Tuesday, January 11, 2011

Circular Reasoning

Yesterday I read a report about the European Sovereign Somethingorother Fund (EFSF), one of many acronyms Ma Merkel assures us is set to ride to the rescue should the campaign to recolonize -- sorry, I mean rescue -- the PiIGS (Portugal, ireland, Italy, Greece and Spain) gets really hairy.  In includes the first chart, which details the respective contributions various European countries have made to this particular Deus Ex Machina, which represent $440b in total firepower.

This sounds like the big guns at first, but it turns out to be remarkably expensive to bail out even rinky-dink little countries like Greece and Ireland (and Portugal pretty soon).  For example, later in the report they give a breakdown of Ireland's recent $85b bailout.  About a quarter comes from raiding the country's pensions (65 year old Irish have just doubled down on Guinness), about a quarter comes from the EFSF, and the rest from the IMF and related alphabet soups.  The point being that Ireland is set to receive $22b out of this $440b, despite the fact that it contributed only $7b.  Of course, if they only got out what they put in, it wouldn't be a bailout.

But take a glance at the other chart, from this morning's WSJ, which has the CDS spreads on these countries' debt.  Credit Default Swaps are insurance the lenders can buy in case the guy they're loaning to skips town -- so this chart shows how everyone is confident that the Germans will pay their debt back, but increasingly less so for the rest of the dominoes.  Looking at this got me thinking about what the appropriate CDS spread for the EFSF itself would be.  After all, this is essentially a distressed bond fund like any other.  Each country agrees to put up the capital shown, and on the basis of this collateral, the fund will go out and borrow in the markets.  True to form, S&P and Moody's have blessed this structure with their kiss of death -- a perfect AAA rating -- so it's practically guaranteed to blow up.  Because the ratings agencies are walking on eggshells at this point, they did manage to extract a pound of flesh, and the fund will only be able to issue $367b worth of debt, so that the total sovereign guarantees backing it are 120% of the amount of bonds it can issue and subsequently use to make rescue loans.  That sounds safe, ¿right?

Look at what happens, though, when you try to bail out one of the big PiIGS.  Ireland gets $22b from the fund, Greece got $110b in total, and let's say that includes $28b from the fund, just to use the same breakdown between rescuers.  This means that Greece got between 2 and 3 times what they put in.  They haven't announced Portugal's package yet because they are still busy denying that it will need a bailout, but we can guess that if Portugal is about the same size as Greece (as measured by their contributions to the fund, which I'm assuming were calculated off of something like their respective contributions to eurozone GDP) it will get about the same amount of bailout.  So the little countries -- the P, the lower case i, and the G -- are eating up around $75b of capacity.  If the ratio of fund bailout to fund contribution hold at, say, 2.5 times, bailing out Spain would require $156b and Italy would cost $236b.

Let's see then:

$28 + $22 + $236 + $28 + $156 = $470 billion > $440 billion >> $367 billion

Hmmmm ...

Maybe we should be generous and assume that Italy won't need a bailout.  In that case, the fund would disburse $234b, or 64% of its total capacity to the 4 remaining borrowers.  However, given that it doesn't make much sense for Spain to try pulling itself up by its own bootstraps  (the last entity that crafted a successful program of loaning to itself was called Enron), there is a clause in the fund whereby a country being rescued is no longer liable for their contribution.  If Spain pulls out of its $52b commitment, the fund's available capacity would be reduced by 120% of this amount, leaving it with $388b nominally and around $305b of effective firepower, $234b of which (77%) would have been loaned to PiGS.  And that's not even adjusting for the guys who are exempt because they're already being bailed out (though they are smaller) Of course, theoretically Germany and France could just pony up more, but try telling the Germans and French that.

So now look at this bond fund from the perspective of an investor.  You loan these guys $440b, of which only $388b has a contingent guarantee that does not contain a political bomb, and they're going to go invest 60% of it in dodgy Southern European countries that have had huge property bubbles, face years of austerity budgets and wage deflation, and already have other sovereign debts about the same size as the GDP (not to mention private and financial sector debt, which we have seen migrates to the sovereign as a last resort).  I admit, you have some wiggle room.  You could probably get your money back if the losses to these guys were under 20%.  But what sort of credit spread would you demand for investing in this?  Where should the price of its own CDS fall in the continuum of that chart?

On second thought, I'm probably being just pessimistic.  I'm sure somebody will bail out the bailout.  So what could go wrong?

See and download the full gallery on posterous

UPDATE: Apparently, the Capitalist Axiomatic is not big in Japan.  Go figure.
Japan has pledged to buy more than 20 per cent of the eurozone’s first ever bond issue, raising expectations that other international investors will support the pioneering fund-raising move and help ease the region’s debt crisis.
The European financial stability facility, the €440bn ($570bn) eurozone bail-out fund, is marketing its first bond issue of up to €5bn among investors in Europe, the US and Asia. Bankers close to the deal are confident of attracting support from sovereign wealth funds in China, Norway and the Middle East.


Zantox said...

Sovereign wealth funds, national treasuries and other governmental bond purchasers have more motivation than purely return.

Both Japan and China need trading partners and an investment like this does double duty of buying goodwill and ensuring they have people to sell to.

Clark said...

My inner snark wants to say that they *better* have more motivation than that.

But of course you're right. Not only do they buy themselves some goodwill and room for further currency maneuver, but they may already be the bond creditors with the most to lose.

Since Brad Setser went off the air I haven't followed how much the various usual surplus suspects have invested in Europe, but certainly they also suffer from any defaults or even further currency weakness.

Zantox said...

Of course they *better* have more motivation :)

You just happen to have written from the "bond market" perspective, which is only driven on return and a slight tone of irony in your Japanese update.

Their purchases actually do more than double duty as well (had to hit and run comment earlier) -- they help keep afloat the Euro (since both are trying to keep their currencies low), shore up their bad investment with good money (as you noted in your comment), provide stability and support for a non-greenback treasury alternative, perhaps win a political friend on the international stage (whaling, WTO, other contentious issues, etc) and ultimately why not chase a little bit of return as a kicker? It's not like USTs are big returners these days...

At the end of the day, even if the Japanese/Chinese governments gets most -- or even some -- of their money back, its probably a pretty good investment. But for you, me or the "bond vigilantes"? eh, pass.