From John Hussman’s latest weekly letter, a pretty excellent shredding of last week’s big deal.
The gist: There’s still no “deal” in place, just a framework, and the leveraging won’t work like people imagine, especially not the “First-loss” insurance, which only kicks in in the event of a default, at which point, bondholders would need A LOT more money than is being offered in order to feel protected.
With respect to Europe’s perceived “solution” to its debt crisis, the 50% write-down of Greek debt is appropriate, but it’s not clear that this includes a writedown of Greek obligations to “official” holders such as other European governments and agencies. If not, it’s unclear whether the writedown is really deep enough to allow Greece to avoid further debt problems several years out.
Likewise, I suspect that investors are celebrating various “headline” figures (such as “1 trillion euros”) without much understanding of what they are cheering about. The European Financial Stability Facility (EFSF) is a Luxembourg corporation to which European states have committed 440 billion euros of backing, beyond which the EFSF must issue its own bonds to investors in order to make loans (not grants) to recipient countries or banks. There are two basic options that the EFSF contemplates for “leveraging” its 440 billion euros (which will actually probably be closer to 250 billion for all of Europe after amounts needed for Greece and bank recapitalizations). One is to issue “credit enhancements” or “partial protection certificates” that would be sold along with the new debt of European governments, where the certificates would provide first-loss protection of say, 20% of face value. Alternatively, the EFSF could construct a “special purpose vehicle” or SPV in each given country – basically an investment company formed to buy European debt – where the EFSF would “provide the equity tranche of the vehicle and hence absorb the first proportion of losses incurred by the vehicle.”
So to start with, the EFSF is not actually an operating “bailout fund” at present – it’s a shell corporation with a business plan and a certain amount of promised capital – not yet in hand – from European governments, in search of additional funding from private investors. Its intended business is to a) partially insure European debt, using capital from European governments, which these governments will obtain by issuing debt to investors, or b) to purchase European debt outright, by issuing EFSF debt to investors, leveraging capital obtained from European governments, which these governments will obtain by issuing debt to investors.
In effect, European leaders have announced “We have agreed to solve our debt problem, leveraging money we do not have, to create a fund, which will then borrow several times that amount, in order to buy enormous amounts of new debt that we will need to issue.”
As Jens Weidmann, the President of the German Bundesbank objected about this plan last week, “It is tied to higher risks of losses and to increased sharing of risks. The way they are constructed, the leveraging instruments are not too different from those which were partly responsible for creating the crisis, because they concealed risks.”
Moreover, the benefit to private investors is suspect. The basic idea of leveraging the EFSF is to provide enough “credit enhancement” to make European debt attractive. What is the value of that credit enhancement? Well, if the expected recovery rate is 80% or more, and the probability of default is fairly low, then the insurance (a promise to take “first loss” of 20%) isn’t really needed in the first place. If you do the maths, the expected effect on yields is something on the order of 1-2% on 1 year debt, and a fraction of a per cent for longer dated debt. Unfortunately, when the insurance really is needed (assuming more typical recovery rates around 50% and default probabilities higher than 15% or so), a 20% first-loss provision does little but reduce an extremely high interest rate to a lower, but still intolerably high interest rate. Given debt-to-GDP ratios of 100% or more, that protection does nothing to avoid certain default except to delay it for a small number of years.
On that note, don’t look now, but even if you were to assume an optimistic 80% recovery rate, Portuguese yields already imply certain default within less than 2 years. Assuming a more typical 60% recovery rate, the probability of a Portugese default within 2 years was 68% as of Friday (that same recovery rate produces an implied default probability of 88% within 3 years, and 100% within 5 years).
The bottom line is that a 20% first-loss provision is irrelevant until you need it, and then it suddenly is not nearly enough. Consider also that the IMF just raised its estimate of required European bank recapitalization to 300 billion euros. Even if regulators demand less, enormous amounts of capital must quickly be raised either directly by issuing stock (which would require banks to issue shares in nearly the same amount as their existing float), or failing that, by depleting the committed funds of the EFSF. It is an open question how much of the EFSF commitment will actually be available for use beyond mopping up the Greek writedown, especially if the economy fails to avoid a recession. In any event, it appears very unlikely that Europe has achieved a durable solution.