Did the Europeans Just Invent a New Government Backed Derivative?

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The chief executive of the European Financial Stability Facility has written a letter to the Financial Times to explain why EFSF bonds are not CDOs.

CDOs, or collateralized debt obligations, are a type of structured financial product that is funded by payments made from bonds or other fixed-income securities. CDOs typically have multiple tranches, which represent different payment priorities. (For example, junior tranches of the CDO would get paid after senior tranches. Junior tranches, therefore, would pay higher rates of interest to compensate investors for their additional risk.)

CDOs are fairly complicated securities—and when a financial stability special purpose vehicle like the EFSF gets compared to such securities their management can get a little upset.

In his letter to the Financial Times, Klaus Regling, the chief executive of the EFSF argued why he believes EFSF bonds aren't CDOs: "The essential difference between the EFSF and a CDO is that EFSF debt has no tranche structure. There is no seniority and all investors have exactly the same rights."

Joseph Cotterill, in his coverage for the Financial Times Alphaville, argues the opposite case:

"For argument’s sake, never mind that the FT noted the EFSF is not technically a CDO in any case. (And cast aside thoughts that Regling doth protest too much, perhaps.)"

"We’re still not convinced. In fact, we think Regling is underselling the EFSF’s biggest strength — its flexibility, achieved through structured finance — by denying all CDO comparisons."

If you found the argument and counterargument confusing, you're probably not alone.

And that may be just the point.

When a special purpose vehicle, which was intended to increase the stability of sovereign debt, begins to receive criticism because of the complexity of its structure, you can be forgiven for wondering if it does more harm than good.


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