. Lets suppose that one, such as Ireland, requests the funds and the other EFSF members need to approve it. If you are Portugal, the next widest sovereign, do you really want to approve Ireland? Does it not add to your own potential problems as you are adding to your own debt burden? How popular would that be at home, while pushing domestic austerity measures? Is there a risk that your own debt gets downgraded by the rating agencies as a result, hastening your own slide wider into the arms of the EFSF? And if Ireland is off the table after receiving the EFSF loan, might the market not turn to the next vulnerable target anyway? And if somehow you do not agree to backstop Ireland, would that not be a sign of weakness that would cause the market to immediately take a run at your debt anyway?

One could certainly make an argument that the best course of action for the weak countries would be to request their own EFSF loans as soon as the first country requests. It gets you off the hook immediately, before you guarantee the debt of others that you can ill afford to guarantee, and probably assures that you maximize how much funding you can get. Waiting just increases your own burden and makes the available pie smaller. Maybe Portugal can afford to wait and play along if Ireland comes in, but surely not if it looks like Spain might need to. Then it is a race to get the funds first!

Exaggerated Headline and Slippery Slope

EFSF was designed with two goals in mind. First, the EU governments clearly wanted to present a facade of full cooperation, with big confidence-inspiring headline numbers and minimal actual exposure risk. Second, to fund the EFSF bonds, “AAA” ratings were needed and the rating agencies wanted to be on sound ground where the “AAA” guarantors (primarily Germany and France) cover all the money that could actually be disbursed to the borrowers. But as in all confidence building exercises, it works best without having to be utilized. If it does need to get used, it might well create serious political / fiscal backlash both in the weak and strong countries, combined with a possible race to draw down by all the weak credits.

It is NOT rocket science

QE2 is not rocket science, it is a lot more confusing than that. More and more people are coming out publicly against it. There are a myriad of arguments against it: likely to be ineffective, a scary opening of the inflationary Pandora's box, too many potential unintended consequences, a provocation for potential currency and trade wars, overstepping of the government's (at least, the Fed's) role to use public policy and funds to force investors into riskier asset allocations, deliberately weakened currency is bad and not a sign of strength ("Yes, I've used old 100 zloty notes to blow my nose as the bill was cheaper and softer than Kleenex and at the time the economy was very weak"). The argument in favor of QE2 seems to add up to increasing liquidity and the wealth effect (in a eerie echo of the "trickle down economics"). But liquidity does not seem to be a problem now, and the wealth effect impacts a relatively small portion of the population who are already busy shopping at Tiffany's to buy much more.

As this debate continues, it notable that many of people who have spoken out against QE2, were supporters of QE1. At the time of QE1, there was almost no market support for mortgages and the corporate bond market was in shambles. By stepping into a market which most people argued was cheap but in which they were too scared to invest their own money, the Fed created demand for mortgages and was thus able to get that market normalized. With Fed's lead, people who believed the mortgage market was priced irrationally gained the confidence to put on risk, and were rewarded for that.

QE2, on the other hand, seems to be pouring in money into a market that already seems bid without, By doing that the Fed is not solving a demand problem, and also potentially exacerbating the supply problem. If the curve was incredibly steep and everyone was piling into 1-month paper and avoiding 5-year, it would make sense, and sadly, some day we might be in that position, but for now with 5-year treasuries yielding under 1.25%, that is not an issue. Why does the government need to step in to buy more of what private investors are already buying?

Barron's touched on one of our favorite themes "the inability to rerun history without the intervention makes it hard to invalidate their self-serving claims." In spite of Helicopter Ben's extensive knowledge of the Great Depression, economics is not a "hard" science where every action has a clear attributable reaction. We can guess what the most likely outcomes might be, but there are just too many moving parts, and with people involved, not every action has the expected reaction. People do not always act rationally, and what might be actually rational for someone depends on so many factors that it is impossible to predict.

QE2 is here for now, but we hope that momentum against it is building sufficiently that it might never be fully implemented. Mr. Bernanke seems to be getting confident that he can manage the market's expectations. That scares us, because as soon as he is truly believes that he can manage the market's expectations, the market will not be managed that way. It is just not as easy as rocket science.

"Don't Fire Until You See the Whites of Their Eyes"

In many ways this single quotation sums up much of what makes America great. At Bunker Hill, a group of American soldiers facing a much better armed and trained British force, rather than doing the easy thing – panicking, firing haphazardly, and scattering in the wind - braved their challenge, inflicting 3 times the casualties on the ‘superior’ British force and helping set the stage to win the war! They faced adversity, didn't ask to be coddled, didn't need things to be easy, and ultimately after much hardship, emerged from the war victorious.

What does this have to do with the economic situation of today? We have become a land that does not believe in adversity or in suffering through pain. We want our politicians and central bank to do everything they can to make problems go away – and go away NOW. Do we really care about the long-term consequences? We all say we do, but the reality is we are unwilling to accept anything bad right now to reduce adverse long-term results. If we had been on Bunker Hill, maybe instead of having midterm elections this week, we would be arguing whether the Tories or Whigs are better representing us in parliament.

Mr. Bernanke is a scholar and expert on the Great Depression. But what does that really mean? That is he has analyzed what was done, and of that, what did and did not seem to work as expected. The problem is that although economics has a lot of parallels with hard sciences (math, statistics, data), it is simply not like physics or chemistry. Hard sciences are based on making detailed theoretical predictions that can be tested in the real world. Soft sciences use a “control” group concept. In economics, neither concept is possible. It is impossible to know what the real cause and effect are. You cannot know that one action led to one result and that another would have led to a different result. You can theorize, and make intelligent arguments, but it is not provable. There were never two identical economies in similar amounts of distress where stimulus was supplied in one but not the other. Or where trade barriers went up in one but not the other. Nor where currency was recklessly devalued in one but not the other. The best one can manage in studying economics is to analyze what occurred and make conjectures as to why things happened. But those conjectures cannot be tested nor even compared to something similar. This means that to some extent we are just guessing at what could have been done differently and what the results would have been.

The consensus seems to be that in the Great Depression not enough was done soon enough. That seems plausible enough, and it is a hypothesis that fits well psychologically with the “feel no pain” culture we currently enjoy. It is also arguable that the problems were so deep that nothing done during the Great Depression had the desired impact, and only World War II dragged the economies out of the morass. But it is also possible, maybe even equally plausible, that had money been thrown at the problem hand over fist in the beginning of the Great Depression, its initial stages would not have been as bad, but that it also would have dragged on longer as the early stimulus masked the symptoms of the disease? Or that stimulus could not be applied effectively until time had done a lot of the work to correct many of the problems by stabilizing the economy at a new lower balance. Or that trying to keep the economy at an artificially high level early in the crisis would make later interventions ineffective.

Doctors know that you can't give morphine to every patient for every type of pain. They know that over time the efficacy diminishes (and it is addictive), so they reserve it for extreme emergencies. Even something as simple as antibiotics needs to be rationed out of concern of encouraging the development of resistant strains. Why is there so little fear that we are wasting our ammunition early in a long, and sadly normal, phase of deleveraging during which we have to learn to live within our means and also within the context of how the rest of the planet lives?

Clearly early government intervention helped in the current crisis. The economy undoubtedly would have hit a lower level had the government not spent so much money and implemented so many policies. But the early intervention might well have been a Pyrrhic victory – the economy did not collapse as much as it would have but it might well have forced resolution of problems that are still there and that are preventing a healthy recovery accompanied by real reduction of unemployment. Maybe we would have that money to use now, and maybe we would have more faith that government intervention accomplishes its stated goals and that politicians are acting to promote better lives for us rather than their own careers. Maybe with more time to plan and think, we would have implemented far better policies that gave a much bigger bang for the buck. So yes, the economy could have been worse than it got, but it is possible that today it would have been in much better shape for it.

Traders have stop losses, at least in part, to deal with the fact that when you are losing money you often do not and cannot think clearly and thus make bad decisions. So you force yourself out of the position and hopefully into clearer thinking. The government works in the exact opposite way. It only rushes in to get things done when things are bad and when no one is left thinking straight. For instance, there seems to be universal agreement that letting Lehman fail was bad, but at the time there was strong agreement that it was right to save Bear Sterns. Bear was much smaller than Lehman. It would have been ugly to let Bear go, no doubt, but not as ugly as Lehman, and possibly the decision to let Lehman fail might never have had to come up if everyone learned the lesson from Bear. With the relief after the Bear bail-out, everything went back to business as usual without anyone trying to use the “bought time” to fix the problems of the other investment banks.

Poverty has always existed in the US, and for many people life has become much worse than it was before the housing bubble burst and years of living beyond their means came crashing down on them. But sometimes it seems that we have more people with 40-inch flat screen TVs whining about how unfair the system is than China has people with 40-inch TVs. In a larger context, life in the US is not so bad, and maybe we need to establish a new baseline. It is hard to admit, and particularly hard for a politician to get re-elected admitting, that we have a lot of pain to endure as a result of consuming so much for so long. TV personalities can snicker at how the French are striking because the retirement age is increasing to 62 from 60, but turn red in the face with self righteous anger at thoughts that the Bush tax cuts to people making over $250,000 won't be extended.

Every proposal to spend NOW is accompanied by talking about how we will fix our problems LATER, when times get better. What if we have not yet hit the lows? What if the new normal is not going to allow that? Even Basel III gives the banks 5 years to fix things! Are we so worried about bank stock prices that we do not want them to recapitalize as needed before then next crisis hits? Why do we assume that we have 5 years to fix that? We are not out of the woods, and blithely assuming that at some point in the future things will be better and we can pay for what we are doing seems naive and even dangerous. Just keep doubling down, eventually you'll win, right? We all know that the doubling down, when it doesn’t work, is far far far worse than having just fought through a losing position.

Maybe all these points are moot, as we are in expert hands after all. But, as already stated, economics is not like the other sciences. There are no experiments that can test a hypothesis and then be replicated. There is no way to know what would DEFINITIVELY work, what would not have worked, and whether what was done was harmful or actually optimal in the long run! It is as much about individual and group psychology as it is about data and statistics and rigorous sounding pronouncements. In what other “science” is there one M.M. who was awarded a Nobel Prize for ‘proving’ capital structure does not matter, while another M.M. built two substantial fortunes, at least in part, on the presumption that capital structure DOES matter! It is not clear that anyone knows the right thing to do, but it is clear that spending all your ammunition up front with nothing left in reserve is the wrong approach.

Hope for shorts?

The market continues to be very difficult to trade from the short end. Thursday and yesterday both gave some hope to shorts as equities weren't able to hold on to early gains, but we are still up from Wednesday's rebound levels. IG and HY credit outperformed stocks significantly yesterday and neither faded much into the close and even this morning, credit seems stronger than equities. With all the noise in the market, so many comments/rumors about the Fed, QE2, mortgage putbacks, etc, its hard to pinpoint any particular driver, but yesterday did feel like it was the first time we sold off on good news.

We have certainly seen a lot of rallies on the back of bad news, but yesterday's better than expected Dallas Fed number, actually did seem to trigger a sell off. Our thesis has been that the economy is slowing and may well double dip, and that QE2 won't be particularly effective in stopping that process. Selling off on good news really isn't part of that, and we were wondering what to do, but the reality is that +2.6 isn't really that good. Better than what was expected, and assuming no revisions, its positive for the economy, but well within the range of data expectations for an economy muddling along. Obviously we all continue to watch the data, but we are hopeful that enough QE2 has now been built in that we won't rally on bad news, and that being short can be rewarded.

The other story that gives us hope for the shorts, is that every talking head is now all over the story that weak dollar is good for stocks. On the surface this trend is there. What we find difficult to understand, is why a strong Euro would be good for stocks there? Doesn't it make sense that if weak dollar is good for US stocks, a strong Euro is bad for European stocks? Yet, 8 out of the last 10 trading days, saw the CAC move same direction as SPX, and DAX and UKX moved same direction as SPX on 7 out of 10 days. DAX and CAC outperformed the SPX in that time, and UKX barely lagged. So, it seems that people look at the $, trade SPX based on the $ move, and then trade European stocks on the back of the move in SPX? That doesn't seem sustainable. Is it because Euro is also weakening against EM currencies? The EM story does seem partially intact as Bovespa has moved the same direction SPX "only" 6 out of the past 10 trading, so its not tracking as closely, and is actually down for the period while the SPX is up. I think the strong $, strong stocks, story is getting more complex, and that the smart/fast money is already beginning to figure out what the next key "tell" will be. Once the entire market "knows" the tell, its usually near the end of its usefulness. It may appear to work for awhile, but the reality is that some other data will be really what's driving it. Greek spreads? LIBOR? As usual, we have no clue what to look for next, but the simplicity of the "dollar down, stocks up" seems to be getting played out, and we would be careful following that as main trading cue.

Where is AIG?

Stocks of the monoline insurers are up 10% to 25% in a week as stories of mortgage putbacks have become front page news. Hedge funds, institutional investors, and the mortgage insurers of all types are all making headlines as they try to push back their losses onto the original pools of loans that they insured, claiming that the loans never met the stated underwriting criteria. The robo-signings and the latest foreclosure mess only strengthens the view that banks were not diligent when they originated the loans or created the mortgage pools.

What is shocking, is that so far AIG does not appear to be involved. AIG FP was one of the biggest losers in the CMO fiasco. They (and the taxpayers) have as much as anyone to gain from pushing back on those original pools they insured (or wrote protection on), being in the unique position of having paid out 100 cents on the dollar to unwind the swaps with Goldman, Merrill, SocGen, etc. Why is AIG silent? Is it because they are working on their case and keeping a low profile? Or is the government is so clueless that they aren't investigating the potential to reclaim money for taxpayers? Or is it that they are refusing to rock the "equities" boat, scared to sue Goldman (after the relatively trivial Abacus settlement), or even do not want to sue Citi (which they - or rather we - also own)?