Stocks have rallied in recent days on hopes that European Union leaders and policy-makers are close to an agreement that would significantly increase the firepower of the European Financial Stability Fund (EFSF) — essentially the euro zone's rescue fund for troubled member states — so that it can help deal with the zone's long-simmering debt crisis.
Mike Riddell, a fund manager at M&G Investments, believes there are more than one or two reasons this optimism could be misplaced. In fact, he believes there are 10.
1. The risk that one of the triple-A-rated guarantors of the EFSF could be downgraded, as Standard & Poor's warned over the weekend.
2. Riddell is also worried that the “EFSF’s current size and form aren’t sufficient to bail out Spain and Italy.”
3. However, he says, if the EFSF were big enough to bail out Spain and Italy, the chances of a downgrade increase.
4. Legal risk. “Investors in EFSF bonds have no understanding of what the money is to be used for. And if an EFSF guarantor reneges on its guarantee, then there’s no payback (so if Slovakia pulls out, Germany just ends up guaranteeing more)” said Riddell in a research note on Wednesday.
5. The fact that Spain and Italy would be initial guarantors of the scheme but could end up needing the EFSF’s support causes the problem of “fungibility”.
6. Varied guarantors, some of which could need bailouts themselves. “Each EFSF bond has different guarantors, so the first EFSF bond was issued in January to bail out Ireland. Portugal remains to this day one of the guarantors for that particular bond, despite Portugal itself also needing to be bailed out,” said Riddell, who also worries that another very large AAA-rated supranational issuer of bonds could crowd out other private sector entities or governments and push up their borrowing costs if they do not have an ‘explicit’ guarantee.
7. More bond-issuance from guarantors. “Further down the road, if bank or sovereign restructuring is necessary and the EFSF guarantors need to pay out to the EFSF investors, then the guarantors will need to raise money by issuing bonds, which increases debt levels, which leads you back to the risk of downgrade for the guarantors,” said Riddell.
8. A sovereign restructuring by a euro zone member would be “proof that the EFSF support mechanism and fiscal discipline measures have failed. It does nothing to address solvency.”
9. The EFSF is supposed to last until 2013, when it would need to start all over again with the European Stability Mechanism (ESM), which could subordinate the EFSF.
10. And finally, a lack of pre-funding. “Investors need to be persuaded to part with billions of euros to invest in a vehicle with an ever-expanding mandate that lends money to European governments and banks at precisely the time when the market has decided," Riddell said, "that those governments and banks are insolvent."