• 30 Nov 2012 at 6:17 PM

EFSF Conveniently Downgraded

Here are two tiny little puzzles about Moody’s’s’s downgrade of the European Financial Stability Facility from Aaa to Aa1 just now. But first, here is some math on EFSF guarantees; basically every €100 of EFSF bonds has €165 of member guarantees, of which €103ish were Aaa-rated and €62ish were not. Until Moody’s downgraded France last week. Now it appears that each €100 EFSF bond has only €67 of Aaa guarantees, €36 of Aa1, and €62 of … various lesser things.

So the puzzles: first, this thing – the EFSF – is basically a structured credit product that is roughly two-thirds guaranteed by a Aaa thing, one-third guaranteed by an Aa1 thing, and roughly another two-thirds guaranteed by an assorted lower-rated miscellany that you can safely ignore. Should that make it (1) Aaa, (2) Aa1, or (4) other? S&P, as it happens, has a mechanism to sort of solve this, which is to say that a bond is rated by its probability of defaulting. Discarding the cats and dogs (and ignoring correlation questions), something that is 1/3 AA+ and 2/3 AAA has about an AA+ chance of defaulting: even if those AAAs are rock-solid, a default by that AA+ counts 100% as a default. Moody’s doesn’t have that – they, in theory, rate structured products1 based on expected loss, not just chances that there will be a default. So something that is two-thirds Aaa and one-third Aa1 is … at least arithmetically closer to Aaa than Aa1, is it not? (Especially if you assume the cats and dogs add a little bit of recovery.) But here you are stuck in a granular world: a thing that is two-thirds Germany and one-third France may be better than France, but I guess it’s also worse than Germany, so you gotta pick one or the other and I suppose pessimism is always a good look.

But a second and possibly related puzzle: if you were the EFSF, would you be bummed about being downgraded? Here is a weird fact2 (via Alea): Read more »

  • 29 Jun 2012 at 12:35 PM

Europe Is All Better (As Of January 2013)

Ooh look there’s another Europe thing. In this thing, Europe, in the form of the almost-existing ESM,* will take equity (?) stakes in troubled Eurozone banks, rather than its previous plan of buying senior debt of troubled Eurozone sovereigns so those sovereigns can invest the proceeds in equity stakes of their troubled banks.

There has been a lot of talk about collectivizing some European government debt, with people proposing plans in which Europe as a whole would be responsible for the amount of each country’s debt under X% of GDP, or over Y% of GDP, or other. You can think of this as sort of a more financialized, more palatable, and more targeted version of that: instead of collectivizing an arbitrary dollar amount of each country’s sovereign debt, you collectivize the amount needed to bail out that country’s insolvent banks. This favors peripheral countries (because they have most of the bad banks, or at least the bad banks whose badness expresses itself in the form of insolvency rather than criminality), yet also has a certain appeal to Euro-core financial bureaucrats because the collectivized debt is going to bankers like them rather than to over-vacationed Greek pensioners etc. And money being fungible it’s not the worst outcome for the pensioners etc. either.

The other thing about this new Europe thing is that the EFSF/ESM can stabilize peripheral government debt in the market without imposing new austerity conditions and without taking seniority, though people have doubts about that because you can always flip yourself into seniority if you’re the lender of last resort. And there are many other details to be worked out and I invite you to read about them from someone who knows something about them. But the new news is the bank capitalizing, and that seems promising; the syllogism is I guess (1) this is TARP and (2) TARP kind of worked, ergo (3) this will kind of work. Read more »

  • 17 Jan 2012 at 11:58 AM

Europe Needs A Better Blender

I guess we should talk about Europe and credit ratings. Now France isn’t AAA and Italy isn’t A and Portugal isn’t investment grade and here is something that someone at S&P actually said:

Our role is to give timely information to investors and if you give them timely information, if you give it to them in modest increments, then we think that they can make their own judgments about how they are going to allocate their portfolios.

Really! That could be S&P’s motto, “timely information, but in modest increments. Also not really that timely.”

If you’re into this sort of thing, though, the action is not in France so much as it is in the European Financial Stability Facility. The EFSF is basically, France and Germany and the other eurozone countries issue a bunch of debt*, put it into a blender, pulse until smooth, and then issue it as “EFSF debt.” The EFSF gets the money and uses it to prop up Greece, buy Italian bonds, etc. Because all the things are also all the other things, people saw this and were like:

1. Hey, that’s a CDO!
2. CDOs suck boo etc.

Here’s what the EFSF had to say about those claims:
Read more »

We’ve noted here before the irony that Europe is both (1) screwing with your ability to get paid on CDS on shaky European sovereign debt (sort of) and (2) hoping people will buy more shaky European sovereign debt because they can get tradeable first-loss protection, suspiciously reminiscent of CDS, from the EFSF on those bonds. The further irony is that, at the same time as it’s touting the free transferability and liquidity of that first-loss protection as a selling point, Europe is moving to restrict investors from owning sovereign CDS unless they can prove they really need it, to hedge sovereign debt or correlated assets.

Today FT Alphaville has the details on the potential EFSF-issued first loss protection (full Q&A here). The plan would be to let member states who are “under market pressure” to issue bonds along with “partial protection certificates” that would, on a payment default on the underlying bond, pay off an amount equal to the principal loss on the bond, up to some cap. The EFSF is coy on the cap but admits it might be around 20% of the bond’s principal. The payoff would be in the form of EFSF bonds, which are currently AAA rated: so if your Spanish bonds, say, only pay off 50 cents on the dollar, you’d get an extra 20 cents face value of AAA rated EFSF bonds of unspecified terms.

Importantly, these certificates would be freely tradeable:
Read more »