“We are all reacting to headlines – every new headline triggers another move. There is so much uncertainty it’s difficult to navigate.”Thus spoke Jack Ablin, chief investment officer of Harris Private Bank, quoted in an article published in The Guardian. The article first appeared online on Oct. 18 at 19.35 BST (14.35 EST) with the headline: “France and Germany ready to agree €2 trillion euro rescue fund.” Needless to say, as per Mr. Ablin’s prediction, New York markets moved significantly on the news, The Wall Street Journal Real Time Brussels blog reported. An European Union official told us that the figure had been derived through a “simplistic” method. The endowment of the fund is €440 billion but it can guarantee commitments of up to €780 billion. The question of how to “leverage” it to maximize its firepower has been dividing European policy-makers ahead of the upcoming summits here in Brussels this weekend. Over the last few days, debate appears to be centering around the idea that the EFSF will guarantee first losses in Italian and Spanish new bond issuances. The Guardian story reported that “Senior diplomats say this will deliver a fivefold increase in the fund’s firepower – giving it more than €2 trillion compared with the current €440 billion lending capability.” First, let’s look at where this “fivefold” idea comes from. Let’s assume Italy wants to issue €10 billion in bonds. The EFSF could buy them, using up €10 billion of its firepower. But if instead the EFSF guarantees 20% of the value, as an inducement to private investors who actually buy the bonds, the EFSF only uses up €2 billion. Essentially, Italy can issue €50 billion of insured bonds at a cost of just €10 billion to the EFSF. Of course the exercise isn’t that simple, nor is its benefit to the firepower of the EFSF so easy to calculate. But, let’s just accept that it is in order to follow the reasoning presented in the Guardian. Even so, the €2 trillion figure is highly misleading. Here’s why. The EFSF’s €440 billion isn’t all to be used for Italian and Spanish bond purchases. Of that endowment, EUR26 billion will be dedicated to Portugal’s bailout plan, €17.7 billion will go to Ireland and a considerable percentage of €109 billion will go to the new Greek bailout. For argument’s sake, let’s assume this new bailout will be €109 billion and that the IMF will pay one third of it, keeping its participation at the level of the first Greek bailout. Under these plausible assumptions, the EFSF will pay around €72.6 billion of the second Greek program. It’s also highly likely that the EFSF will take on part or all of the remainder of the Greek bailout program, which will be around €35 billion after the disbursement of the November tranche. Total EFSF outlays to the three program countries add up to €116.4 billion. Another function the EFSF will be used for is bank recapitalization. According to the Guardian story “Overall recapitalization required will be closer to €100 billion… French and German banks, senior sources said, can meet the new capital ratio target of their own without recourse to state funds, let alone the EFSF.” So of the €100 billion required for bank recapitalization, some will not come from the EFSF. Let’s assume the EFSF bank recapitalization outlay will be €50 billion, with Germany and France sorting their own houses out. So if we’re following the Guardian reasoning, we should be doing the following basic arithmetic: €440 billion minus €116.4 billion (Greece, Ireland, Portugal) minus €50 billion for the banks. Equals €273.6 billion. That is the figure which, under our assumptions, will be used for first-loss guarantees in the Italian and Spanish bond markets. Now let’s turn to the issue of multiplying that by a number that reflects how the EFSF will be leveraged. According to the Guardian sources, that will be five. However, Dow Jones Newswires has reported that negotiations are closer to a 25% first-loss guarantee. That would turn the five into a four. See how easily the €2 trillion+ figure becomes… €1 trillion? Without even going into technical analysis of the leveraged EFSF, the estimate is halved. All of which suggests headlines aren’t always the best thing to go by. Read more.
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