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.