It appears that European leaders are still attempting to build a "firewall" around Italy and Spain by somehow transforming the European Financial Stability Facility (EFSF) into a bond insurer.
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German Chancellor Angela Merkel and French President Nicolas Sarkozy.
What seems to be under consideration is a scheme that would have the EFSF take the first 20 percent of any loss on euro zone sovereign debt .
According to French Finance Minister Francois Baroin, this would make the ESFS five times more effective.
The difficulty is that its not clear EFSF has enough capital to make good on its guarantees. Spain and Italy have around 2.2 trillion euros ($3.07 trillion) in bonds outstanding. Taking a 20 percent loss on those bonds would come close to entirely wiping out the 440 billion euro ($613 billion) fund.
The other problem is that the insurance scheme would transform sovereign debt into a structured credit that no one really knows how to price.
Former hedge-fund manager Bruce Krasting explains:
The enhanced bonds would be “Story” bonds. In my experience, story bonds have a very limited investor interest. I have no doubt that ten of billions of these bonds could be sold, but trillions? The USA Treasury market is the most liquid in the world. The total public float (excludes Fed and Intergovernmental) is about $9 trillion. The proposal is that an amount equal to 1/3 of the U.S. public float of new EU enhanced bonds are issued in just a few years. [In my humble opinion] that will never happen.
The global bond markets will have to figure out how to price this new debt. I’ve been pondering this for days. I can’t come up with a pricing structure that works.
Consider a newly issued 10-year Italian sovereign bond that has a 20 percent first loss guaranty by the EFSF. Assume that the German 10-year was 2 percent and Italian at 5 percent (about where we are today). You tell me, how is that new bond going to trade based on this?
This is not equivalent to 20 percent German risk and 80 percent Italian. That would be far too easy. But if the market were to trade it as an 80/20, it would imply that the new Italian Enhanced Bond (“IEB”) would yield about 4.4 percent. This would mean that the IEB/German spread would be 240 basis points, while older Italian debt had a spread of 300 basis points. If that were the result, it would be a disaster. While 60 basis points is a big deal, it would do nothing to stabilize Italy’s long-term debt cost. For a new program to work, it would have to drive the IIB/German spread to 100 basis points.
Krasting thinks the bonds will need a very high yield to attract investors, which makes them damn near pointless. The only way that the could trade at lower yields would be if the European Central Bank committed to holding down their yields. But that seems to be off the table for now.
It really is quite something to watch the leadership of Europe publicly demonstrate its delusions by attempting to resolve a credit crisis with the creation of a complex structured debt vehicle. Reminds me of the days when "The Entity" was going to save the U.S. banking system.
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