EFSF vs. ESMThe “quantum leap” in the Euro Area Debt Crisis Management?Cristiana CornoStructured CreditThe Debt Crisis: Di...
SummaryThis document aims to show the big difference between ESM (European Stability Mechanism 2013onwards) and his presen...
Agenda•• Overview   Overview•• Euro bailout   Euro bailout•• Towards resolution    Towards resolution                     ...
How we got here?Introduction   Dynamite:         Economic imbalances intra Europe         Soft budget constraints         ...
DynamiteEconomic imbalances inside the EU  Credit fuelled internal boom with boomerang effects, not addressed until when t...
DynamiteInconsistent application of sanctions    The Stability and Growth Pact (SPG) was adopted in 1997 in order to maint...
DynamiteThe no bailout clause   Maastricht Treaty Article 125: “the Union shall not be liable for or assume the commitment...
DetonatorImmediate triggers  Costs of the financial crisis: Northern Rock (September 2007), Lehman default (September 2008...
Agenda•• Overview   Overview•• Euro bailout   Euro bailout•• Towards resolution    Towards resolution                     ...
Euro bailoutGreek crisis escalation   In October 2009 a new credit derivatives index   was     introduced   in   the   mar...
Euro bailoutContagion    On the 10th May. The EU presents:             750b programme to secure the stability of the euro ...
Euro bailoutOverview of the Greek facility              Greek      EU/IMF       Total          %             gov debt    d...
Euro bailoutThe bill   Big contribution of Italy nothwistanding the small peripheral exposure. Italy is the country making...
Euro bailoutThe mechanics  Both the facilities were based on a derogation to art.125 of the TFEU contained in art.122.2 wh...
Agenda•• Overview   Overview•• Euro bailout   Euro bailout      EFSM      EFSF•• Towards resolution    Towards resolution ...
Euro bailout: EFSMCharacteristics   The EU is empowered by the EU Treaty to borrow from the markets. It enjoys a preferred...
Euro bailout: EFSM  Activation  EFSM and EFSF enjoy a similar activation process with the differences outlined below due t...
Euro bailout: EFSM Market and Issuance    Under the Eu medium term programme (previously EEC and Euratom programme) a firs...
Euro bailout: EFSMSpread behaviour  Spread in primary market ranged from Euribor6m+ 8 bps (in recent issues) up to Euribor...
-20                                0                                    20                                         40     ...
Euro bailout: EFSMNot with underlying risk   Low and negative correlation with underlying risk:           6               ...
Euro bailout: EFSMComparables (1) EIB most direct comparable. 156b outstanding market. Owned by the 27 Eu countries with s...
Euro bailout: EFSMComparables (2)    EIB shareholders                5y                 5y      Shareholder       % EIB   ...
Euro bailout: EFSMIssuance  The first issue EU2.5 dec15 performed quite well in secondary market (issued at euribor6m + 8b...
Agenda•• Overview   Overview•• Euro bailout   Euro bailout      EFSM      EFSF•• Towards resolution    Towards resolution ...
Euro bailout: EFSFThe criticized EFSF (1)   Finalised    in June 2010 between the 16 euro area member with the famous “EFS...
Euro bailout: EFSFThe criticized EFSF (2)   The granting of the loan terms and condition have to be approved by unanimity ...
Euro bailout: EFSFCdo or not cdo (1)   Over guarantees. Each guarantor issues unconditional and irrevocable guarantees to ...
Euro bailout: EFSFCdo or not cdo (2)   Cash buffer. A cash reserve will be retained from the amount disbursed in order to ...
Euro bailout: EFSFEFSF weaknesses and strength  CDO SEMPLIFICATION       Debt issued is fully covered by AAA guarantees an...
Euro bailout: EFSFOn lending capabilities   Based on our assumptions, gross financing need the rescue package should be of...
Euro bailout: EFSFEFSF rating agencies opinions  Weaknesses:         reduced lending ability         risk that the guarant...
Euro bailout: EFSFEFSF pricing as AAA basket (1)  For construction each debt issued will be a basket of AAA rated guarante...
Euro bailout: EFSFEFSF pricing as AAA basket(2)  Forgetting the non AAA guarantees we can price the EFSF as a fixed AAA ba...
Euro bailout: EFSFEFSF pricing as AAA basket(3)   The correct way to look at EFSF as an investment product is as a replica...
Euro bailout: EFSFChallenges and March 24-25 meeting decision  LENDING CAPABILITIES INCREASE TO ORIGINAL SIZE. Details pos...
Euro bailout: EFSFEFSF for Ireland   To lend €17.7 billion to Ireland, the EFSF has set up a 27b billion programme. The fi...
Euro bailoutEuropean Issuance & Market Impact   On assumption EFSF programme for Portugal 35b, lending front loaded (60% i...
Agenda•• Overview   Overview•• Euro bailout   Euro bailout•• Towards resolution    Towards resolution                     ...
Towards resolutionA comprehensive response to sovereign crisis  Dynamite.        Economic imbalances intra Europe        S...
Towards resolution:ESMOne step forward (1)    On 24-25 March 2011, the European Council confirmed to establish a permanent...
Towards resolution: ESMOne step forward (2)   STRUCTURE WITH CALLABLE CAPITAL (similar to multilateral development banks) ...
Towards resolutionEFSF vs. ESM Temporary                                                         Permanent Special vehicle...
“QUANTUM LEAP” in the euro area debt crisis management?  One step forward                                                 ...
Annex1. Changes to the SP existing rules by Eurogroup, Ecofin and theECouncil, on 20 March 2005 SP rules dilution:        ...
Annex1. Changes to the SP existing rules by Eurogroup, Ecofin and theECouncil, on 20 March 2005     Following the identifi...
Annex2. Greek crisis escalation    Dec 9: Fitch downgrades to BBB+ and S&P follows suit    Feb 10: Goldman Sachs scandal b...
Annex3. Cash buffer decomposition in EFSFThe cash buffer is made up by two component:    a general cash reserve (fungible ...
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Presentazione Ny

  1. 1. EFSF vs. ESMThe “quantum leap” in the Euro Area Debt Crisis Management?Cristiana CornoStructured CreditThe Debt Crisis: Different Rules for a Different WorldNew York, May 17-20 2011
  2. 2. SummaryThis document aims to show the big difference between ESM (European Stability Mechanism 2013onwards) and his present precursor EFSF. I will try to show how they differ in nature, aim and legalframework. Being: EFSF a temporary facility born in emergency , under a derogation of the no bail out clause due to “exceptional occurrences”, as an intergovernmental agreement ( outside EU architecture) ESM a permanent institution, with a reestablishment of the no bail out clause (possible investor bail in), as an international organization with simplified EU treaty revision (one step further towards becoming a proper EU institution)I thought it could be interesting to review the current European crisis trough the evolution of the NO BAILOUT clause: Starting from the lack of the credibility of the no bail out clause as one of the causes of the current crisis Its derogation in the Euro bail out and the instruments used Its strong re-assessment in the ESM framework EFSF vs. ESM 1
  3. 3. Agenda•• Overview Overview•• Euro bailout Euro bailout•• Towards resolution Towards resolution EFSF vs. ESM 2
  4. 4. How we got here?Introduction Dynamite: Economic imbalances intra Europe Soft budget constraints Implicit bail-in clause Detonator: Costs of financial crisis Worldwide recession, end of asset bubbles and extraordinary pay/profit in the financial sector, increasing risk aversion Greek specific problems with accountancy irregularities EFSF vs. ESM 3
  5. 5. DynamiteEconomic imbalances inside the EU Credit fuelled internal boom with boomerang effects, not addressed until when they became excessive: ASSET BUBBLES: misallocation of resources in the construction real estate sector (Spain, Ireland) and extraordinary pay and profit in the financial sector TRADE DEFICIT: loss of competitiveness in the poorest countries due to rapidly rising prices and wages (Italy, Portugal), with import raising and export decreasing NET CAPITAL IMPORT: huge capital outflow from Germany to other European countries (from 1995 to 2008 Germany was the world second largest capital exporters after China) Basically what has been described as a “perfect emerging market crisis without the currency flexibility tool” EFSF vs. ESM 4
  6. 6. DynamiteInconsistent application of sanctions The Stability and Growth Pact (SPG) was adopted in 1997 in order to maintain and enforce fiscal discipline in the EMU. All members were required to respect the following criteria: national debt lower than 60% of GDP annual budget deficit no higher than 3% of GDP Severe sanctions for criteria breaches: a deposit of 0.2% GDP convertible in fee if the deficit persisted for two following years a variable fee of 10% of the excess deficit, capped at 0.5% of GDP There have been 30 violations from 2000 to 2008:Country Number of breaches Belgium 0 Core countries, unable/unwilling to satisfy the criteria, started asking for a Germany 4 Spain 1 dilution of the sanctions since 2003*. An agreement was reached in 2005 France 4 Ireland Italy 1 5 Punitive proceedings were started when dealing with Portugal (2002) and Netherlands Austria 1 1 Greece (2005), though fines were never applied Luxemburg 0 Portugal 4 Finland 0 As a result, no sanctions have ever been applied Greece 9 (*) See Annex1 for more details EFSF vs. ESM 5
  7. 7. DynamiteThe no bailout clause Maastricht Treaty Article 125: “the Union shall not be liable for or assume the commitments of central governments” (no bailout clause). This precise rule was not applied because of: Fear of contagion to other countries International exposure of the banking system, exacerbated by the Basel framework (Government bonds have 0% risk weight in the calculation of the Tier 1 ratio) Lack of a mechanism to solve liquidity/solvency crisis and even of a possible Euro withdrawal/expulsion The non bailout clause became an implicit bailout principle, with the consequence of default probability disappearing from government markets BIS Q1 2010 BIS Q3 2010 BANKING EXPOSURE Greece Ireland Portugal Spain BANKING EXPOSURE Greece Ireland Portugal Spain CHANGE GERMANY 520,70 51,00 205,80 46,00 217,90 568,70 69,40 208,30 48,50 242,50 48,00 FRANCE 491,00 111,60 85,70 49,70 244,00 440,40 92,00 78,10 45,60 224,70 -50,60 ITALY 89,30 8,80 28,60 9,40 42,50 80,60 6,50 24,40 7,90 41,80 -8,70 SPAIN 125,80 1,60 16,20 108,00 0,00 127,60 1,50 17,50 108,60 0,00 1,80 US 378,80 41,20 113,90 37,30 186,40 391,60 43,10 113,90 47,10 187,50 12,80 NETHER 0,00 0,00 0,00 UK 413,00 16,50 222,40 32,40 141,70 431,10 20,40 224,60 33,70 152,40 18,10 EFSF vs. ESM 6
  8. 8. DetonatorImmediate triggers Costs of the financial crisis: Northern Rock (September 2007), Lehman default (September 2008) and AIG bailout (September 08) Worldwide recession in 2008 with related weakness of government revenues and boost of fiscal stabilizer (unemployment benefits), end of asset bubbles (real estate markets) and of the extraordinary profit/pay in the financial sector, increasing worldwide risk aversion Greece specific problems: accountancy irregularities and balance sheet cosmetics to meet Maastricht criteria; the deficit/GDP ratio had been below 3% only for one year Net Cost of Financial Sector Support (Latest available date; percent of 2010 GDP unless otherwise indicated) Direct support Recovery Net direct Cost % gdp Ireland 30 1,3 28,7 Germany 10,8 0,1 10,7 Netherlands 14,4 8,4 6 United Kingdom 7,1 1,1 6 Greece 5,1 0,1 5 Belgium 4,3 0,2 4,1 United States 5,2 1,8 3,4 Spain 2,9 0,9 2 Average 6,4 1,6 4,8 Billions 1528 379 1149 Sources:IMF EFSF vs. ESM 7
  9. 9. Agenda•• Overview Overview•• Euro bailout Euro bailout•• Towards resolution Towards resolution EFSF vs. ESM 8
  10. 10. Euro bailoutGreek crisis escalation In October 2009 a new credit derivatives index was introduced in the market: SOVX WESTERN EUROPE (basket of 15 Euro sovereign cds) At the end of 2009, the new government announced that deficit for the year would have been 12.7% more than three time higher than previously declared 3.7%: the crisis started On the 2nd May, Euro regions agreed a great bailout loan totalling 110b to bring the country through the next 3 years. ECB announced that it would drop all the rating requirements for Greek bonds Demonstrators set fires in Athens killing 3 people EFSF vs. ESM 9
  11. 11. Euro bailoutContagion On the 10th May. The EU presents: 750b programme to secure the stability of the euro area under a European Commission / EURO / IMF parachute, and the European Central Bank announces the introduction of several measures to preserve market liquidity: Securities Markets Programme, reactivation of swap lines with the Federal Reserve, introduction of additional liquidity-providing operations Aim was to provide funding in conjunction with the IMF,under strict conditionality to economic and fiscal adjustment programmes.” Amount Instrument Rate Repayment IMF 30 Stand-By Arrangement facility which SDR plus 200 basis point under 3years, 3,25 years after after exceptional access to IMF resources, with a 100bps mark up on amount the disboursement, amounting to more than 3,200% of outstanding over 3y for the amount over spread in 8 quaterly Greece’s quota. 300% of the country quote (approx instalments (2y). 3.83%) EURO 80 Pool of bilateral loans from European The initial rate to be paid on the eu loan 3 years after theCOUNTRIES Member states in accordance with was intended to be 300 bps over disboursement and (Irland and their participation to ECB share libor/swap for maturities lower than 3 spread in 8 quaterly Slovakia not capital, managed by the European years and 400 bps over 3 year plus a instalments (2y).partecipating) Commission. 50bps charge to cover operational costs (approx 5.5%). EFSF vs. ESM 10
  12. 12. Euro bailoutOverview of the Greek facility Greek EU/IMF Total % gov debt debt + Debt Institution Extending now the repayment terms of the ECB EU/IMF loan means making the loan junior today 286 103,00 339,00 30,38% to bondholder : Merkel asking “to negotiate an extension of maturities on its Jun 2011 279 115,00 344,00 33,43% bonds before receiving a new European Sep 2011 268 123,00 341,00 36,07% Union aid package“ Dec 2011 263 128,00 341,00 37,54% Mar 2012 256 138,00 344,00 40,12% Jun 2012 234 144,00 328,00 43,90% Disbursements (done and planned) billions Sep 2012 226 150,00 326,00 46,01% 2010 31,05 Dec 2012 225 152,00 327,00 46,48% 2011 46,05 Mar 2013 217 158,00 325,00 48,62% 2012 24,00 June 2013 203 160,00 313,00 51,12% 2013 8,00 In order to avoid restructuring by mid 2012 the institutional sector will hold circa 40% of the Greek debt, the European holding (30%) will rank “pari passu” with bond holders. This creates incentives for EFSF both to ask for seniority (formally or asking for collateral) in further loans and to ask for maturity extension of the government bonds, thereby worsening solvency crisis. This to stress how a bad designed bailing out system (which does not address solvency but only liquidity) risks creating unintended consequences by worsening the country solvency and becoming a channel of contagium in itself. ESM will be a step forward: debt sustainability will be come core in providing financial assistance. EFSF vs. ESM 11
  13. 13. Euro bailoutThe bill Big contribution of Italy nothwistanding the small peripheral exposure. Italy is the country making the greatest efforts BIS end of q1 2010 TOTAL LIABILITIES BANKING EXPOSURE Greece Ireland Portugal Spain GERMANY 168,55 520,70 51,00 205,80 46,00 217,90 FRANCE 129,46 491,00 111,60 85,70 49,70 244,00 ITALY 109,28 89,30 8,80 28,60 9,40 42,50 SPAIN 70,89 125,80 1,60 16,20 108,00 0,00 US 47,80 378,80 41,20 113,90 37,30 186,40 NETHER 38,60 0,00 UK 32,58 413,00 16,50 222,40 32,40 141,70 EFSF vs. ESM 12
  14. 14. Euro bailoutThe mechanics Both the facilities were based on a derogation to art.125 of the TFEU contained in art.122.2 which refers to: “natural disasters or exceptional occurrences. Being born under “exceptional circumstances”, they will both expire in June 2013. Aim: address liquidity issues and not solvencyEFSM (60b)‫‏‬ EFSF (440b)‫‏‬usage of the European Union funding vehicle to borrow fromMedium Term Note to borrow markets based onfrom capital markets and lend intergovernmental arrangementto Euro states and a complex formalization of the pool of bilateral loan to Greece. Portugal plan is to be approved on the 16-17 European Council meeting. EXTERNAL AID IMF EFSM EFSF BILATERAL 28 November Ireland 67,5 22,5 22,5 17,7 4,8 7 April Portugal 78 26 26 26 EFSF vs. ESM 13
  15. 15. Agenda•• Overview Overview•• Euro bailout Euro bailout EFSM EFSF•• Towards resolution Towards resolution EFSF vs. ESM 14
  16. 16. Euro bailout: EFSMCharacteristics The EU is empowered by the EU Treaty to borrow from the markets. It enjoys a preferred creditor status. The EFSM is the facility to grant loan/credit lines to the Member States (Council Regulation 407/2010, 11 may 2010). EU enjoys a AAA credit rating by the three major rating agencies. Direct and unconditional obligations of the EU and guarantees by the 27 Member States (joint and several liabilities, established by Treaty Law). EU Member States are legally obliged to ensure that the budget always has sufficient funds to meet the EU‟s obligations, for this purpose the Commission may draw on all Member States. Investors are only exposed to the credit risk of the EU Loan Characteristics Under the EFSF facility the fund raised is passed on to the Member States borrowing. This back-to-back imposes constraints on EU issuance (timing, amounts, maturities…) The big difference between the BOP facility and EFSM is that in the former there is no penalty rate EFSF vs. ESM 15
  17. 17. Euro bailout: EFSM Activation EFSM and EFSF enjoy a similar activation process with the differences outlined below due to different legal framework Application for aid Formal requesto to Euro members Economic stabilisation Memorandum of understanding programme Agreed between EU, IMF, beneficiary country Negotiated by EC, in cooperation with Approved by ECOFIN/Eurogroup (qualified IMF and ECB majority 55% countries and 65% population), IMF, Includes strong conditionality national Parliament of beneficiary country Loan Terms Based on the EC porposal the European Council determines theQualified majority amount of the country programme and Unanimitydecision, being the loan terms consensus, beingEU an EFSF aninternational intergovernamentalinstitution Final Terms agreement Based on the specific borrowing transaction. EFSF vs. ESM 16
  18. 18. Euro bailout: EFSM Market and Issuance Under the Eu medium term programme (previously EEC and Euratom programme) a first benchmark has been issued in December 2008 to finance partially a loan to Hungary and then to Latvia and Romania Funding in euro only. Maturity driven by features of underlying loan : we know exactly the average duration of the issuance (7,5 years) Total market outstanding amounts to 22b euros with average issue size 1-2b The 2011 issuance (2015 and 2018) related to Ireland ( and partially to Romania) has seen an increase in the issue size to 4,5-5b CPN ISSUE_DT MATURITY OUTSTANDING ASW AT ISSUANCE ASWEUROPEAN UNION 3,25 09/12/08 09/12/11 2.000.000.000 15,00 -53,76EUROPEAN UNION 3,125 25/02/09 03/04/14 1.000.000.000 30,00 -13,10EUROPEAN UNION 3,25 26/03/09 07/11/14 2.000.000.000 35,00 -9,72EUROPEAN UNION 3,125 27/07/09 27/01/15 2.700.000.000 25,00 -9,33EUROPEAN UNION 2,5 12/01/11 04/12/15 5.000.000.000 12,00 -7,88EUROPEAN UNION 3,625 06/07/09 06/04/16 1.500.000.000 40,00 -1,08 EFSF 2,75 01/02/11 18/07/16 5.000.000.000 6,00 0,51EUROPEAN UNION 2,375 22/09/10 22/09/17 1.150.000.000 8,00 2,67EUROPEAN UNION 3,25 24/03/11 04/04/18 4.600.000.000 8,00 8,49EUROPEAN UNION 3,375 11/03/10 10/05/19 1.500.000.000 20,00 8,01 EFSF vs. ESM 17
  19. 19. Euro bailout: EFSMSpread behaviour Spread in primary market ranged from Euribor6m+ 8 bps (in recent issues) up to Euribor6m +40 bps in correlation with the AAA universe spread at time of issuance Usually issued at discount to comparables and performed strongly in secondary market Spread behaviour in secondary market highly correlated with the AAA credit universe (0.89% as represented by JpMorgan index,”Maggie all” of the same maturity) Low and negative correlation with a proxy of euro government risks (represented by SOVX Western Europe) Historically Issuance trades in line with the rating category rather than underlying risk. ASW AT ISSUE ASW_AAA_ON_MTY EU3,2512/2011 15,00 26,05 EU3,1254/2014 30,00 54,45 EU3,2511/2014 35,00 62,93 EU3,6254/2016 40,00 34,97 EU3,1251/2015 25,00 20,95 EU3,3755/2019 20,00 20,71 1° bond issue for EU2,3759/2017 8,00 15,15 Ireland EU2,512/2015 12,00 -0,25 EU3,254/2018 8,00 12,02 Cheapest ever EFSF vs. ESM 18
  20. 20. -20 0 20 40 60 80 17/02/09 100 17/03/09 17/04/09 17/05/09 17/06/09 Trading with AAA risk 17/07/09 17/08/09 17/09/09 17/10/09 17/11/09 Euro bailout: EFSM 17/12/09 17/01/10 17/02/10 17/03/10 17/04/10 17/05/10 17/06/10 17/07/10 EU3.125 apr14 asw 17/08/10 AAA spread same maturity 17/09/10 High positive correlation with AAA rated securities rather than underlying risk: 17/10/10 17/11/10 17/12/10 17/01/11 17/02/11 17/03/11 17/04/11EFSF vs. ESM19
  21. 21. Euro bailout: EFSMNot with underlying risk Low and negative correlation with underlying risk: 6 250 EU3.125 apr14 asw sovx 4 2 200 0 02/10/09 17/11/09 31/12/09 23/02/10 13/04/10 01/06/10 14/07/10 25/08/10 08/10/10 30/11/10 18/01/11 02/03/11 13/04/11 -2 150 -4 -6 100 -8 -10 50 -12 -14 -16 0 EFSF vs. ESM 20
  22. 22. Euro bailout: EFSMComparables (1) EIB most direct comparable. 156b outstanding market. Owned by the 27 Eu countries with share in line with the countrys share of GDP within the EU. Due to different legal framework (EIB multilateral development bank) difficult to make a relative value comparison. Like other multilateral development banks only a fraction (5%) of subscribed capital is paid in. The remaining can be called. EIB has 263b of subscribed capital (2009 capital increase). The payment of called capital is an obligation under the Eu treaty and the obligation to answer to capital being called prevails on national laws Eu issuance should trade cheaper than EIB (on underlying basket). At present we are at tight level and given supply outlook on Eu issuance it make sense to exit EU to buy EIB Still personally I prefer EU issuance based on: 1. Transparency of loan portfolio 2. Lower leverage then EIB 3. Temporary facility EFSF vs. ESM 21
  23. 23. Euro bailout: EFSMComparables (2) EIB shareholders 5y 5y Shareholder % EIB ASW EU_BC ASW Based on underlying risk the EU France 16,17% -10,82 16,44% -10,82 issuance should trade wider than Germany 16,17% -41,29 21,11% -41,29 the EIB. Italy 16,17% 100,21 13,64% 100,21 United Kingdom 16,17% -34,05 13,05% -34,05 Spain 9,70% 156,47 8,51% 156,47 Belgium 4,48% 69,28 3,83% 69,28 Netherlands 4,48% -28,51 5,28% -28,51 Sweden 2,97% -52,72 2,69% -52,72 Denmark 2,27% -50,81 2,02% -50,81 Austria 2,25% -10,72 2,19% -10,72 Poland 2,07% -9,43 1,99% -9,43 Finland 1,28% -28,08 1,47% -28,08 Greece 1,22% 1135,97 1,79% 1135,97 Portugal 0,78% 570,79 1,37% 570,79 Czech Republic 0,76% 52,73 0,89% 52,73 Hungary 0,72% 11,91 0,95% 11,91 Ireland 0,57% 718,60 1,27% 718,60 Romania 0,52% 43,84 0,00% 43,84 Slovakia 0,26% 76,22 0,37% 76,22 Slovenia 0,24% 53,96 0,29% 53,96 Bulgaria 0,18% 225,00 0,00% 225,00 Lithuania 0,15% 172,54 0,21% 172,54 Luxembourg 0,11% -38,03 0,23% -38,03 Cyprus 0,11% 285,86 0,15% 285,86 Latvia 0,09% 0,00 0,11% 0,00 Estonia 0,07% 0,00 0,00% 0,00 Malta 0,04% 0,00 0,00% 0,00 Total 1,00 40,15 1,00 48,92 EFSF vs. ESM 22
  24. 24. Euro bailout: EFSMIssuance The first issue EU2.5 dec15 performed quite well in secondary market (issued at euribor6m + 8bps) and is performing better than 18 issue with curve steepening, given loan maturity to be hedged EFSF vs. ESM 23
  25. 25. Agenda•• Overview Overview•• Euro bailout Euro bailout EFSM EFSF•• Towards resolution Towards resolution EFSF vs. ESM 24
  26. 26. Euro bailout: EFSFThe criticized EFSF (1) Finalised in June 2010 between the 16 euro area member with the famous “EFSF framework agreement” The EFSF is a supranational financing vehicle to raise funds backed by a pool of bilateral guarantees of the individual EURO member states. It is a "société anonyme" (limited liability company), start up capital of 30 million, subscribed by the EAMS based on their share in the ECB capital. The individual guarantees are “irrevocable and unconditional guarantees" of the EAMS, the Guarantor, in proportion to their share in the capital of the European Central Bank, “contribution keys”. These contribution keys are adjusted for each support operation, to take in account the stepping-out member (the borrower ),”adjusted contribution keys”. Unanimity is the rule (2/3 of total guarantee commitment attending) Two observer from the ECB and the European Commission sit on the board. Debts instruments issued by the EFSF must be accounted as government debt of the MS according to their contribution key as guarantors (Eurostat opinion). EFSF vs. ESM 25
  27. 27. Euro bailout: EFSFThe criticized EFSF (2) The granting of the loan terms and condition have to be approved by unanimity by the EAMS. The EFSF is only charged with raising the funding on the market and making the loan, with the technical assistance of other institutions, notably the European Investment Bank (legal and administrative) and the German public debt agency (risk management). The average rating of the guarantors is AA (not dissimilar form EIB and EU underlying risk), but due to legal framework, it had to provide further credit enhancement mechanism to get to the AAA rating necessary for: reputation being able to fund in distressed and highly correlated market The debt issued by EFSF is serviced by the underlying loan. In case of default of the borrower the debt is serviced by the guarantors pro-rata, then from the a buffer and finally it is envisaged the possibility of further credit enhancement mechanism EFSF vs. ESM 26
  28. 28. Euro bailout: EFSFCdo or not cdo (1) Over guarantees. Each guarantor issues unconditional and irrevocable guarantees to the amount of: ADJ Contribution Key* x 120% x EFSF Nominal Obligation. Hence the guarantees provided exceed the debt issued by 20%. If one of the guarantors is enable to meet its share the remaining guarantors will increase their contribution up to 120% of their pro-rata share, making the 20% over guarantee fungible between guarantors Non AAA Guarantee Different debt issue will have a different EFSF mix of guarantors depending on the bond borrower stepping-out and amount of AAA Guarantees cash buffer EFSF vs. ESM 27
  29. 29. Euro bailout: EFSFCdo or not cdo (2) Cash buffer. A cash reserve will be retained from the amount disbursed in order to size the gap between the debt nominal amount and the AAA grossed up-guarantee. In this way a structure which resembled correctly a cdo becomes a fixed basket of AAA securities and cash with an over guarantee from non AAA countries (details in annex2 on cash buffer decomposition) Non AAA Guarantee Non AAA Guarantee + Cash buffer = Cash buffer EFSF bond AAA Guarantees Loan AAA Guarantees EFSF vs. ESM 28
  30. 30. Euro bailout: EFSFEFSF weaknesses and strength CDO SEMPLIFICATION Debt issued is fully covered by AAA guarantees and cash. Strong commitment to further credit enhancement mechanism in case of rating migration: the CDO features have been considered irrelevant for rating purposes but they are important for precise pricing ACCOUNTANCY ISSUE Notwithstanding the fact that the non AAA guarantees are useless to get the AAA rating they do account for national debt in the guarantors accounts REDUCED LENDING CAPABILITIES Due to over-guarantee mechanism the amount the EFSF can borrow is nearly 366b (440/1,2). The lending power goes down to roughly 213b. The overall Euro rescue is reduced from 750b to 410b enough to save Greece, Ireland, Portugal, Belgium but not Spain INCREASE CORRELATION AND CHANNELS OF CONTAGION DUE TO BAILOUT SYSTEM EFSF vs. ESM 29
  31. 31. Euro bailout: EFSFOn lending capabilities Based on our assumptions, gross financing need the rescue package should be of around 643b to include Spain, 1,5 trillion to cover also Italy Font: BIMI reaserch EFSF vs. ESM 30
  32. 32. Euro bailout: EFSFEFSF rating agencies opinions Weaknesses: reduced lending ability risk that the guarantee is not enforceable against the guarantor (German constitutional law ruling on legality of the statute enabling Germany to guarantee EFSFs debt obligations still pending) great dependence on AAA rated countries Strengths: strong political support from European countries; commitment to maintain EFSF creditworthiness (provision of additional credit enhancement mechanism in case of rating migration). programme conditionality and monitoring from EC, ECB reduced operational risks due to German DBO acting as facility agent, with treasury and risk management tasks, EIB providing administrative and legal support the multi guarantees mechanism should enable the facility to fund herself easily also in difficult market. base for permanent ESM EFSF vs. ESM 31
  33. 33. Euro bailout: EFSFEFSF pricing as AAA basket (1) For construction each debt issued will be a basket of AAA rated guarantees, cash, plus non AAA guarantee. The basket will be homogeneous through tranches, but the cash buffer will vary in size. Maxiumn Original Out Over Out Over Out Greece, Over commitment contribution Greece & guarantees Greece, guarantees Ireland, guarantees keys Ireland Ireland & Portugal & Portugal Spain Belgium 15292,18 3,48% 3,64% 4,36% 3,73% 4,48% 4,28% 5,14% Germany 119390,07 27,13% 28,38% 34,06% 29,15% 34,98% 33,42% 40,11% Ireland 7002,4 1,59% Out Out Out Spain 52352,51 11,90% 12,45% 14,94% 12,78% 15,34% Out France 89657,45 20,38% 21,32% 25,58% 21,89% 26,27% 25,10% 30,12% Italy 78784,72 17,91% 18,73% 22,48% 19,24% 23,08% 22,05% 26,47% Cyprus 863,09 0,20% 0,21% 0,25% 0,21% 0,25% 0,24% 0,29% Luxembourg 1101,39 0,25% 0,26% 0,31% 0,27% 0,32% 0,31% 0,37% Malta 9562.33.36 0,09% 0,09% 0,11% 0,10% 0,12% 0,11% 0,13% Netherlands 25143,58 5,71% 5,98% 7,17% 6,14% 7,37% 7,04% 8,45% Austria 12241,43 2,78% 2,91% 3,49% 2,99% 3,59% 3,43% 4,11% Portugal 11035,38 2,51% 2,62% 3,15% Out Out Slovenia 2072,92 0,47% 0,49% 0,59% 0,51% 0,61% 0,58% 0,70% Slovakia 4371,54 0,99% 1,04% 1,25% 1,07% 1,28% 1,22% 1,47% Finland 7905,2 1,80% 1,88% 2,26% 1,93% 2,32% 2,21% 2,66% Greece 12387,7 2,82% Out Out Out Total Guarantee 440000 100,00% 420609,9 1,2000000 409574,52 1,2000000 357222,01 1,2000000 AAA Gurantees 255439,12 58,05% 72,88% 74,84% 85,81% Pricing EFSF vs. ESM 32
  34. 34. Euro bailout: EFSFEFSF pricing as AAA basket(2) Forgetting the non AAA guarantees we can price the EFSF as a fixed AAA basket (using the asw level and a cash level of euribor6m + 8bps) we get the pricing below. In term of underlying risk the EFSF should trade richer than EU and EIB issuance, but they are not comparable directly. Out Greece Out Greece, Out Greece, Out Greece, & Ireland Ireland & Ireland, Ireland, Portugal Portugal & Portugal & Spain Italy AAA Gurantees 72,88% 74,84% 85,81% 92,67% AAA Pricing -27,45 -27,45 -27,45 -27,45 Cash buffer 27,12% 25,16% 14,19% 7,33% Cash pricing 8,00 8,00 8,00 8,00 Pricing -17,83 -18,53 -22,42 -24,85 In the market EU and EFSF issuance are trading almost flat, due probably to perceived complexity, weaker legal framework of the guarantees. Also we can expect the EFSF issuance to be highly dependent to AAA rating migration issues. The correct way to look at EFSF is a convex replica of underlying portfolio. EFSF vs. ESM 33
  35. 35. Euro bailout: EFSFEFSF pricing as AAA basket(3) The correct way to look at EFSF as an investment product is as a replica of the underlying basket of AAA guarantees and cash. In this way it offers 3 main advantages:1. It trades cheaper than underlying basket almost 25 bps2. It has a convex feature in case of AAA rating migration due to the non AAA guarantees.3. The transaction cost (bid/offer) are lower than the replicating basket’s In this way EFSF issuance can be useful to replicate a AAA exposition ( for example in a government fund) or mixed to replicate a benchmark index. EFSF vs. ESM 34
  36. 36. Euro bailout: EFSFChallenges and March 24-25 meeting decision LENDING CAPABILITIES INCREASE TO ORIGINAL SIZE. Details postponed to next June meeting. Possible solutions: increase the total amount of guarantees: by 72% to get to original 440b. non AAA guarantors to deposit cash take off the non AAA over-guarantees from ESFS debt and mix the EFSF funding instrument with bilateral loan from weaker countries leave the AAA rating: the weighted average of the guarantors is consistent with AA rating a mix of increased AAA guarantees and upfront cash or collateral commitments from lower rated countries. SCOPE EXPANSION government bonds purchase only in primary market under strict conditionality No decision on pre-emptive short term loan EFSF vs. ESM 35
  37. 37. Euro bailout: EFSFEFSF for Ireland To lend €17.7 billion to Ireland, the EFSF has set up a 27b billion programme. The first tranche of the programme for Ireland was issued on 25 January 2011 middle east 11% 2% asia america 36% europe uk 46% 5%The amount transferred to Ireland was exactly the Amount issued €5 billionissuance amount multiplied by the grossed-up Issue price: mid swap +6 bpspercentage of AAA member states (73%). Effective lending cost to Ireland 5.9%Therefore the cash reserve is 1.3b roughly, made up by Applied margin: 2.47% on all maturities0,87b of fungible cash (0.5% of debt amount plus npv of Amount transferred to Ireland €3.6bmargin) and 0,43b of loan specifi buffer. Cover ratio of 9. EFSF vs. ESM 36
  38. 38. Euro bailoutEuropean Issuance & Market Impact On assumption EFSF programme for Portugal 35b, lending front loaded (60% in 1° year) Ireland 2011 Done Q1 Remaining Timing 2012 EFSF 16,50 5,00 11,50 Next tranche secondo quarter, 2 benchmarks in first half 10,00 Benchmark bonds 3,00 1,00 2 2,00 EFSM 17,60 8,40 9,20 4,90 Benchmark bonds 4-5 2,00 2-3 benchmark transaction in first half 2011, at least one 10y bon 1-2 Portugal 2011 Done Q1 Remaining Timing 2012 EFSF 10,40 10,40 17,33 Benchmark bonds EFSM 7,80 7,80 13,00 Benchmark bonds Total 52 13,40 38,90 0,00 45MARKET IMPACT Issuance well perceived by the market Spread tightening (core – big peripheral) due to increase perceived correlation and core market losing safe heaven bid, asset swap widening in core markets with asset swap curve flattening No significant crowding out on supranational market EFSF vs. ESM 37
  39. 39. Agenda•• Overview Overview•• Euro bailout Euro bailout•• Towards resolution Towards resolution EFSF vs. ESM 38
  40. 40. Towards resolutionA comprehensive response to sovereign crisis Dynamite. Economic imbalances intra Europe Soft budget constraint Implicit bail-in clause Addressed by: New level of economic governance and Pact for Euro Strengthening of the Stability Pact Making orderly restructuring possible and less costly via ESM and stronger banks EFSF vs. ESM 39
  41. 41. Towards resolution:ESMOne step forward (1) On 24-25 March 2011, the European Council confirmed to establish a permanent crisis resolution mechanism the European Stability Mechanism (ESM). ESM is built entirely on the EFSF framework. The ESM will assume the role of the EFSF in providing financial assistance to Euro area Member States after June 2013. EFSF will remain operational until it has received full payment of loans to Member States and repaid all liabilities. Any undisbursed or unfunded portions of existing loan facilities will be transferred to the ESM. “EU INTERNATIONAL INSTITUTION”The ESM will be an intergovernmental organisation under public international law, set up by a treaty change (art. 136) via asimplified revision procedure by end of 2012. The following wording will be added to art.136: “The member states whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguardthe stability of the euro as a whole. The granting of any required financial assistance under the mechanism will be made subjectto strict conditionality”Revision procedure requires unanimity in the EU council (all 27) by end of 2012, national approval but no referenda.New structure: EUROPEAN UNION INTERNATIONAL INSTITUTION makes the TRICK:Contrary to the case of EFSF the debt of borrowing country will be recorded as due to the ESM and notrerouted to Member states (Eurostat opinion) EFSF vs. ESM 40
  42. 42. Towards resolution: ESMOne step forward (2) STRUCTURE WITH CALLABLE CAPITAL (similar to multilateral development banks) should be consistent with AAA rating without need of overcollateralization “The ESM will have a capital structure similar to multilateral lending institutions. It can be expected that this will be reflected in the assessment by credit rating agencies in line with their general standards for subscribed capital and operating procedures of such institutions. “ from EFSF faq. LENDING CAPABILITY. Effective lending capacity will be 500b with 700b subscribed capital, unchanged under original EFSF/EFSM facilities, but better efficiency ratio (48% 212 over 440, 71% 500 over 700) Note that callable capital/ guarantee from AAA will be 360b, plus 80b cash and probably some convergence of EFSM 60b facilities PREFERED CREDITOR STATUS, JUNIOR ONLY TO IMF. This step is necessary to limit loss and could limit negative effects of restructuring via debt buy-back PRIVATE SECTOR INVOLVEMENT. Public acknowledgement that restructuring is a REAL POSSIBILITY. ESM will be able both to: provide liquidity to solvent states bridge finance to states in process of negotiating a debt reduction. EFSF vs. ESM 41
  43. 43. Towards resolutionEFSF vs. ESM Temporary Permanent Special vehicle EU international institution Capital endowment 30m (only 18m subscribed) Capital endowment 700b No decision making power ---------------------------- Decision making power based on mutual --- agreement Individual guarantees Individual guarantees Liquidity assistance ------------------------------------- Liquidity assistance and bridge finance in debt --- restructuring Primary market bond purchase under strict Primary market bond purchase under strict conditionality conditionality --------------------------------------------------------------- Private holders bail in if debt sustainability ----- analysis negative (CAC from 2013) 440b guarantees ---------------------------------------- Mix of paid in capital (80b) and callable capital ------------ and guarantees (620b) Triple AAA 255b Triple AAA 360b Pari passu Credit preferred status Unanimity of EMS Mutual agreement ECB share contribution ECB share contribution with small adjustment EFSF vs. ESM 42
  44. 44. “QUANTUM LEAP” in the euro area debt crisis management? One step forward Still to come Solid legal base with Treaty change ESM capital accumulation (pre-funding): as before the guarantees/callable capital scheme activation risks Accountancy issues solved creating contagium when activated. Preferred status and private holders involvement with risk Secondary market purchase and short term pre-emptive that bailout system becomes a source of contagium in loan not addressed. itself decreasing EU institution arrangement with single individual Better efficiency ratio between total commitment and guarantees (unanimity), not join and several as in EU lending power institution (qualified majority) Lending capability almost unchanged “It takes courage to jump” EFSF vs. ESM 43
  45. 45. Annex1. Changes to the SP existing rules by Eurogroup, Ecofin and theECouncil, on 20 March 2005 SP rules dilution: While the official deficit threshold will be maintained, there will be a derogation – allowing a member state to exceed temporarily the 3 per cent figure to a limited extent – in the event of slow economic growth (no precise figures being provided). A temporary (period of time not defined) deficit will not be declared excessive if the member state concerned devotes considerable public expenditure to one of several ‘other relevant factors’ 1) investment; 2) research and development; 3) structural reforms (only those which have a long term impact on the solidity of public finances will be taken into account); 4) EU policy goals; 5) European unification; 6) international ‘solidarity’ (which the French insisted would include spending on both aid and military). Further consideration would be given to these ill-defined spending categories. Once the 3 per cent deficit limit is reached the Council and Commission will examine the extent to which spending on these ‘pertinent factors’ contribute to the deficit in question. A member state which has achieved a public spending surplus during periods of relatively strong economic growth and which has a relatively low debt burden will be treated more leniently A member state exceeding the 3 per cent threshold will obtain a delay of 3 years to bring its deficit down again. The objective remains to bring the deficit below the threshold within a year following the launch of the EDP but a government can obtain a delay of a year if there are particular circumstances that should be taken into consideration (notably slow economic growth). Before advancing to the sanctions procedure the Commission will prepare a report to determine whether a supplementary delay of a year should be allowed. EFSF vs. ESM 44
  46. 46. Annex1. Changes to the SP existing rules by Eurogroup, Ecofin and theECouncil, on 20 March 2005 Following the identification of an EDP by the Commission and the Council, a member state will have 6 months (not just the current 4) to propose corrective measures. As in the Commission’s recommendation, member states are to avoid pro-cyclical budgets in good times (when real growth is superior to potential growth) but there is to be no obligation for these member states to achieve a budget surplus. More effort will be demanded from member states with a relatively heavy debt burden which have not undertaken structural reforms. The mid-term objective of each member state will be determined with regard to two factors: 1) those member states with low debt levels and strong growth are allowed a medium term deficit of 1 per cent; 2) those member states with high debt levels and weak growth prospects will have to move to a deficit close to balance or in surplus (as is currently the case but this objective will be redefined every four years). Member states which have not yet attained their medium term objective will have to reduce their structural deficit – depending upon the level of economic growth – by 0.5 per cent of GDP. 13 EFSF vs. ESM 45
  47. 47. Annex2. Greek crisis escalation Dec 9: Fitch downgrades to BBB+ and S&P follows suit Feb 10: Goldman Sachs scandal becomes public. Ackermann (DB Ceo) meets Papandreou and proposing Merkel’ economic advisor a Greek bailout from private banks, Germany and France each lending 7.5b. The proposal is denied since not complaint to art.125 of the TFEU. March 10 New tax and salary cut to civil servant in return of some sort of solidarity fro European states. Situation more pressing with 20b debt redemption in May. The European countries and ECB would have come in support of Greece. April 10:Germany agrees to subsided a 30b Emu loan to Greece with additional 15b coming from IMF. On the 22th Apr EU announces that Greek deficit for 2009 was at 13.6 higher than already reviewed number. On 23-Apr a 45b EMU/IMF plan gets activated, on the 27-Apr National Bank of Greece and EFG Eurobank Ergasias get downgraded to junk from Moodys. Greece is downgraded to junk status, Spain lowered to AA from AA+, Portugal from A+ to A-. On the 02 May Euro regions agree a greater bailout loan totalling 110b to bring the country through the next 3 years. ECB announces that it would drop all the rating requirements for Greek bonds. Demonstrators set fires in Athens killing 3 people. EFSF vs. ESM 46
  48. 48. Annex3. Cash buffer decomposition in EFSFThe cash buffer is made up by two component: a general cash reserve (fungible cash reserve). An upfront fee of 0.5% applied on the principal amount of the loan plus the net present value of the loan margin (2,47 for Ireland) is retained by EFSF from the cash amount disbursed to the borrower. It will be the ultimate remuneration of the guarantors, but it is retained as loss absorbing capital and credited to a general cash reserve together with any interest income. As loan get repaid and the cash reserve exceed the amount necessary to repay the loan it becomes “free cash” and can be used to reduce the loan specific cash buffer for new loans. It will be distributed only when all the funding instruments issued by EFSF have been repaid. a loan specific cash buffer. It is sized in order to fill the gap between the nominal amount of the funding instrument, net of funding cost (negative carry) and the 120% of the AAA rating guarantees plus the cash reserve. It will be used to cover shortfalls in payments by a borrowing country should the guarantees be insufficient. If there will be no default, it will be used to redeem the debt instrument. If the guarantees are called, the funds available under the LSCB may be transferred to the guarantor Member States or maintained in the EFSF for possible future operations. Cash investment guidelines. For construction the EFSF will potentially have large amounts of cash. The guidelines investment policy have two objectives: 1) cash to be invested in high quality liquid debt instruments issued in euros, 2) reduce the negative carry between the cost of funding and the investment holdings EFSF vs. ESM 47

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