Click here to read this article in pdf format: october-27-2011

As we write these comments, no concrete proposal for the European Financial Stability Facility (EFSF) has been presented after the summit that took place yesterday, among leaders of the European Union (EU). However, markets seem to consider as highly likely that three fundamental decisions will be made:

1.-The EFSF will be leveraged, under a first-loss insurance scheme, to cover the initial losses on newly issued debt of EU sovereigns.

2.-Greece’s sovereign debt will be restructured without triggering a credit event.

3.-The eventual haircut (i.e. discount) on Greek debt will be significant (approximately 50%) , higher than 20% for the purpose of our discussion below.

Together, these three measures, if implemented, would generate an inconsistent system, leaving the European Monetary Union in worse shape.

The current limit on the European Financial Stability Facility is EUR440BN. If we subtract the existing commitments to fund the Irish, Portuguese and Greek programmes, we are left with approximately EUR200BN. If these were pledged to cover, say the first 20% of newly issued sovereign debt of EU members, we would have about a trillion Euros, 20% insured (i.e. Eur200BN/0.2 = Eur1 trillion). This would mean that investors of the first trillion Euros in sovereign debt would only suffer losses, if these surpass 20% of their investments.

How can we tell investors they will be safe enough with a 20% cushion, if they simultaneously see a haircut on the Greek debt in the order of 50%? To make matters worse, if existing hedged (with credit default swaps) investors of other EU peripherals sovereign debt see that no credit event is triggered (i.e. default is not acknowledged) in the Greek case, why would they keep paying to insure their bond holdings with credit default swaps? After all, those who thought were properly hedged on their Greek debt holdings would now see that the insurance premiums they bought are useless.

The consequence of these last two measures would generate a sell off in sovereign credit default swaps, eventually taking liquidity from this market, and in the process, likely increasing the cost of owning the newly issued debt that the leverage EFSF initially sought to cheapen, by providing a 20% first-loss insurance.

Lastly, as a structured credit product, the senior tranche owned by investors (the EFSF would have a subordinated tranche of 0-20% in losses, investors would be senior, with exposure to losses above 20%) will be negatively impacted if the contagion (i.e. correlation of defaults) spreads (i.e. increases) within the European Monetary Union. Think of this example: suppose that a veterinarian sold a farmer an insurance contract where the first 20% of the cattle covered by the contract would be refunded, if it catches a certain disease. As long as that disease is contained, the insurance contract provides the farmer with peace of mind. It is clear then that if the disease becomes epidemic, the farmer will find himself in a more compromised position.

Investors of EU sovereign debt are actually in a position weaker than that of our hypothetical farmer. The same sellers of the insurance, by forcing haircuts bigger than the loss they insure and without triggering a credit event would actually be increasing the likelihood that the default contagion within the region spreads. Bondholders without a proper hedge may fire sell their investments, raising the cost of the newly issued debt, further threatening the position of the EU banks, which are currently asked to increase their capital.

This could indeed end in a vicious circle that would dangerously spiral, for if we are correct…the next logical step would be to ask who would reinsure the insurers, as a region-wide collapse is on the horizon. As we saw in the US with mortgage insurers, that person was the Fed. Will that be the fate of the European Central Bank as well? The recent rally in gold seems to tell us the answer.

Martin Sibileau