Photo: abbamouse on Flickr
Don’t pop the champagne yet.Citi’s Willem Buiter and Ebrahim Rahbari say that “big bazooka” to rescue the eurozone we’ve been hearing rumours about lately is not all it’s been cooked up to be, though the idea does have merit.
In a note out this morning he sketches out the nitty gritty of what a plan to lever the European Financial Stability Facility might look like, and the devil is all in the details.
A plan to guarantee first losses on sovereign bonds would indeed expand the firepower of the EFSF, but a 20% first loss guarantee to bondholders might not be enough to keep money pumping to a struggling Spain and Italy.
[Of note: Buiter and Rabhari speak generally about the possibility of a ‘big bazooka,’ but specifically reference this Allianz plan (via Also Sprach Analyst).]
'Under these proposals, the EFSF would take the first X per cent loss on €Y worth of eligible sovereign debt. This would permit the EFSF resources available for sovereign bond insurance in this manner, €Z, say, to support purchases of sovereign debt of up to €(100/X)Z.'
Source: Citi
- The EFSF must maintain a triple A credit rating to be attractive to investors as an insurer.
- The rating of the EFSF will affect the ratings of euro area sovereigns.
- A bunch of countries (including Italy and Spain) will probably have to step out of these guarantee commitments.
That equates to about €1.5 trillion ($2.08 trillion) in debt insurance, assuming that the EFSF guaranteed the first 20% of bondholders' losses.
Previous commitments to Greece, Portugal, and Ireland cut into the size of funds available. These calculations also assume that Italy and Spain will be unable to contribute to the insurance program, and will probably need insurance on their own bonds.
Buiter and Rahbari think this number will be about €50 billion ($69 billion) less if the EFSF is also used to provide bank support.
Though it could absorb as much as €726 billion ($1005 billion) in losses, not all that money is AAA-rated. The point of shoring up sovereign bonds is to keep borrowing costs low for those governments, but if more risk is introduced into the equation (i.e. the EFSF loses its AAA rating) that won't happen.
- The EFSF as an insurer has positive rating implications relative to some of the other plans being tossed around.
- That equates to a more positive ratings outlook for eurozone sovereigns, although these implications are not significantly different as all proposals involve the same expected loss.
- Not going through the political approval process is a MAJOR plus to this plan.
The EFSF can choose to only insure new issuances of sovereign debt, not outstanding bonds, of struggling PIIGS countries.
This makes an insurance plan far cheaper for the EFSF than, say, the European Central Bank (which would presumably have to insure both). By keeping borrowing costs down, it would contain contagion from spreading to Italy and Spain.
'The size of the NPV loss for the investors conditional on a default having occurred is therefore likely to be large: if the sovereign is going to default at all, she might as well be hung for a sheep as for a lamb.
We are therefore sceptical that, if there is a reasonable expectation that the recovery rate following a sovereign default in the Euro Area could be as little as 60 per cent or 50 per cent, that the markets would be happy to fund these sovereigns at sustainable interest rates to the sovereigns, with just a 20 per cent first-loss rate, even if this insurance were granted free of charge. A 40 or even 50 per cent first-loss rate might well be required.'
Source: Citi
Buiter and Rahbari guess that insuring a 40-50% first-loss would require around €600-750 billion ($830-1040 billion), far more than the €300 billion ($415 billion) available with the current resources.
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