Trader Talk

Traders Trying to Handicap EU Summit

Sell into the news? Traders are already trying to handicap the EU Summit meeting on October 23.

Naturally, skeptics abound, particularly around the concept of using the EFSF as a "first loss" insurance policy. Under this scenario, sovereign bondswill be issued to finance expiring bonds, and the EFSF will be used to back, say, the first 20 percent of any losses.

While this may not be the only solution — and there is considerable debate about whether Germany will even agree to leverage the EFSF— it is one major aspect of the package being discussed, along with a bigger haircut on Greek debt and recapitalization of banks.

Here're the major objections to using the EFSF as an insurance policy:

1) the leverage is constrained by the size of the fund and will likely not satisfy markets. Many analysts have pointed out that the 440 billion euros available to the EFSF has already been partially committed to Greece, Portugal, and Irish bonds, so the amounts available to lever are lower — perhaps 350 billion. Some additional money may also be held back to recapitalize European banks, we don't know how much, but it may be an additional 50 to 100 billion euros, reducing the available leverage to perhaps 250 billion euros. Thus, even if the fund is levered 4x, to 1 billion euros, it is still short of market "expectations" of 2 trillion euros.

The EU, of course, is well aware of this problem. That's why you are hearing these "trial balloons" about emerging market countries contributing to the EFSF (via the IMF) to increase the "bazooka" of the EFSF. Having, say, Brazil or India contribute money would help solve that lack of leverage.

2) even if a greatly leveraged EFSF is created, investors are not likely to be comforted by these insurance policies for very long because the economies of Italy and Spain will likely worsen. Investors will likely demand even higher insurance, putting even more pressure on the EFSF's limited resources.

This is certainly a possibility, and that's why some say that that if an insurance policy is pursued, the losses insured should be closer to 40 percent than 20 percent to cut short this argument.

It does go to the heart of the debate: is the idea of a "first loss" on insurance policies enough to ring-fence the contagion? It's not clear, but supporters point out that it would: 1) likely result in lower yields for (insured) Italian and Spanish bonds, and possibly for the uninsured bonds as well, and 2) greatly reduce the likelihood of a default in Spain or Italy, at least in the next few years.

3) there cannot be "unlimited" firepower without full backing from the ECB, which is unlikely to happen. That's true, whether the ECB will step in ultimately is also hotly debated.

Thank you, Moody's! As annoying as these now-daily debt downgrades are (they downgraded Spain's debt last night by two notches), they are serving to focus the concentration of the European Union on the need for a broader, accelerated solution to Europe's debt crisis.

Moody's put it bluntly on Spain: "no credible resolution of the current sovereign debt crisis has emerged." They are maintaining a negative outlook on Spain's rating "to reflect the downside risks from a potential further escalation of the euro area crisis."

What would change that opinion? A "structural reform plan coupled with a convincing solution to the euro area crisis would trigger a return to a stable outlook."

Nothing like a blunt assessment to focus the attention at the EU Summit.

Spain will have the opportunity to start dealing with the need for structural reforms, particularly of the uncompetitive labor market and government spending, soon: there are elections in November. In the meantime, expressions of clear support from the EU is essential.

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