More potato gun than bazooka?



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27 October 2011

Euro area leaders had promised that last night’s summit would deliver a “comprehensive solution” to the euro area’s debt crisis. But euro area leaders failed to deliver. While there were fairly comprehensive programmes to deal with the sideshows of the crisis – Greece and banks – the summit failed to deliver clear agreement on the much more important issue of how to  leverage the EFSF and stop contagion once and for all. So, where does that leave us? This blog looks in detail at last night’s deal.

Greek debt restructuring

What was agreed?

  • To increase the “voluntary” haircut on private investor holdings of Greek debt from the 21% NPV reduction agreed on 21 July to a 50% nominal reduction.
  • Official sector (euro area plus IMF) will provide an additional €100bn of funds to Greece to provide financing up to 2014.
  • The additional bailout package will provide for the recapitalisation of Greek banks.
  • While the restructuring will not trigger a CDS credit event according to ISDA (International Swaps and Derivatives Association), rating agencies will attach a default rating to Greece. So, a scheme will be put in place to ensure that Greek banks still have access to ECB liquidity.
    • 

What’s still to be decided?

  • There is only an “outline” agreement on a 50% haircut, so actual participation is unclear. 
  • A new programme for Greece is to be agreed by the end of 2011 and the exchange of the bonds to be implemented at the beginning of 2012.
  • IMF has yet to sign up to the second bailout package.

 
What does it mean?

  • Reaching agreement on a larger Greek debt restructuring is welcome given that the 21% reduction agreed in July was clearly too small. 
  • But even the 50% nominal discount envisaged in this latest package is unlikely to see expectations of an eventually larger default disappear – even under this scheme Greece’s debt stock is still expected to be 120% of GDP in 2020. 
  • Such debt levels are unlikely to allow the Greek government to return to capital markets.
  • More fundamentally, the Greek government will have to continue to implement the austerity measures that have crucified the economy over recent quarters. Growth remains a distant prospect.

 

Bank recapitalisation
 

 What was agreed?

  • Seventy of the EU’s largest banks will be expected to temporarily meet a Core Tier 1 capital ratio of 9% after accounting for market valuation of sovereign debt exposures as of 30 September 2011. The shortfall as at end-June 2011 is calculated at €106bn.
  • Banks will have until 30 June 2012 to address any shortfalls and will first be expected to raise any capital required from private sources, including hybrid debt to equity conversions, before calling on either national governments or, as a last resort, the European Financial Stability Facility.
    • 

What’s still to be decided?

  • The numbers released last night by the European Banking Authority (EBA) are preliminary figures based on end-June 2011 balance sheets. The final capital shortfalls will be released in November based on end-September 2011 balance sheets.


What does it mean?

  • The funds to recapitalise banks in Greece and Portugal will come from their respective bail-out programmes and any shortfalls will be covered by the EFSF. In Italy and Spain, on the other hand, private capital will be difficult to mobilise, while further state aid will undermine the sovereigns' already weak fiscal position. 
  • The final capital shortfall calculations will be based on market prices of government bonds at end-September. A failure to arrest the spread of contagion of the sovereign crisis to Italy and Spain will make this figure look out of date very rapidly, reigniting concerns about bank capital. 
  • Ultimately, if market participants don't consider that the plan to leverage the EFSF has killed off the threat of a wider euro area sovereign debt restructuring, no amount of capital raised will assuage concerns about banks’ capital positions.
  • While national supervisory authorities have been requested to ensure that the planned recapitalisation does not lead to excess deleveraging, in practice it will be exceptionally difficult to prevent banks from going down this route.


Increasing the EFSF’s firepower

What was agreed?

The option of turning the EFSF into a bank was definitively ruled out. Instead, leaders agreed to two options to leverage the EFSF: 

  • The EFSF will offer risk insurance for new debt issued by Member States. This insurance can be purchased by investors as an option when buying bonds in the primary market. 
  • The establishment of new SPVs, financed by private and public financial institutions and investors, designed to extend loans, recapitalise banks and to purchase bonds of fiscally-troubled euro area member states in the primary and secondary markets. 
  • The intention is that the EFSF will be allowed to use both option simultaneously, where possible. In addition, leaders called for more work on possible options to leverage the EFSF further in cooperation with the IMF.
    • 

What’s still to be decided?

  • What are the costs of the insurance? Do the costs differ across member states? Will the price of the insurance be proportional to the risk of default of a member state as, for example, determined by CDS contracts? 
  • What is the maximum amount of insurance investors will be allowed to purchase?   
  • Under what circumstances will the insurance be paid out? Is a credit event as defined by ISDA needed to trigger a payout? Who decides on the payout of the insurance? 
  • Will the new insurance contracts be tradeable assets in financial markets? If yes, how will these assets trade relative to CDS? 
  • What funds are available to the proposed SPVs? Who (if anyone) will contribute to these funds.


What does it mean?

  • It seems unlikely that the insurance scheme, as proposed, will stop contagion. Concerns about the size of guarantees available (less than €300bn), the likelihood of payout (will a “voluntary” restructuring of Italy’s debt along the lines of that currently being pushed through on Greece be covered by the insurance?) and redistribution effects (if there is demand for French protection that will lower the amount available for Italian protection) are all factors that will make investors cautious about purchasing risk insurance. 
  • With the insurance scheme focusing on the primary market, the new arrangements leave Italy’s and Spain’s secondary market “unprotected”. And with the political situation in Italy more uncertain than ever, yields on Italy’s unprotected bonds worth around €1.9tn are set to rise further unless either the ECB or, in due course, any new SPV that is established intervenes more aggressively in the secondary market to contain spreads.  
  • After recent comments by officials from Brazil and Norway underlining their unwillingness to contribute to a SPV, we remain highly sceptical that European leaders will be able to gather enough resources from non-European countries to establish a SPV of sufficient size to arrest concerns of contagion in “unprotected” secondary markets.
    • 

What’s next?

Market reaction to last night’s deal has been positive, with equity markets rallying strongly and euro area spreads tightening. In that sense, the market reaction has been similar to that seen after the 21 July summit. And we all know what happened subsequently. There is clearly a risk that the same will happen this time once markets have had time to digest exactly what (or perhaps more pertinently what isn’t) in last night’s deal. Specifically, the lack of a definitive plan to leverage the EFSF, and the woolly nature of both the proposed insurance scheme and the SPVs leave huge uncertainties about the way forward from here. All eyes will now turn to the G-20 summit in Cannes at the end of next week (3-4 November). Given that both Norway and Brazil have demurred from putting money into a SPV, hopes of establishing a large fund have to be slim, although more support from the IMF may well be offered. But no plausible SPV or additional IMF resources can ultimately do anything other than act as embellishment to the euro area response. And while today has seen some positive headlines about a €1tn EFSF having been agreed to, markets are likely to soon latch on to the fact that there is no such thing in reality, with no new money having come from euro area countries last night at all. Once this reality sinks in, markets may well prove less indulgent, with sentiment reversing and attention turning to when euro area leaders will hold their next summit to come up with their next plan.


 Grant Lewis, Head of Research

Tobias S. Blattner, Euro area Economist

 

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