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ex nihilo nihil fit

Tuesday October 25th 2011

As European politicians shuttle bank and forth between their national capitals and Brussels our minds are focused on Wednesday, October 26th 2011.
It comes down to how can the European Financial Stability Facility (EFSF) be leveraged. Before we go further, it is appropriate for a little time to be spent considering exactly what leverage means.
What Is Leverage?

The use of a variety of financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
It all sounds so simple when the Euro Zone leadership say they have have a fund called the EFSF worth EUR440Bn, however, we know that this amount of money is insufficient to achieve everything on our wish list:
  1. Bail out Greece
  2. Ring fence doubtful debt in Italy and Spain
  3. Recapitalise the Euro Zone banks that have accumulated too much doubtful debt
So let's leverage the EFSF and boost the firepower. The first idea from the French (who still do not accept how poorly placed BNP Paribas, Credit Agricole or Soc Gen really are), was to turn the EFSF into a bank so that it could soak up cheap funding from the ECB. The ECB was opposed and the German's simply said no.
The task is then how to in effect increase the capital available to the EFSF without putting more capital into it?
Now I am no financial Luddite, however, when I start to hear this  idea, i.e. lets get something for nothing I start to become twitchy. Something for nothing and European politico's/bureaucrats makes me nervous.
Nothing comes from nothing or ex nihilo nihil fit
So what is the European snake oil plan? An Credit Enhancement Insurance Model (CEIM) and a "Special Purpose Investment Vehicle" if ever an acronym  was appropriate it is here...(SPIV)!
The 2 options singularly or in tandem do not create difficult changes to the existing EFSF and now that France has abandoned its idea of turning the fund into a bank EU leaders will decide on Wednesday which of the approaches left on the table should be used. It does appear as if a combination will be carry the day.
Under the CEIM the EFSF will heighten confidence in new debt issued by a struggling member state by guaranteeing an unspecified proportion of the losses that could be incurred in the event of a default.
Note the bold type...anything that is left "unspecified" at the outset is going to open to fractious debate later on. One can just see it happening.
The procedure is for the EFSF to extend a loan to a member state, which would buy EFSF bonds in return. These bonds serve as collateral for a partial protection certificate that will be held in trust for the state. The bond and the certificate are to be be freely tradable, according to the paper. If the state defaulted, the investor could surrender the protection certificate to the trust and receive payment from the EFSF.
QUESTION: Will the markets be provided with a clear and indisputable definition of what will constitute a default under such an arrangement. I forecast right now that any struggling state will start trying to play fast and loose with future years budgets so as to avoid default.
QUESTION: If a state that is party to the EFSF CEIM does default, is it ever to be allowed back into the scheme?
QUESTION: If a state issues and honours coupon and maturity sums due on say a 2 year note, once the debt is matured can they roll over their EFSF CEIM facility.
QUESTION: How much debt in (a) total (b) relative to GDP (c) by maturity or duration can a state have in play at any given time?
POINT OF ORDER: Is this not somewhat like "EUROBONDS" via the back door?
The CEIM option will not apply to nation states currently receiving Euro Zone/International Monetary Fund bailouts as the no longer issue bonds on the primary market. So it will answer the needs of Greece, Portugal or Ireland. (The latter is actually making good progress).
Under the SPIV programme, one or more SPIV's will be established centrally or in a beneficiary member state to invest in sovereign bonds in the primary and secondary markets. It is a structured product and the senior debt element can be credit rated, therefore targeted toward fixed income investors.
QUESTION:  What is the liquidity?
QUESTION:  Who will make the market?
QUESTION:  What will Bid Ask spread be?
QUESTION:  What size can be traded?
QUESTION:  Is it exchange listed?
The SPIV would be funded by freely traded instruments, such as senior debt and participation capital instruments. The EFSF would also invest in this, and would absorb the first proportion of losses incurred by the vehicle if a state defaulted.
So we are faced with a complex process of leverage which is designed to help both the investor and the state to invest or operate. However, be warned, leverage through the CEIM or SPIV will entail risk for the providers of capital to the EFSF. Use of  leverage to make an investments will come down on the side of "REWARD" only if the investment works. If in the case of sovereign states, the economy does not respond, or the people reject austerity and elect a less stringent government i.e. the original investment moves against the investor, the losses will be much greater than it would've been if the investment had not been leveraged - leverage magnifies both gains and losses.
The investor can call upon the EFSF guarantee...but what happens when the market makes a margin call on the EFSF?
Once again it appears as if the very politicians and bureaucrats that have accused the markets of dabbling in financial voodoo are now dancing with the devil themselves. Hmm...can we short the CEIM or SPIV instruments...oh what a great debate that would be! 

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