EFSF vs.

ESM
The quantum leap in the Euro Area Debt Crisis Management?
Cristiana Corno
Structured Credit
The Debt Crisis: Different Rules for a Different World
New York, May 17-20 2011
EFSF vs. ESM 1
Summary
This document aims to show the big difference between ESM (European Stability Mechanism 2013
onwards) and his present precursor EFSF. I will try to show how they differ in nature, aim and legal
framework. Being:
EFSF a temporary facility born in emergency , under a derogation of the no bail out clause due to
exceptional occurrences, as an intergovernmental agreement ( outside EU architecture)
ESM a permanent institution, with a reestablishment of the no bail out clause (possible investor
bail in), as an international organization with simplified EU treaty revision (one step further
towards becoming a proper EU institution)
I thought it could be interesting to review the current European crisis trough the evolution of the NO BAIL
OUT clause:
Starting from the lack of the credibility of the no bail out clause as one of the causes of the
current crisis
Its derogation in the Euro bail out and the instruments used
Its strong re-assessment in the ESM framework
EFSF vs. ESM 2
Euro bailout
Euro bailout Euro bailout
Agenda
Towards resolution
Towards resolution Towards resolution
Overview
Overview Overview
EFSF vs. ESM 3
How we got here?
Introduction
Dynamite:
Economic imbalances intra Europe
Soft budget constraints
Implicit bail-in clause
Detonator:
Costs of financial crisis
Worldwide recession, end of asset
bubbles and extraordinary pay/profit in
the financial sector, increasing risk
aversion
Greek specific problems with
accountancy irregularities
EFSF vs. ESM 4
Dynamite
Economic imbalances inside the EU
Credit fuelled internal boom with boomerang effects, not addressed until when they became excessive:
Basically what has been described as a perfect emerging market crisis without the currency flexibility
tool
ASSET BUBBLES: misallocation of resources in
the construction real estate sector (Spain, Ireland)
and extraordinary pay and profit in the financial
sector
TRADE DEFICIT: loss of competitiveness in the
poorest countries due to rapidly rising prices and
wages (Italy, Portugal), with import raising and
export decreasing
NET CAPITAL IMPORT: huge capital outflow from
Germany to other European countries (from 1995
to 2008 Germany was the world second largest
capital exporters after China)
EFSF vs. ESM 5
Dynamite
Inconsistent application of sanctions
The Stability and Growth Pact (SPG) was adopted in 1997 in order to maintain and enforce fiscal
discipline in the EMU. All members were required to respect the following criteria:
national debt lower than 60% of GDP
annual budget deficit no higher than 3% of GDP
Severe sanctions for criteria breaches:
a deposit of 0.2% GDP convertible in fee if the deficit persisted for two following years
a variable fee of 10% of the excess deficit, capped at 0.5% of GDP
There have been 30 violations from 2000 to 2008:
Country Number of breaches
Belgium 0
Germany 4
Spain 1
France 4
Ireland 1
Italy 5
Netherlands 1
Austria 1
Luxemburg 0
Portugal 4
Finland 0
Greece 9
As a result, no sanctions have ever been applied
(*) See Annex1 for more details
Core countries, unable/unwilling to satisfy the criteria, started asking for a
dilution of the sanctions since 2003*. An agreement was reached in 2005
Punitive proceedings were started when dealing with Portugal (2002) and
Greece (2005), though fines were never applied
EFSF vs. ESM 6
Dynamite
The no bailout clause
Maastricht Treaty Article 125: the Union shall not be liable for or assume the commitments of central
governments (no bailout clause). This precise rule was not applied because of:
Fear of contagion to other countries
International exposure of the banking system, exacerbated by the Basel framework
(Government bonds have 0% risk weight in the calculation of the Tier 1 ratio)
Lack of a mechanism to solve liquidity/solvency crisis and even of a possible Euro
withdrawal/expulsion
The non bailout clause became an implicit bailout principle, with the consequence of default probability
disappearing from government markets
BIS Q1 2010 BIS Q3 2010
BANKING EXPOSURE Greece Ireland Portugal Spain BANKING EXPOSURE Greece Ireland Portugal Spain CHANGE
GERMANY 520,70 51,00 205,80 46,00 217,90 568,70 69,40 208,30 48,50 242,50 48,00
FRANCE 491,00 111,60 85,70 49,70 244,00 440,40 92,00 78,10 45,60 224,70 -50,60
ITALY 89,30 8,80 28,60 9,40 42,50 80,60 6,50 24,40 7,90 41,80 -8,70
SPAIN 125,80 1,60 16,20 108,00 0,00 127,60 1,50 17,50 108,60 0,00 1,80
US 378,80 41,20 113,90 37,30 186,40 391,60 43,10 113,90 47,10 187,50 12,80
NETHER 0,00 0,00 0,00
UK 413,00 16,50 222,40 32,40 141,70 431,10 20,40 224,60 33,70 152,40 18,10
EFSF vs. ESM 7
Detonator
Immediate triggers
Costs of the financial crisis: Northern Rock (September 2007), Lehman default (September 2008) and
AIG bailout (September 08)
Worldwide recession in 2008 with related weakness of government revenues and boost of fiscal
stabilizer (unemployment benefits), end of asset bubbles (real estate markets) and of the extraordinary
profit/pay in the financial sector, increasing worldwide risk aversion
Greece specific problems: accountancy irregularities and balance sheet cosmetics to meet Maastricht
criteria; the deficit/GDP ratio had been below 3%only for one year
Net Cost of Financial Sector Support
(Latest available date; percent of 2010 GDP unless otherwise indicated)
Direct support Recovery Net direct Cost % gdp
Ireland 30 1,3 28,7
Germany 10,8 0,1 10,7
Netherlands 14,4 8,4 6
United Kingdom 7,1 1,1 6
Greece 5,1 0,1 5
Belgium 4,3 0,2 4,1
United States 5,2 1,8 3,4
Spain 2,9 0,9 2
Average 6,4 1,6 4,8
Billions 1528 379 1149
Sources:IMF
EFSF vs. ESM 8
Euro bailout
Euro bailout Euro bailout
Agenda
Towards resolution
Towards resolution Towards resolution
Overview
Overview Overview
EFSF vs. ESM 9
Euro bailout
Greek crisis escalation
In October 2009 a new credit derivatives index
was introduced in the market: SOVX
WESTERN EUROPE (basket of 15 Euro
sovereign cds)
At the end of 2009, the new government
announced that deficit for the year would have
been 12.7% more than three time higher than
previously declared 3.7%: the crisis started
On the 2
nd
May, Euro regions agreed a great bailout loan totalling 110b to bring the country
through the next 3 years. ECB announced that it would drop all the rating requirements for Greek
bonds
Demonstrators set fires in Athens killing 3 people
EFSF vs. ESM 10
Euro bailout
Contagion
On the 10th May. The EU presents:
750b programme to secure the stability of the euro area under a European Commission /
EURO / IMF parachute, and
the European Central Bank announces the introduction of several measures to preserve
market liquidity: Securities Markets Programme, reactivation of swap lines with the Federal
Reserve, introduction of additional liquidity-providing operations
Aim was to provide funding in conjunction with the IMF,under strict conditionality to economic and fiscal
adjustment programmes.
Amount Instrument Rate Repayment
IMF 30 Stand-By Arrangement facility which
exceptional access to IMF resources,
amounting to more than 3,200% of
Greeces quota.
SDR plus 200 basis point under 3years,
with a 100bps mark up on amount
outstanding over 3y for the amount over
300% of the country quote (approx
3.83%)
3,25 years after after
the disboursement,
spread in 8 quaterly
instalments (2y).
EURO
COUNTRIES
(Irland and
Slovakia not
partecipating)
80 Pool of bilateral loans from European
Member states in accordance with
their participation to ECB share
capital, managed by the European
Commission.
The initial rate to be paid on the eu loan
was intended to be 300 bps over
libor/swap for maturities lower than 3
years and 400 bps over 3 year plus a
50bps charge to cover operational costs
(approx 5.5%).
3 years after the
disboursement and
spread in 8 quaterly
instalments (2y).
EFSF vs. ESM 11
Euro bailout
Overview of the Greek facility
In order to avoid restructuring by mid 2012 the institutional sector will hold circa 40% of the Greek debt, the
European holding (30%) will rank pari passuwith bond holders. This creates incentives for EFSF both to ask for
seniority (formally or asking for collateral) in further loans and to ask for maturity extension of the government
bonds, thereby worsening solvency crisis.
This to stress how a bad designed bailing out system (which does not address solvency but only liquidity) risks
creating unintended consequences by worsening the country solvency and becoming a channel of contagiumin
itself. ESM will be a step forward: debt sustainability will be come core in providing financial assistance.
Greek
gov debt
EU/IMF
debt +
ECB
Total
Debt
%
Institution
today 286 103,00 339,00 30,38%
J un 2011 279 115,00 344,00 33,43%
Sep 2011 268 123,00 341,00 36,07%
Dec 2011 263 128,00 341,00 37,54%
Mar 2012 256 138,00 344,00 40,12%
J un 2012 234 144,00 328,00 43,90%
Sep 2012 226 150,00 326,00 46,01%
Dec 2012 225 152,00 327,00 46,48%
Mar 2013 217 158,00 325,00 48,62%
J une 2013 203 160,00 313,00 51,12%
Extending now the repayment terms of the
EU/IMF loan means making the loan junior
to bondholder : Merkel asking to
negotiate an extension of maturities on its
bonds before receiving a new European
Union aid package
Disbursements (done and planned) billions
2010 31,05
2011 46,05
2012 24,00
2013 8,00
EFSF vs. ESM 12
Euro bailout
The bill
Big contribution of Italy nothwistanding the small peripheral exposure. Italy is the country making the
greatest efforts
BIS end of q1 2010
TOTAL LIABILITIES BANKING EXPOSURE Greece Ireland Portugal Spain
GERMANY 168,55 520,70 51,00 205,80 46,00 217,90
FRANCE 129,46 491,00 111,60 85,70 49,70 244,00
ITALY 109,28 89,30 8,80 28,60 9,40 42,50
SPAIN 70,89 125,80 1,60 16,20 108,00 0,00
US 47,80 378,80 41,20 113,90 37,30 186,40
NETHER 38,60 0,00
UK 32,58 413,00 16,50 222,40 32,40 141,70
EFSF vs. ESM 13
Euro bailout
The mechanics
Both the facilities were based on a derogation to art.125 of the TFEU contained in art.122.2 which refers
to: natural disasters or exceptional occurrences. Being born under exceptional circumstances, they will
both expire in J une 2013. Aim: address liquidity issues and not solvency
EFSM (60b)
usage of the European Union
Medium Term Note to borrow
from capital markets and lend
to Euro states
EFSF (440b)
funding vehicle to borrow from
markets based on
intergovernmental arrangement
and a complex formalization of the
pool of bilateral loan to Greece.
Portugal plan is to be approved on the 16-17 European Council meeting.
EXTERNAL AID IMF EFSM EFSF BILATERAL
28 November Ireland 67,5 22,5 22,5 17,7 4,8
7 April Portugal 78 26 26 26
EFSF vs. ESM 14
Euro bailout
Euro bailout Euro bailout
Agenda
Towards resolution
Towards resolution Towards resolution
Overview
Overview Overview
EFSM
EFSF
EFSF vs. ESM 15
The EU is empowered by the EU Treaty to borrow from the markets. It enjoys a preferred creditor status.
The EFSM is the facility to grant loan/credit lines to the Member States (Council Regulation 407/2010, 11
may 2010).
EU enjoys a AAA credit rating by the three major rating agencies.
Direct and unconditional obligations of the EU and guarantees by the 27 Member States (joint and
several liabilities, established by Treaty Law). EU Member States are legally obliged to ensure
that the budget always has sufficient funds to meet the EUs obligations, for this purpose the
Commission may draw on all Member States.
Investors are only exposed to the credit risk of the EU
Loan Characteristics
Under the EFSF facility the fund raised is passed on to the Member States borrowing. This back-to-back
imposes constraints on EU issuance (timing, amounts, maturities) The big difference between the BOP
facility and EFSM is that in the former there is no penalty rate
Euro bailout: EFSM
Characteristics
EFSF vs. ESM 16
Euro bailout: EFSM
Activation
EFSM and EFSF enjoy a similar activation process with the differences outlined below due to different
legal framework
Application for aid
Formal requesto to Euro members
Economic stabilisation
programme
Negotiated by EC, in cooperation with
IMF and ECB
Includes strong conditionality
Memorandum of understanding
Agreed between EU, IMF, beneficiary country
Approved by ECOFIN/Eurogroup (qualified
majority 55% countries and 65% population), IMF,
national Parliament of beneficiary country
Loan Terms
Based on the EC porposal the
European Council determines the
amount of the country programme and
the loan terms
Final Terms
Based on the specific borrowing
transaction.
Qualified majority
decision, being
EU an
international
institution
Unanimity
consensus, being
EFSF an
intergovernamental
agreement
EFSF vs. ESM 17
Under the Eu medium term programme (previously EEC and Euratom programme) a first benchmark
has been issued in December 2008 to finance partially a loan to Hungary and then to Latvia and
Romania
Funding in euro only. Maturity driven by features of underlying loan : we know exactly the average
duration of the issuance (7,5 years)
Total market outstanding amounts to 22b euros with average issue size 1-2b
The 2011 issuance (2015 and 2018) related to Ireland ( and partially to Romania) has seen an increase
in the issue size to 4,5-5b
Euro bailout: EFSM
Market and Issuance
CPN ISSUE_DT MATURITY OUTSTANDING ASW AT ISSUANCE ASW
EUROPEAN UNION 3,25 09/12/08 09/12/11 2.000.000.000 15,00 -53,76
EUROPEAN UNION 3,125 25/02/09 03/04/14 1.000.000.000 30,00 -13,10
EUROPEAN UNION 3,25 26/03/09 07/11/14 2.000.000.000 35,00 -9,72
EUROPEAN UNION 3,125 27/07/09 27/01/15 2.700.000.000 25,00 -9,33
EUROPEAN UNION 2,5 12/01/11 04/12/15 5.000.000.000 12,00 -7,88
EUROPEAN UNION 3,625 06/07/09 06/04/16 1.500.000.000 40,00 -1,08
EFSF 2,75 01/02/11 18/07/16 5.000.000.000 6,00 0,51
EUROPEAN UNION 2,375 22/09/10 22/09/17 1.150.000.000 8,00 2,67
EUROPEAN UNION 3,25 24/03/11 04/04/18 4.600.000.000 8,00 8,49
EUROPEAN UNION 3,375 11/03/10 10/05/19 1.500.000.000 20,00 8,01
EFSF vs. ESM 18
Spread in primary market ranged from Euribor6m+8 bps (in recent issues) up to Euribor6m +40 bps in
correlation with the AAA universe spread at time of issuance
Usually issued at discount to comparables and performed strongly in secondary market
Spread behaviour in secondary market highly correlated with the AAA credit universe (0.89% as
represented by J pMorgan index,Maggie allof the same maturity)
Low and negative correlation with a proxy of euro government risks (represented by SOVX Western
Europe)
Historically Issuance trades in line with the rating category rather than underlying risk.
Euro bailout: EFSM
Spread behaviour
ASW AT ISSUE ASW_AAA_ON_MTY
EU3,2512/2011 15,00 26,05
EU3,1254/2014 30,00 54,45
EU3,2511/2014 35,00 62,93
EU3,6254/2016 40,00 34,97
EU3,1251/2015 25,00 20,95
EU3,3755/2019 20,00 20,71
EU2,3759/2017 8,00 15,15
EU2,512/2015 12,00 -0,25
EU3,254/2018 8,00 12,02
1 bond issue for
Ireland
Cheapest ever
EFSF vs. ESM 19
High positive correlation with AAA rated securities rather than underlying risk:
Euro bailout: EFSM
Trading with AAA risk
-20
0
20
40
60
80
100
1
7
/
0
2
/
0
9
1
7
/
0
3
/
0
9
1
7
/
0
4
/
0
9
1
7
/
0
5
/
0
9
1
7
/
0
6
/
0
9
1
7
/
0
7
/
0
9
1
7
/
0
8
/
0
9
1
7
/
0
9
/
0
9
1
7
/
1
0
/
0
9
1
7
/
1
1
/
0
9
1
7
/
1
2
/
0
9
1
7
/
0
1
/
1
0
1
7
/
0
2
/
1
0
1
7
/
0
3
/
1
0
1
7
/
0
4
/
1
0
1
7
/
0
5
/
1
0
1
7
/
0
6
/
1
0
1
7
/
0
7
/
1
0
1
7
/
0
8
/
1
0
1
7
/
0
9
/
1
0
1
7
/
1
0
/
1
0
1
7
/
1
1
/
1
0
1
7
/
1
2
/
1
0
1
7
/
0
1
/
1
1
1
7
/
0
2
/
1
1
1
7
/
0
3
/
1
1
1
7
/
0
4
/
1
1
EU3.125 apr14 asw
AAA spread same maturity
EFSF vs. ESM 20
Low and negative correlation with underlying risk:
Euro bailout: EFSM
Not with underlying risk
-16
-14
-12
-10
-8
-6
-4
-2
0
2
4
6
0
2
/
1
0
/
0
9
1
7
/
1
1
/
0
9
3
1
/
1
2
/
0
9
2
3
/
0
2
/
1
0
1
3
/
0
4
/
1
0
0
1
/
0
6
/
1
0
1
4
/
0
7
/
1
0
2
5
/
0
8
/
1
0
0
8
/
1
0
/
1
0
3
0
/
1
1
/
1
0
1
8
/
0
1
/
1
1
0
2
/
0
3
/
1
1
1
3
/
0
4
/
1
1
0
50
100
150
200
250
EU3.125 apr14 asw sovx
EFSF vs. ESM 21
EIB most direct comparable. 156b outstanding market. Owned by the 27 Eu countries with share in line
with the country's share of GDP within the EU. Due to different legal framework (EIB multilateral
development bank) difficult to make a relative value comparison.
Like other multilateral development banks only a fraction (5%) of subscribed capital is paid in. The
remaining can be called. EIB has 263b of subscribed capital (2009 capital increase). The payment of
called capital is an obligation under the Eu treaty and the obligation to answer to capital being called
prevails on national laws
Euro bailout: EFSM
Comparables (1)
Eu issuance should trade cheaper
than EIB (on underlying basket).
At present we are at tight level and
given supply outlook on Eu
issuance it make sense to exit
EU to buy EIB
Still personally I prefer EU issuance
based on:
1. Transparency of loan portfolio
2. Lower leverage then EIB
3. Temporary facility
EFSF vs. ESM 22
Euro bailout: EFSM
Comparables (2)
EIB shareholders 5y 5y
Shareholder % EIB ASW EU_BC ASW
France 16,17% -10,82 16,44% -10,82
Germany 16,17% -41,29 21,11% -41,29
Italy 16,17% 100,21 13,64% 100,21
United Kingdom 16,17% -34,05 13,05% -34,05
Spain 9,70% 156,47 8,51% 156,47
Belgium 4,48% 69,28 3,83% 69,28
Netherlands 4,48% -28,51 5,28% -28,51
Sweden 2,97% -52,72 2,69% -52,72
Denmark 2,27% -50,81 2,02% -50,81
Austria 2,25% -10,72 2,19% -10,72
Poland 2,07% -9,43 1,99% -9,43
Finland 1,28% -28,08 1,47% -28,08
Greece 1,22% 1135,97 1,79% 1135,97
Portugal 0,78% 570,79 1,37% 570,79
Czech Republic 0,76% 52,73 0,89% 52,73
Hungary 0,72% 11,91 0,95% 11,91
Ireland 0,57% 718,60 1,27% 718,60
Romania 0,52% 43,84 0,00% 43,84
Slovakia 0,26% 76,22 0,37% 76,22
Slovenia 0,24% 53,96 0,29% 53,96
Bulgaria 0,18% 225,00 0,00% 225,00
Lithuania 0,15% 172,54 0,21% 172,54
Luxembourg 0,11% -38,03 0,23% -38,03
Cyprus 0,11% 285,86 0,15% 285,86
Latvia 0,09% 0,00 0,11% 0,00
Estonia 0,07% 0,00 0,00% 0,00
Malta 0,04% 0,00 0,00% 0,00
Total 1,00 40,15 1,00 48,92
Based on underlying risk the EU
issuance should trade wider than
the EIB.
EFSF vs. ESM 23
Euro bailout: EFSM
Issuance
The first issue EU2.5 dec15 performed quite well in secondary market (issued at euribor6m +8bps) and
is performing better than 18 issue with curve steepening, given loan maturity to be hedged
EFSF vs. ESM 24
Euro bailout
Euro bailout Euro bailout
Agenda
Towards resolution
Towards resolution Towards resolution
Overview
Overview Overview
EFSM
EFSF
EFSF vs. ESM 25
Euro bailout: EFSF
The criticized EFSF (1)
Finalised in J une 2010 between the 16 euro area member with the famous EFSF framework
agreement
The EFSF is a supranational financing vehicle to raise funds backed by a pool of bilateral guarantees of
the individual EURO member states. It is a "socit anonyme" (limited liability company), start up
capital of 30 million, subscribed by the EAMS based on their share in the ECB capital.
The individual guarantees are irrevocable and unconditional guarantees" of the EAMS, the Guarantor, in
proportion to their share in the capital of the European Central Bank, contribution keys.
These contribution keys are adjusted for each support operation, to take in account the stepping-out
member (the borrower ),adjusted contribution keys.
Unanimity is the rule (2/3 of total guarantee commitment attending)
Two observer from the ECB and the European Commission sit on the board.
Debts instruments issued by the EFSF must be accounted as government debt of the MS according to
their contribution key as guarantors (Eurostat opinion).
EFSF vs. ESM 26
Euro bailout: EFSF
The criticized EFSF (2)
The granting of the loan terms and condition have to be approved by unanimity by the EAMS.
The EFSF is only charged with raising the funding on the market and making the loan, with the technical
assistance of other institutions, notably the European Investment Bank (legal and administrative) and the
German public debt agency (risk management).
The average rating of the guarantors is AA (not dissimilar form EIB and EU underlying risk), but due to
legal framework, it had to provide further credit enhancement mechanism to get to the AAA rating
necessary for:
reputation
being able to fund in distressed and highly correlated market
The debt issued by EFSF is serviced by the underlying loan. In case of default of the borrower the debt is
serviced by the guarantors pro-rata, then from the a buffer and finally it is envisaged the possibility of
further credit enhancement mechanism
EFSF vs. ESM 27
Euro bailout: EFSF
Cdo or not cdo (1)
Over guarantees. Each guarantor issues unconditional and irrevocable guarantees to the amount of:
ADJ Contribution Key* x 120% x EFSF Nominal Obligation. Hence the guarantees provided exceed the
debt issued by 20%. If one of the guarantors is enable to meet its share the remaining guarantors will
increase their contribution up to 120% of their pro-rata share, making the 20% over guarantee fungible
between guarantors
AAA Guarantees
EFSF
bond
Non AAA Guarantee
Different debt issue will have a different
mix of guarantors depending on the
borrower stepping-out and amount of
cash buffer
EFSF vs. ESM 28
Euro bailout: EFSF
Cdo or not cdo (2)
Cash buffer. A cash reserve will be retained from the amount disbursed in order to size the gap between
the debt nominal amount and the AAA grossed up-guarantee. In this way a structure which resembled
correctly a cdo becomes a fixed basket of AAA securities and cash with an over guarantee from non AAA
countries (details in annex2 on cash buffer decomposition)
AAA Guarantees
EFSF
bond
Loan
Cash buffer
= +
AAA Guarantees
Non AAA Guarantee
Non AAA Guarantee
Cash buffer
EFSF vs. ESM 29
CDO SEMPLIFICATION
Debt issued is fully covered by AAA guarantees and cash. Strong commitment to further credit
enhancement mechanism in case of rating migration: the CDO features have been considered
irrelevant for rating purposes but they are important for precise pricing
ACCOUNTANCY ISSUE
Notwithstanding the fact that the non AAA guarantees are useless to get the AAA rating they do
account for national debt in the guarantors accounts
REDUCED LENDING CAPABILITIES
Due to over-guarantee mechanism the amount the EFSF can borrow is nearly 366b (440/1,2).
The lending power goes down to roughly 213b. The overall Euro rescue is reduced from 750b to
410b enough to save Greece, Ireland, Portugal, Belgium but not Spain
INCREASE CORRELATION AND CHANNELS OF CONTAGION DUE TO BAILOUT SYSTEM
Euro bailout: EFSF
EFSF weaknesses and strength
EFSF vs. ESM 30
Euro bailout: EFSF
On lending capabilities
Based on our assumptions, gross financing need the rescue package should be of around 643b to
include Spain, 1,5 trillion to cover also Italy
Font: BIMI reaserch
EFSF vs. ESM 31
Euro bailout: EFSF
EFSF rating agencies opinions
Weaknesses:
reduced lending ability
risk that the guarantee is not enforceable against the guarantor (German constitutional law ruling
on legality of the statute enabling Germany to guarantee EFSF's debt obligations still pending)
great dependence on AAA rated countries
Strengths:
strong political support from European countries; commitment to maintain EFSF creditworthiness
(provision of additional credit enhancement mechanism in case of rating migration). programme
conditionality and monitoring from EC, ECB
reduced operational risks due to German DBO acting as facility agent, with treasury and risk
management tasks, EIB providing administrative and legal support
the multi guarantees mechanism should enable the facility to fund herself easily also in difficult
market.
base for permanent ESM
EFSF vs. ESM 32
Euro bailout: EFSF
EFSF pricing as AAA basket (1)
For construction each debt issued will be a basket of AAA rated guarantees, cash, plus non AAA
guarantee. The basket will be homogeneous through tranches, but the cash buffer will vary in size.
Maxiumn
commitment
Original
contribution
keys
Out
Greece &
Ireland
Over
guarantees
Out
Greece,
Ireland &
Portugal
Over
guarantees
Out Greece,
Ireland,
Portugal &
Spain
Over
guarantees
Belgium 15292,18 3,48% 3,64% 4,36% 3,73% 4,48% 4,28% 5,14%
Germany 119390,07 27,13% 28,38% 34,06% 29,15% 34,98% 33,42% 40,11%
Ireland 7002,4 1,59% Out Out Out
Spain 52352,51 11,90% 12,45% 14,94% 12,78% 15,34% Out
France 89657,45 20,38% 21,32% 25,58% 21,89% 26,27% 25,10% 30,12%
Italy 78784,72 17,91% 18,73% 22,48% 19,24% 23,08% 22,05% 26,47%
Cyprus 863,09 0,20% 0,21% 0,25% 0,21% 0,25% 0,24% 0,29%
Luxembourg 1101,39 0,25% 0,26% 0,31% 0,27% 0,32% 0,31% 0,37%
Malta 9562.33.36 0,09% 0,09% 0,11% 0,10% 0,12% 0,11% 0,13%
Netherlands 25143,58 5,71% 5,98% 7,17% 6,14% 7,37% 7,04% 8,45%
Austria 12241,43 2,78% 2,91% 3,49% 2,99% 3,59% 3,43% 4,11%
Portugal 11035,38 2,51% 2,62% 3,15% Out Out
Slovenia 2072,92 0,47% 0,49% 0,59% 0,51% 0,61% 0,58% 0,70%
Slovakia 4371,54 0,99% 1,04% 1,25% 1,07% 1,28% 1,22% 1,47%
Finland 7905,2 1,80% 1,88% 2,26% 1,93% 2,32% 2,21% 2,66%
Greece 12387,7 2,82% Out Out Out
Total Guarantee 440000 100,00% 420609,9 1,2000000 409574,52 1,2000000 357222,01 1,2000000
AAA Gurantees 255439,12 58,05% 72,88% 74,84% 85,81%
Pricing
EFSF vs. ESM 33
Euro bailout: EFSF
EFSF pricing as AAA basket(2)
Forgetting the non AAA guarantees we can price the EFSF as a fixed AAA basket (using the asw level
and a cash level of euribor6m +8bps) we get the pricing below. In term of underlying risk the EFSF
should trade richer than EU and EIB issuance, but they are not comparable directly.
In the market EU and EFSF issuance are trading almost flat, due probably to perceived complexity,
weaker legal framework of the guarantees. Also we can expect the EFSF issuance to be highly
dependent to AAA rating migration issues. The correct way to look at EFSF is a convex replica of
underlying portfolio.
Out Greece
& Ireland
Out Greece,
Ireland &
Portugal
Out Greece,
Ireland,
Portugal &
Spain
Out Greece,
Ireland,
Portugal &
Italy
AAA Gurantees 72,88% 74,84% 85,81% 92,67%
AAA Pricing -27,45 -27,45 -27,45 -27,45
Cash buffer 27,12% 25,16% 14,19% 7,33%
Cash pricing 8,00 8,00 8,00 8,00
Pricing -17,83 -18,53 -22,42 -24,85
EFSF vs. ESM 34
Euro bailout: EFSF
EFSF pricing as AAA basket(3)
The correct way to look at EFSF as an investment product is as a replica of the underlying basket of AAA
guarantees and cash. In this way it offers 3 main advantages:
1. It trades cheaper than underlying basket almost 25 bps
2. It has a convex feature in case of AAA rating migration due to the non AAA guarantees.
3. The transaction cost (bid/offer) are lower than the replicating baskets
In this way EFSF issuance can be useful to replicate a AAA exposition ( for example in a government
fund) or mixed to replicate a benchmark index.
EFSF vs. ESM 35
Euro bailout: EFSF
Challenges and March 24-25 meeting decision
LENDING CAPABILITIES INCREASE TO ORIGINAL SIZE. Details postponed to next J une meeting.
Possible solutions:
increase the total amount of guarantees: by 72% to get to original 440b.
non AAA guarantors to deposit cash
take off the non AAA over-guarantees from ESFS debt and mix the EFSF funding instrument with
bilateral loan from weaker countries
leave the AAA rating: the weighted average of the guarantors is consistent with AA rating
a mix of increased AAA guarantees and upfront cash or collateral commitments from lower rated
countries.
SCOPE EXPANSION
government bonds purchase only in primary market under strict conditionality
No decision on pre-emptive short term loan
EFSF vs. ESM 36
Euro bailout: EFSF
EFSF for Ireland
To lend 17.7 billion to Ireland, the EFSF has set up a 27b billion programme. The first tranche of the
programme for Ireland was issued on 25 J anuary 2011
2%
36%
5%
46%
11%
middle east
asia
america
europe
uk
The amount transferred to Ireland was exactly the
issuance amount multiplied by the grossed-up
percentage of AAA member states (73%).
Therefore the cash reserve is 1.3b roughly, made up by
0,87b of fungible cash (0.5% of debt amount plus npv of
margin) and 0,43b of loan specifi buffer.
Amount issued 5 billion
Issue price: mid swap +6 bps
Effective lending cost to Ireland 5.9%
Applied margin: 2.47% on all maturities
Amount transferred to Ireland 3.6b
Cover ratio of 9.
EFSF vs. ESM 37
Euro bailout
European Issuance & Market Impact
On assumption EFSF programme for Portugal 35b, lending front loaded (60% in 1 year)
Ireland 2011 Done Q1 Remaining Timing 2012
EFSF 16,50 5,00 11,50 Next tranche secondo quarter, 2 benchmarks in first half 10,00
Benchmark bonds 3,00 1,00 2 2,00
EFSM 17,60 8,40 9,20 4,90
Benchmark bonds 4-5 2,00 2-3 benchmark transaction in first half 2011, at least one 10y bon 1-2
Portugal 2011 Done Q1 Remaining Timing 2012
EFSF 10,40 10,40 17,33
Benchmark bonds
EFSM 7,80 7,80 13,00
Benchmark bonds
Total 52 13,40 38,90 0,00 45
MARKET IMPACT
Issuance well perceived by the market
Spread tightening (core big peripheral) due to increase perceived correlation and core market
losing safe heaven bid, asset swap widening in core markets with asset swap curve flattening
No significant crowding out on supranational market
EFSF vs. ESM 38
Euro bailout
Euro bailout Euro bailout
Agenda
Towards resolution
Towards resolution Towards resolution
Overview
Overview Overview
EFSF vs. ESM 39
Towards resolution
A comprehensive response to sovereign crisis
Dynamite.
Economic imbalances intra Europe
Soft budget constraint
Implicit bail-in clause
Addressed by:
New level of economic governance and Pact for Euro
Strengthening of the Stability Pact
Making orderly restructuring possible and less costly
via ESM and stronger banks
EFSF vs. ESM 40
Towards resolution:ESM
One step forward (1)
On 24-25 March 2011, the European Council confirmed to establish a permanent crisis resolution
mechanism the European Stability Mechanism (ESM).
ESM is built entirely on the EFSF framework. The ESM will assume the role of the EFSF in providing
financial assistance to Euro area Member States after J une 2013. EFSF will remain operational until it
has received full payment of loans to Member States and repaid all liabilities. Any undisbursed or
unfunded portions of existing loan facilities will be transferred to the ESM.
EU INTERNATIONAL INSTITUTION
The ESM will be an intergovernmental organisation under public international law, set up by a treaty change (art. 136) via a
simplified revision procedure by end of 2012. The following wording will be added to art.136:
The member states whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard
the stability of the euro as a whole. The granting of any required financial assistance under the mechanism will be made subject
to strict conditionality
Revision procedure requires unanimity in the EU council (all 27) by end of 2012, national approval but no referenda.
New structure: EUROPEAN UNION INTERNATIONAL INSTITUTION makes the TRICK:
Contrary to the case of EFSF the debt of borrowing country will be recorded as due to the ESM and not
rerouted to Member states (Eurostat opinion)
EFSF vs. ESM 41
Towards resolution: ESM
One step forward (2)
STRUCTURE WITH CALLABLE CAPITAL (similar to multilateral development banks) should be
consistent with AAA rating without need of overcollateralization
LENDING CAPABILITY. Effective lending capacity will be 500b with 700b subscribed capital, unchanged
under original EFSF/EFSM facilities, but better efficiency ratio (48% 212 over 440, 71% 500 over 700)
PREFERED CREDITOR STATUS, JUNIOR ONLY TO IMF. This step is necessary to limit loss and could
limit negative effects of restructuring via debt buy-back
PRIVATE SECTOR INVOLVEMENT. Public acknowledgement that restructuring is a REAL
POSSIBILITY. ESM will be able both to:
provide liquidity to solvent states
bridge finance to states in process of negotiating a debt reduction.
Note that callable capital/ guarantee fromAAA will be 360b, plus 80b cash and probably some
convergence of EFSM 60b facilities
The ESM will have a capital structure similar to multilateral lending institutions. It can be expected that
this will be reflected in the assessment by credit rating agencies in line with their general standards for
subscribed capital and operating procedures of such institutions. fromEFSF faq.
EFSF vs. ESM 42
Towards resolution
EFSF vs. ESM
Temporary
Special vehicle
Capital endowment 30m (only 18m subscribed)
No decision making power ----------------------------
---
Individual guarantees
Liquidity assistance -------------------------------------
---
Primary market bond purchase under strict
conditionality
---------------------------------------------------------------
-----
440b guarantees ----------------------------------------
------------
Triple AAA 255b
Pari passu
Unanimity of EMS
ECB share contribution
Permanent
EU international institution
Capital endowment 700b
Decision making power based on mutual
agreement
Individual guarantees
Liquidity assistance and bridge finance in debt
restructuring
Primary market bond purchase under strict
conditionality
Private holders bail in if debt sustainability
analysis negative (CAC from 2013)
Mix of paid in capital (80b) and callable capital
and guarantees (620b)
Triple AAA 360b
Credit preferred status
Mutual agreement
ECB share contribution with small adjustment
EFSF vs. ESM 43
QUANTUM LEAP in the euro area debt crisis management?
ESM capital accumulation (pre-funding): as before the
guarantees/callable capital scheme activation risks
creating contagium when activated.
Secondary market purchase and short term pre-emptive
loan not addressed.
EU institution arrangement with single individual
guarantees (unanimity), not join and several as in EU
institution (qualified majority)
Lending capability almost unchanged
It takes courage to jump
Solid legal base with Treaty change
Accountancy issues solved
Preferred status and private holders involvement with risk
that bailout system becomes a source of contagium in
itself decreasing
Better efficiency ratio between total commitment and
lending power
Still to come One step forward
EFSF vs. ESM 44
Annex1. Changes to the SP existing rules by Eurogroup, Ecofin and the
ECouncil, on 20 March 2005
SP rules dilution:
While the official deficit threshold will be maintained, there will be a derogation allowing a member state to exceed
temporarily the 3 per cent figure to a limited extent in the event of slow economic growth (no precise figures being
provided).
A temporary (period of time not defined) deficit will not be declared excessive if the member state concerned
devotes considerable public expenditure to one of several other relevant factors 1) investment; 2) research and
development; 3) structural reforms (only those which have a long term impact on the solidity of public finances will
be taken into account); 4) EU policy goals; 5) European unification; 6) international solidarity (which the French
insisted would include spending on both aid and military). Further consideration would be given to these ill-defined
spending categories. Once the 3 per cent deficit limit is reached the Council and Commission will examine the
extent to which spending on these pertinent factors contribute to the deficit in question.
A member state which has achieved a public spending surplus during periods of relatively strong economic growth
and which has a relatively low debt burden will be treated more leniently
A member state exceeding the 3 per cent threshold will obtain a delay of 3 years to bring its deficit down again. The
objective remains to bring the deficit below the threshold within a year following the launch of the EDP but a
government can obtain a delay of a year if there are particular circumstances that should be taken into consideration
(notably slow economic growth). Before advancing to the sanctions procedure the Commission will prepare a report
to determine whether a supplementary delay of a year should be allowed.
EFSF vs. ESM 45
Annex1. Changes to the SP existing rules by Eurogroup, Ecofin and the
ECouncil, on 20 March 2005
Following the identification of an EDP by the Commission and the Council, a member state will have 6 months (not
just the current 4) to propose corrective measures.
As in the Commissions recommendation, member states are to avoid pro-cyclical budgets in good times (when real
growth is superior to potential growth) but there is to be no obligation for these member states to achieve a budget
surplus.
More effort will be demanded from member states with a relatively heavy debt burden which have not undertaken
structural reforms.
The mid-term objective of each member state will be determined with regard to two factors: 1) those member states
with low debt levels and strong growth are allowed a medium termdeficit of 1 per cent; 2) those member states with
high debt levels and weak growth prospects will have to move to a deficit close to balance or in surplus (as is
currently the case but this objective will be redefined every four years). Member states which have not yet attained
their medium term objective will have to reduce their structural deficit depending upon the level of economic
growth by 0.5 per cent of GDP. 13
EFSF vs. ESM 46
Annex2. Greek crisis escalation
Dec 9: Fitch downgrades to BBB+and S&P follows suit
Feb 10: Goldman Sachs scandal becomes public. Ackermann (DB Ceo) meets Papandreou and proposing Merkel
economic advisor a Greek bailout from private banks, Germany and France each lending 7.5b. The proposal is denied since
not complaint to art.125 of the TFEU.
March 10 New tax and salary cut to civil servant in return of some sort of solidarity fro European states. Situation more
pressing with 20b debt redemption in May. The European countries and ECB would have come in support of Greece.
April 10:Germany agrees to subsided a 30b Emu loan to Greece with additional 15b coming from IMF. On the 22th Apr EU
announces that Greek deficit for 2009 was at 13.6 higher than already reviewed number. On 23-Apr a 45b EMU/IMF plan
gets activated, on the 27-Apr National Bank of Greece and EFG Eurobank Ergasias get downgraded to junk from Moody's.
Greece is downgraded to junk status, Spain lowered to AA from AA+, Portugal from A+to A-.
On the 02 May Euro regions agree a greater bailout loan totalling 110b to bring the country through the next 3 years. ECB
announces that it would drop all the rating requirements for Greek bonds. Demonstrators set fires in Athens killing 3 people.
EFSF vs. ESM 47
Annex3. Cash buffer decomposition in EFSF
The cash buffer is made up by two component:
a general cash reserve (fungible cash reserve). An upfront fee of 0.5% applied on the principal amount of the loan plus the
net present value of the loan margin (2,47 for Ireland) is retained by EFSF from the cash amount disbursed to the borrower.
It will be the ultimate remuneration of the guarantors, but it is retained as loss absorbing capital and credited to a general
cash reserve together with any interest income. As loan get repaid and the cash reserve exceed the amount necessary to
repay the loan it becomes free cash and can be used to reduce the loan specific cash buffer for new loans. It will be
distributed only when all the funding instruments issued by EFSF have been repaid.
a loan specific cash buffer. It is sized in order to fill the gap between the nominal amount of the funding instrument, net of
funding cost (negative carry) and the 120% of the AAA rating guarantees plus the cash reserve. It will be used to cover
shortfalls in payments by a borrowing country should the guarantees be insufficient. If there will be no default, it will be used
to redeem the debt instrument. If the guarantees are called, the funds available under the LSCB may be transferred to the
guarantor Member States or maintained in the EFSF for possible future operations.
Cash investment guidelines.
For construction the EFSF will potentially have large amounts of cash. The guidelines investment policy have two objectives:
1) cash to be invested in high quality liquid debt instruments issued in euros, 2) reduce the negative carry between the cost
of funding and the investment holdings