So the authorities have seemingly realised the old EFSF plan doesn’t work. What about the new plan?
There has been a lot of press coverage about the proposal to turn the existing EFSF (European Financial Stability Facility) into a monoline insurer of sovereign debt, where the new structure would be called the European Sovereign Insurance Mechanism (ESIM).
How is the ESIM supposed to work in theory? No concrete details have been announced, but the basic thrust of the proposal is that the EFSF (and subsequently the ESM) acts as a sovereign bond insurer for new funding and exchange offers. Investors, comforted by the ESIM taking the first 40% of losses in the event of any restructuring, would then be willing to again buy new Greek, Portuguese and Irish debt, or (more likely) exchange their existing bonds into new insured bonds at a level somewhere between current market prices and par. In the very optimistic scenario that a lower insurance coverage (25%) would be required by investors for Spain and Italy, Allianz estimates that the EFSF’s leverage on its existing €440bn commitment could apparently be increased to 3.7x.
That’s the theory, but why does the ESIM not work in practice?
Firstly, conceptually, the idea of bond insurance obviously has a somewhat tarnished track record in recent years (the monolines, Fannie/Freddie, AIG etc all come to mind) and the fundamental problem will be persuading investors that they would ever be able to call on the insurance policy provided by the EFSF/ESIM/ESM when they actually need to.
As with monoline wrapped bonds, investors must be comfortable with the underlying obligor from the start, rather than counting on an insurance policy from a Luxembourg domiciled private company (the EFSF) whose mandate and strategy keep changing, which may or may not exist in its current form after the introduction of the ESM in 2012/2013 (and if it does still exist may well be explicitly subordinated to the ESM and other multilateral creditors), and which itself has very little cash but will have to go to each of the member states to claim under its own guarantee policies.
Claiming under any financial insurance policy is never easy, particularly when investors in this case are likely to be very fragmented and with differing incentives. Bond documentation (and more specifically the articles of association of the EFSF to which it refers) could easily be changed on a political whim, and it is highly unlikely that the documentation would explicitly give investors any practically actionable rights over either the EFSF/ESIM or its guarantors.
There’s also the problem of correlation. The risks of the underlying obligor and the guarantor (and the ultimate sovereign guarantors) defaulting at the same time are highly correlated. Investors are hardly likely to trust that Spain will be willing or able to honour its guarantees to the EFSF in a scenario where Italy defaults, for example.
Getting into the mechanics of the ESIM, setting the required insurance level at what will surely be the outset of a long period of necessary sovereign restructuring is fraught with problems (a bit like buying buildings insurance without having your home valued). Will a share of 40% insurance turn out to be enough of a haircut for Greece, when long dated Greek bonds are already trading at 30 cents in the euro, i.e. implying a 70% writedown? And will 25% be enough for Italy? Given the lack of concrete details it is impossible to verify the calculations or assumptions behind the leverage numbers stated (particularly given that the proposal set out by Allianz is not necessarily a first loss piece, as reported in the press, but potentially a second loss or shared vertical slice).
Allianz argues that the EFSF/ESIM/ESM would be a powerful controlling creditor, with the ability to enforce restructuring on programme countries and the ability to monitor progress against budget targets etc. However, this in itself is an alarming proposition to those who remember the ways the monolines abused their positions as controlling creditors in wrapped transactions. Investors could easily find their entire exposure subordinated in practice to the wishes or votes of the EFSF and/or its largest guarantors such as Germany.
The creation of a new class of partially insured debt for each country would mean several tiers of sovereign debt circulating simultaneously (while the rump of existing bonds runs off), making subsequent restructurings very complex.
Finally, the main supposed benefit of ESIM is the strap line that it doesn’t require any cash to fund. However, this is also its weakness, in that it will still lack the fire-power to deal with a liquidity problem experienced by an individual sovereign. If investors refuse to buy a sovereign’s bonds for any reason (as they have recently) even with a partial loss share arrangement, then it will still require intervention by the ECB or possibly the IMF, who have access to cash to step in and provide the liquidity to refinance maturing issues. Under proposed EU sovereign debt harmonisation proposals, however, the ECB will be able to play a full voting role as a creditor in any subsequent restructuring, meaning that existing investors can in that scenario expect to find themselves outvoted by the rescue liquidity provider, whose own incentives will be to minimise losses to the ECB’s own largest controlling shareholders (starting with Germany).
So the idea that a sovereign insurance policy provided by the very same (or, at best, ‘related’) group of stressed sovereigns would provide “reassurance to the market” seems a ludicrous one. If markets believe that this proposal is a solution to the Eurozone sovereign debt crisis then there is room for disappointment.
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