Tuesday, September 27, 2011

Leveraging the EFSF. TARP style

So I receive a call from my friends at Goldman, the BNP just jumped + 15% intra day. I ask what happened, something about a leverage of the EFSF that would effectively backstop the bank meltdown. Then during an exchange with a friend who just testified in front of the US senate on the EU banking situation, he sends this link, attached with this money shot.

This is an idea building on elements of the U.S. Term Asset-Backed Securities Loan Facility from 2008.

The EFSF and/or ESM could use its funds to cover potential losses the ECB could incur on its purchases of bonds of countries under market stress -- up to a certain amount.

In this way the ECB would have a guarantee it would not lose money on the bonds it buys to smooth out market turbulence under its existing program aimed to improve the transmission mechanism of monetary policy.

Depending on the assumed loss, the money at EFSF disposal could guarantee bond purchases many times its size. Like an insurer, it would only pay out in case of a default -- an unlikely scenario for Spain or Italy.

For example, the EFSF could say it would cover the first 20 percent of losses that the bank could suffer in case of a default -- multiplying the EFSF's firepower fivefold.

The problem with this solution is that it would require the ECB to continue buying euro zone government bonds, which the bank does not want to do, as it can be perceived as helping finance government fiscal policies.

I am not sure I buy what is written above, because, very frankly it doesn't make a lot of sense. The part "ECB buys bonds, and then covers the first 20% loses in the bank" is very fuzzy. If you want to leverage the pot it is fairly easy and let me see if I can put the words back in order following the US example.

You sell a sort of CDS, at a preferred rate to the market rate.
1/ The bank is effectively backstopped, it could say pay the first 20% default but a steeper fall would fall on EFSF. So the book value would be discounted to 80c on eur much better than the current 60-50% haircut. Banks like that, markets like that because it puts a floor on the loses.
2/ The collateral you have to post is the EFSF. If it has 440B in capital and you assume a 20% prob of default you are leveraging 5X or 2Trillion effective coverage. Yep, THAT will do it.
3/ it may violate maastricht as it will target banks, maybe not, I don't know and in any case I don't expect the individual governments to block this.
4/ probability is that NOTHING will default (outside of greece), the EFSF gets the premium. Now, a premium like this has a price, a steep price let's say 5% (no idea), on 0.5T that is 25B, that is a small cost for the full protection.
5/ It is an effective way to take all the risk on public purse. Of course the 'Armageddon' scenario that all debt blows up will completely blow up the EFSF since it only has 20% of the collateral. But by then QE should be a palatable option for everyone involved.
6/ This effectively STOPS the greek contagion by creating a federal insurance for the banks.

In a previous post I had argued that they needed QE to leverage the EFSF but what they have done is leverage it via CDS like constructs with the banking system. Absolutely brilliant shock and awe without resorting to QE (if inspired by the Geithner trip I suppose).

Of course Greece will still default and what they do is still up in the air, but as far as 'contagion' goes this is over.


Anonymous said...

got this from a friend, but dont get it:

"The EFSF, after the most recent expansion is 440 billion euros.
That's the amount pledged by the eurozone member countries, to be
spent on buying the debt of at least greece, and possibly others. It
could be transferred directly as cash, or indirectly as a kind of
insurance against loss.

The leveraging means the eurozone members pledge the same amount, but
added to that are funds borrowed from other entities, possibly the
ECB, and then the losses aren't distributed evenly. The EFSF is on the
hook for the first 20% or so, meaning the eurozone countries' 440B is
suddenly much more at risk. That's not always obvious from the
reporting, and might not be grasped by the politicians who vote for

And what's worse, is that the 20% cushion won't be enough, so the ECB
will still end up with losses, which would require it to raise capital
from eurozone members anyway. We'll see how politically acceptible
that is. The author of the blog suggests that it'll be easy enough to
print money. I think it's likely to push some goverments over the

The guy's example is similar, but slightly more favourable to the EFSF
and ECB, since they take the 2nd and 3rd losses respectively, and
someone else is on the hook for the first - possibly the institution
being bailed out. It changes the sums, but not the worst case

He reckons it'll stop contagion dead. I reckon the 2 trillion figure
is meaningless. You have to concentrate on the 440 billion figure, and
the size of the problem. It won't work, and the 440 figure is the one
the markets will play chicken with.

The current feeling seems to be that the ECB isn't willing to play the
game anyway, and that the funds could come from the private sector.
It's certainly not going to be any cheaper than coopting the ECB."

Marcf said...

The definition of 'leverage' in the second paragraph is weird but maybe 'factual'. If so there is no 'leverage' as in monetary creation just straight funds from ECB. (which is possible).

The paragraphs about contagion I think miss the point. Particularly, the goal is to backstop the panic in the markets. To cut the negative spiral of "negative expectation -> high yield on debt -> more probability of default of government->bank negative expectation" that is killing the banks at the moment. If you look at the numbers what is priced is usually COMPLETE MELTDOWN, which is of derived of panic histeria. The greek problem is sub 100B. Of course the "worst case" he refers to is the total of europe melting down, but as much as speculators like to speculate, EU sovereign debt is very different from US subprime. Trade this insight at your own risk (I was reading about China CDS spiking this morning which I find hilarious).

If you sell a CDS to the banks you effectively backstop the book value at 80c/eur. That in itself should put an end to the pressure. Remember that what is going on here is speculation pushing trend.

If trend reverses, watch dynamic stabilize and the speculator move on. The second point is that a CDS does not require anyone but the EFSF. The third operational difference is that while the 2T is NOMINAL (only requiring hard cash of 500B) it would be realized as losses occurred on a as needed basis. So QE, if needed, is delayed which is again, more simple than printing money now or selling the CDO today. Finally, it does not force the banks to unload the assets, just puts an insurance floor on it, whereas the CDO would require a market pricing of that debt which is dangerous since the market is so volatile.

On this part I would not only bet that it will work but that it can in fact turn a profit for the ESFS in terms of premium. Which is better than giving 500B outright to capitalize the banks.

Of course the above is right about the core of the issue. That the markets are predatory and have smelled the bacon in the form of the 500B cash and want it injected in the banks as a free gift for people with position on said banks. There is nothing to see here but the rent. The game of chicken means to short these institutions (banks) until the govt gives in. Again a CDS WILL NOT GIVE IN, because the collateral is still with the ESFS instead of being a free gift to the banking system (what happened in the US)

Anonymous said...

Where does all of this money come from? Attaching banking backstops to "the public purse"? When did that stop being the kind of sleazy thing that ought to have bankers put in the electric chair, set to 'slow cook'?

Government backing of loans to buy foreign government's savings bonds? With money that comes from where? And who pays the interest? Where does the other country's money to pay the interest on the loans come from? Interest your government is going to pay on the bonds other governments buy? And where does that money come from? Bernanke's scrotum?

Or is it better when the US Banks that were bailed out to give small businesses loans, and then don't and instead use the money to buy US Savings Bonds and Treasury Certificates that the US Treasury is supposed to pay interest on?

Marcf said...

so excited... why the anonymity.

Yeah, I don't think the banks are all clean in the crisis but clearly a 'bubble' in investment in housing took ALL of us. So huh... look around before you get all high and mighty.

The bank 'bailout' I still have to see a final tally on "cost". One thing is liquidity swaps (which are included in 'bailout' but never really cost anything). The govt debt was stimulus. That debt will need to be repaid. Or monetized (ie. printing presses).

Marcf said...


a month later, the proposal from BNP is essentially what is written above http://www.ft.com/intl/cms/s/0/47fb8f2e-faef-11e0-bebe-00144feab49a.html#axzz1bKCor0Qc