Friday, November 11, 2011

Comparing CDO and CDS-like solutions to EFSF leveraging

The confusion is sky high, both in the markets and the officialdom in the EZ. The ideas on how to leverage the fund are rather straight forward but with different implications.

The CDO Structure: Protect the FIRST 20%
This one is floated by the german banks. The idea is to structure the EFSF rescue fund as a CDO where the reserves are essentially equity tranches so that the "FIRST LOSSES" are borne by the EFSF. This means that if the losses are less than say, 20%, then those losses are taken by the fund. For this to work you need to find the financing for the senior tranches upfront. This achieves "leverage" by committing the core capital to the equity tranche and looking for further financing outside for the higher tranches. This is derided by some critics (amongst them Roubini) as a mirror of the subprime debacle in the US. Of course the main difference is that in one you had REAL subprime bonds defaulting at 80%-100% in the second you have EuroZone sovereign. Not the same thing, but no matter.

The CDS-like structure: Protect the LAST 80%
This one is floated by the french banks. I call it CDS like because the idea (partly my projection I think) is that 80% of the value would be insured (100% CDS I find silly but that is just me). So if you lose 20% that is your loss, but if it goes beyond then it is the EFSF. Note that this is truly a PUT like structure but instead of being on the value of the stock it is on the nominal. It insures A PART of the default but not all. I don't know that such a structure is common place but I am probably wrong on that one. This effectively leverages the fund because the capital is committed as collateral, which is a fraction of the nominal.

why germans vs french?
So what is so hard about these 2 schemes? essentially I think it rests with the banks. The german banks, as of this writing, are off the radar of the markets. Whereas their french counterparts (BNP, SG, CALYON) are already deeply discounted (60% book value). So the french would of course like it if the first 20% was paid for but truly they care more about the downside. Also a 80% put would essentially give them 20% back just like CDO structure, so to them it is a wash on the downside but a minus on the upside. To the germans it is the reverse. The germans have not been discounted so they want protection for the FIRST 20%, the french have already been discounted and would rather see protection for the LAST 80%.

Funding differences
To me the main difference is in how the structure is funded. In case of the CDO structure it depends on outside funding for the senior tranches. The chinese and EM have already said "you can buy it all, if you don't why should we?". In other words it depends on the kindness/greed of strangers which can be complicated.
The CDS, however does not require funding until collateral is called. Collateral call will only happen when Miss Market has really killed the sovereigns and we are in +20% ACROSS THE BOARD discount, which, personally, I view as VERY UNLIKELY. Furthermore at that stage, you just fire up the printing presses, something the ECB has been reluctant to do under Trichet and German tutelage. It is however a necessity.

Market confusion
So in a nutshell the CDO is complicated to get funded (and needs to be funded 100% today). While the CDS is ALREADY funded and the funding would need to happen ONLY IF AND WHEN the shit hits the fan. At that stage QE will be palatable. To me this is a simple case but note that CDS/PUT structure I am talking about is rather exotic. It exists on stocks (put) and on bonds (100% CDS) but the 80% CDS has to be OTC.

1 comment:

Frise Minute said...

Marc Maybe you know this but just in case:

Devil's advocate -- Avocat du diable