30 October 2011

Leveraged EFSF and Redistribution of Wealth

With leveraging the European Financial Security Facility (EFSF), governments in Europe are opting to use the controversial tools and financial structures very similar to those that they strongly criticized barely three years ago. In fact, they are considering something even more toxic. The strange thing is that policy makers, incl. Germany’s parliamentarians, are approving this kind of “solution”.

The situation looks the more desperate given that the new lending capacity of the revamped EFSF, the €1+ trillion, is quite the minimum for extending to Italy and Spain the loan programmes similar to those that have been agreed with Ireland and Portugal.

Does it mean that Europe is out of options? Probably not; Europe is still the wealthiest region in the world (see the Figure below). Remember that household “wealth” is defined as the value of financial assets plus real assets (principally housing) owned by individuals less their debts. Europe’s households do have money.

To better understand what is going on, take a close enough look to the two options for leveraging EFSF (both of which may be applied simultaneously, and could lead to the leverage effect of four to five times).

The major “advantage” of both of these options is that the finance minister of a Member State can say: “We have taken no additional obligations to our country.” The other major “advantage” is that the schemes do not look inflationary (“There is no necessity for the ECB to continue the secondary market program,” sounds much better than “The ECB has purchased almost a fifth of the combined debt of Greece, Ireland, and Portugal...”). In reality, our most prominent political leaders are looking for a polite (read: an obscure enough) way of redistributing global wealth without being “kicked out of the office”.

Option no 1: Providing credit enhancement to new debt issued by Member States (insurance for private investors that are buying bonds in the primary market)

Under this option, the so-called partial protection certificates would be attached to a eurozone Member State’s bond issuance.

“Both items could be issued as a combined package, but would be separable and intended to be freely traded after issuance. The coupon on the sovereign bond should be lower than current market yields because of the protection afforded by the attached certificate, and thereby contribute to the sustainability of financial flows.”

“This could be achieved by the EFSF extending a loan to a member state in order for the member state to acquire EFSF bonds which back the effective guarantee. The bond would then collateralize the partial protection certificate and could be held by a Trust or SPV on behalf of the member state. In the event of a default (to be defined), the investor could surrender the partial protection certificate to the Trust/SPV and receive payment in kind with an EFSF bond,” the draft proposal states.

(Source: forexlive)

Read once again. Not the most simple and transparent form of insurance, eh? I understand the above as follows:
* A Member State in trouble gets a loan from the EFSF (the amount would be equal to the insurance provided by the EFSF, e.g. 20% of the money that the Member State actually needs). It uses the loan to acquire the (AAA-rated) EFSF bonds.
* The same Member State issues its own government bonds in a combined package with the so-called partial protection certificates. The (AAA-rated) EFSF bonds would serve as collateral for the partial protection certificate, and be held by a (separately created) Trust or SPV. Thanks to the partial protection, interest rate would be lower for the Member State.
* Investors buy the bonds of the Member State as well as the partial protection certificates. However, the investor who buys the bonds does not need to be the same as the investor who buys the partial protection certificates.
* If the Member State defaults, the investor with the partial protection certificates would go to the Trust or SPV, surrender the protection certificates and get the (AAA-rated) EFSF bonds. What about the investor who has only the bonds of the defaulted Member State? Well, seems that we have a loser.

This may not be the final scheme that is still to be agreed, but anyway, we could expect something like this. What’s the trick of such complexity? Answer: it’s difficult if possible at all to estimate the fair value of the bonds and partial protection certificates if separated and freely traded after issuance. Hence, it becomes easier to convince “fools” (such as investment funds and others who are investing other people’s money) to take excessive risks.

The good thing for the EFSF is that it does not need to pay even if the Member State defaults; the protected investors only get bonds issued by the EFSF. The bad news for the investor is that the insurance provided by the EFSF is weaker than the insurance provided by an insurance company. Normally, when an insured event (in this case, the default of the Member State) occurs, the insurance buyer gets compensated in cash. In this case, the insurance buyer gets compensated in bonds. Thus, European leaders are considering something potentially even more toxic than a Credit Default Swap (CDS).

Option no 2: Using Special Purpose Vehicles (SPVs) in order to combine resources from private and public financial institutions and investors

“Each dedicated SPV would have a mandate to facilitate funding of member states through loans, and invest in sovereign bonds of a specific country in the primary and secondary markets. This vehicle could be funded by different classes of instruments with distinctive risk/return characteristics,” the draft proposal explains.

The instruments could include a senior debt instrument and a participation capital instrument, both of which would be freely traded instruments. In addition there would have to be an EFSF investment, which would absorb the first proportion of losses incurred by the vehicle, according to the draft.

“The participation capital instrument could be junior to the senior debt instrument but rank ahead of the EFSF investment. This might attract Sovereign Wealth Funds, risk capital investors and potentially some long-only institutional investors. This tranche will potentially share with EFSF any upside generated by the investments,” the draft says.

(Source: forexlive)

Figure 2 below illustrates my interpretation of this scheme. Basically it would work as follows:
* A Member State in trouble asks the EFSF for a certain amount of money.
* EFSF sets up a SPV, slices the liabilities of this SPV and gets them rated by S&P, Moody’s and/or any other rating agency. Each slice will have different risk and return characteristics. Some slices will be AAA-rated, some AA-rated etc.
* The SPV sells its own bonds to the investors (Sovereign Wealth Funds, risk capital funds, institutional investors etc.) and, for the money received from the investors, buys the bonds of the troubled Member State. The SPV’s equity tranche would be owned by the EFSF.

 Again we seem to have a structure that is unreasonably complex and inconsistent. In fact, the EFSF’s draft proposal also provides us with an indication about the prospective “fools”:
* The first 20% (or whatever percentage that will correspond to the EFSF’s leverage) of the losses would be borne by the owners of the EFSF’s equity tranches, i.e. by the guarantors of the EFSF that ultimately are the tax payers of the euro area Member States.
* The second x% of the losses (x% depends on the proportion of the SPV’s other capital instruments) would be taken by the owners of each SPV’s other capital instruments, incl. Sovereign Wealth Funds, the risk capital investors and the other institutional investors (which in turn means that if you are investing into an investment fund, you may easily end up in being in this group of losers)
* The list goes on in accordance with the seniority of the defaulted SPV’s bond investors, less senior investors bearing the losses at first.

Again, we have something absurdly complex. Yet we have apparent winners too: the rating agencies that get paid for assigning the ratings to the complex securities, the inventors of the complex instruments and structures, asset managers who will get the asset management fees anyway etc. (The invention and assessment of such complex stuff – even if nonsense – needs good experts, right?)

To summarise: if you are not a gambler, then stay away from the leverage EFSF and everything related to it. Also, be wary of the asset managers because they are gambling with your money and not with their own. No matter the means (using complex investment products, inflation or whatever tool), the “solution” to the debt crisis is to take the money away from those that have savings, and redistribute it. Most probably we are talking about the middle class and the upper middle class, because those in the top of the wealth pyramid know “the game” far too well, and the others own too little to be interesting.

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