27th October 2011

F&C: The grand plan – will it provide a lasting solution?

Introduction

The Eurozone politicians reached an agreement in the early hours of the morning that has been greeted with relief by the media and markets alike as a significant step forward to a resolution to the ongoing debt crisis. To assess whether the proposed plan is likely to provide the foundation for a sustainable solution to Europe’s debt problems it is worth looking at the 3 main elements of the plan before assessing whether the whole package can be considered as credible and workable.

1. GREECE’S DEBT WRITE OFF

The agreement in late July wrote off 21% of the value of Greece’s sovereign debt and this has now been increased to a more realistic 50%. This equates to an approximate diminution of NPV of about 65% for holders of the bonds. The aim is that the debt/GDP ratio of Greece should fall to about 120% by 2020 from its current level of 160% that is forecast to rise to over 200%.

Comment

The bond market for Greek debt has been implying that a much larger write off has been inevitable for some time and while 50% is a more realistic appraisal of the situation it still falls well short of what is needed. As the statement admits it only reduces the debt/GDP level to 120% in 9 years time. This is the same ratio that Italy has at present and will likely be an underestimate given the deteriorating growth profile for the Greek economy that has consistently fallen short of expectations since the crisis started. The extra austerity measures that were agreed last week by the Greek Parliament will depress economic growth further at the same time that the Eurozone is also slowing down markedly.

To be fair to the policy makers they had to cajole the private sector creditors into accepting a 50% haircut and a larger write off would have been politically impossible. However, it is likely, almost inevitable, that a further write off of Greece’s debt will be required in the future. Another consideration is whether it will constitute a default or not. President Sarkozy has characteristically trumpeted that it is not a default because the banks and other creditors have agreed to the write down on a ‘voluntary’ basis. However, the rating agencies may have a different view. If it is classified as a default the CDS that have been written will be triggered that will realise further losses to the writers of those contracts. While the net amounts of the CDS is believed to be manageable for Greece it would have implications for other periphery countries if they are also forced to write down the value of their debt. If the CDS are not triggered it will be very controversial and will probably lead to much litigation by the holders of the swaps. This is, after all, a de facto default and the banks had to be pressured into accepting a 50% write off against their wishes. This is hardly a voluntary agreement as M Sarkozy would have us believe.

The authorities have stressed that Greece is a ‘one off’ but we have had similar assurances before in this crisis that have soon afterwards been broken. For instance, the first bail out of Greece was not supposed to be followed by further bailouts to Ireland and Portugal, let alone a second one for Greece. If the market and the credit rating authorities eventually regard it as a default and credit event it will mean the taboo has been broken and it significantly increases the chances of other defaults within the Eurozone. This will mean the valuation of debt for the vulnerable nations will be adjusted accordingly, notwithstanding the best efforts of the ECB and the newly empowered EFSF.

BANKS RECAPITALISATION

The second and easiest part of the plan to agree was to recapitalise the banking sector. The European Banking Authority (EBA) conducted a 3^rd stress test on 70 banks. Unlike the previous 2 tests that totally lacked credibility, this exercise was much more realistic. It set a target of a core Tier 1 ratio of 9% for banks to achieve by the end of June 2012 and, crucially, applied mark to market valuations for the tests. The end result was a shortfall of €106bn for the industry. The biggest shortfalls were predictably in Greece (€30bn), Spain (€26bn), Italy (€15bn) and France (€8.8bn). The UK did not have any shortfall and has helped the sector to rally strongly in the London market today. The Plan recommended that the banks raise the capital through, initially, private sources and only if that fails could they rely on state aid or recourse to the beefed up EFSF (bailout fund).

Comment

Clearly this is a vast improvement on the 2 earlier stress tests from the EBA. However, they do not represent the ‘bazooka’ that will be necessary to allay market fears for long and, in this respect, are a contrast to the more effective TARP programme in 2008 in the US following the collapse of Lehman’s (see my earlier note on this topic). The total of €106bn is in line with expectations that had been played down in recent weeks but are well short of what is necessary. Last month, the IMF ruffled feathers by claiming that the European bank sector required €200-300bn extra capital that served as a wake up call to the policy makers. This would have been more realistic but even that would have been the minimum required to provide a comfort blanket to reassure markets that the banks had more than enough capital in the event of contagion spreading further. The tests apply to current markets valuations for government bond holdings but if the crisis deteriorates again this assessment is likely to prove inadequate as prices fall further. The lesson from the US is that it is important to have some leeway in the event of things getting worse, as they have been prone to do in this crisis.

The need to raise extra capital comes at a particularly sensitive time with the rate of economic growth slowing in the Eurozone. A recession in Europe is a strong possibility next year and, depending on how the banks choose to increase their capital ratios, the stress tests could inadvertently significantly raise the chances of a recession or/and make it deeper. This is because the banks will want to preserve capital rather than lend it and will look to de-lever by selling assets and non-core activities. At this time of the cycle the bank sector needs to become less risk averse and not more so to create a climate of credit growth and increased lending for the economy.

In addition to the strictures to raise more capital, the agreement also envisaged improvements to the funding markets that have largely seized up in recent months as confidence has drained in the interbank and wholesale funding market. The term funding (longer term funding) has been non-existent since mid summer except for the largest and best capitalised banks such as HSBC. The Plan has proposed a more coordinated approach aimed at providing term funding support. This would come through public guarantee schemes for senior debt in order to restart the moribund term funding market. This is important because in 2012 the bank sector needs to raise about €500bn of unsecured debt that is the equivalent of 5% of Euroland GDP and much more in the case of some individual countries. While this is welcome, the clear shortcoming is that the guarantees are supposed to come from the national government and would have been much more effective if they had had supranational support. The countries with the weakest banks generally have the highest annual deficits and debt/GDP ratios that will make it more difficult for banks to raise unsecured capital in the term funding market.

3. INCREASED EFSF FIREPOWER

The most complicated and controversial part of the deal has been how and to what extent to increase the capacity of the bailout fund, the EFSF. The fund currently has about €250bn of available resources to disburse and the Plan envisages gearing this up about 4 times to €1000bn. The increased firepower will come from a Special Purpose Investment Vehicle (SPV) or a monoline insurance scheme that will insure a certain percentage of the total capital value of the sovereign bond.

Comment

Although essential details of the scheme are still lacking it is worth commenting on both aspects of it to assess its effectiveness.

The augmented proposed size of the fund of €1000bn means that it limits the amount of insurance that can be provided to the bonds. At this level (on the basis of leverage of 4x) it means that only 20% insurance can be offered to investors. To increase the insurance, and therefore make the asset more attractive to external investors, the gearing would have to be reduced that would in turn shrink the capacity of the fund. The table below illustrates this:

 There is, therefore, a trade off between providing more insurance to entice investment and the gearing of the scheme. Whether an insurance of 20% will be sufficient to attract significant investment is debatable. Also, if Italy or Spain, the 2 large periphery countries did default would the EFSF have the capacity to pay out? The diagram below shows how it would work:

A second shortcoming of the insurance scheme is that the periphery nations would actually be increasing their overall debt by more than the capital they are raising. This is because the recipient peripheral country would take an EFSF loan to buy the EFSF bond to act as the collateral for the newly issued and insured bond.

The insurance scheme will also only apply to new debt in the primary market and not to existing debt in the secondary market. Thus, a 2 tier market of different pricing and yield structures is likely to develop depending on whether the debt is covered by the insurance or not.

The SPV will effectively become the lender of last resort for Eurozone in place of the ECB that has shown a reluctance to assume that role. The aim is to attract seed capital from external sources, including sovereign wealth funds (SWF) to which direct appeals have been made. The capital raised could be levered up and new SPV debt would then be issued. The key to making it a success depends not only the external appetite for such debt but also on the attitude of the rating agencies who may not deem a structured credit vehicle of this nature of sufficiently low risk to merit a triple A rating. The table below shows how it might work although the details are sketchy at the moment:

Overall, the fund’s size is at the low end of expectations. There had been talk of boosting the size of the EFSF to over €2000bn but like the bank recapitalisation plan, expectations had more recently been played down. At the rate the ECB had been buying periphery debt in the market as part of its SMP programme the increased resources will cover the financing needs of Spain and Italy for the next 2 years but that does not include any further bailouts or contingencies. However, as will be explained in the conclusion, whatever the size of the fund it represents a continuation of a liquidity based strategy that is the wrong approach to providing a lasting solution to the crisis.

Conclusion

The bar was set low in terms of what markets believed the politicians could deliver and the measures agreed have met or even surpassed such expectations. The relief that the Grand Plan had taken some bold measures to address the crisis has led to a further rally in risk assets, building on the rise of recent weeks ahead of the announcement, but are policies the right ones and sufficient to provide a permanent solution to the crisis?

The key point to recognise is the Grand Plan does not represent a change in strategy that, I believe, is necessary to provide a successful solution to the crisis. It signals a desire to maintain the status quo of keeping the periphery countries within the EMU while not moving to a full fiscal union. If a monetary union is to be successful it has to be a cohesive tax union as well and for that to happen it has to be a political union. As the fragmented and, at times bitter, discussions of the last few weeks have illustrated we are a long way from that. The Plan still does not address the underlying problem of the Eurozone which is a drastic lack of competitiveness and growth in the periphery countries that are saddled with an overvalued exchange rate they cannot escape from. Although Greece’s solvency problem has been given further relief with the increased debt write off it still has a chronically high debt ratio and other periphery nations have had no help at all. The strategy remains one of throwing more money at the problem in the hope that, like a bad smell, it will eventually go away. Through complicated and clever schemes it redistributes the debt but does not make it go away and, indeed, the leveraging of the EFSF is a risky proposition that has some of the hallmarks of the structured asset products of the sub prime debacle in 2008.

The greater magnitude of the announced measures means that the Eurozone has bought itself more time but that is all. What makes the implementation of the Plan more difficult is that it coincides with a significant deterioration in economic data within the area, as this week’s PMI indicators illustrated. The paradox of greater fiscal probity and higher debt levels has been evident in Greece in recent months and these pressures will be more acute as the Euro economy slows in countries where that are uncompetitive and in need of structural reform.

Quite apart from whether the strategy is right or wrong, the above analysis shows that in all 3 areas the size of the measures is too small to prevent contagion recurring once the initial relief has faded. The sovereign debt premium will remain with the periphery bonds and, if and when, it becomes clear that the low growth environment coupled with the slow pace of reforms are not leading to an improvement in the solvency positions of the periphery countries, contagion will quickly spread once more.

Markets have rallied strongly in recent weeks, not only because of the Eurozone Grand Plan, but also because of slightly better than expected economic data outside Europe and further liquidity injections from the Fed (Operation Twist) and the Bank of England (QE3). China has also hinted at loosening economic policy. This rally is likely to fade as the limitations of today’s deal are more clearly understood in an environment of raised expectations. Looking further ahead any unravelling of the Plan as contagion spreads again will mean risk assets remain vulnerable to a much sharper sell off.

Ted Scott

October 2011

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