Tuesday, September 27, 2011

Analysing the latest battle plan

Team Macro Man chuckled to themselves upon reading the A-Team's latest trial balloon, as the irony of an idea grown out of financial innovation and structured credit coupled with leverage is presented as the solution to a crisis caused by precisely the same things. But in seriousness, TMM are unconvinced that this particular implementation is going to work and give them a B- for effort and finally realising that the time has come to whip out the bazookas, but "must try harder".

The Eurocrats have certainly succeeded in making this plan to leverage the EFSF via the European Investment Bank (EIB) appear complex and thus fulfil the requirement of "pulling the wool over the eyes of electorates and the media", but there are a few problems with this particular implementation that in TMM's view make it a non-starter. As TMM have noted before, bailout complexity can be useful in addressing problems without political or electoral opposition, and they recommend readers take a look at Phillip Swagel's excellent account of the US Treasury under Hank Paulson. The key paragraph from that Brookings piece is:

"At Treasury, two additional lessons were learned: (1) we had better get to work on plans in case things got worse, and (2) many people in Washington, DC did not understand the implications of non-recourse lending from the Fed. This latter lesson was somewhat fortuitous, in that it took some time before the political class realized that the Fed had not just lent JP Morgan money to buy Bear Stearns, but in effect now owned the downside of a portfolio of $29 billion of possibly dodgy assets. This discovery of the lack of transparency of non-recourse lending by the Fed was to figure prominently in later financial rescue plans."

And this is where this plan falls down: it does not involve non-recourse lending. To see this, the plan diagrammatically looks like this (please excuse TMM's Noddy paint skills!):

So the leverage in this case would come from the SPV issuing bonds to the Eurozone banks which they could then repo with the ECB. As a result, the SPV, as a wholly owned subsidiary of the EIB, would have to be recapitalised by the EIB should its capital become depleted. And there are three serious problems here from what TMM can see. Either (i) the SPV is not guaranteed by the EIB, in which case its credit rating would be something like single-A, and therefore there would be few investors willing to buy its bonds, (ii) it would be guaranteed by EIB, and therefore in the case of it requiring more capital, EU members would be compelled to inject more and (iii), the UK is joint equal largest shareholder in the EIB (see chart below). The latter two possibilities are clearly very problematic as the leverage effectively comes in the form of more explicit exposures to EU governments - i.e. France and Germany lose their AAA ratings. But that is not all... The UK will also lose its AAA-rating. This just isn't going to fly in this form and TMM suspect the Dambusters will ruin the A-Team's attempt to build a Dam in front of the rest of Europe.

In TMM's view, the leverage HAS to come from the ECB, just as it did in the Fed lending programs like the Bear Stearns bailouts and TALF etc. And the lending *has* to be non-recourse, in order for losses beyond the initially capitalised 20% to accrue to an entity in such a manner that the EFSF bond and the SPV itself get a AAA rating (and therefore attract demand from SWFs). TMM think, therefore, that the structure needs to look more like this:

The trouble is, that the Bundeathstar really don't want to do this, and the Panzer tanks are firmly blocking the ECB lending to such an SPV. But, as mentioned yesterday, TMM get the impression that the Germans have overplayed their hand (for example, they don't have any friends at the G20), and unless they really are about to leave Europe, they are going to be forced to accept some such plan. The key thing with the above is that it maintains the cloak of complexity for the public, while showing markets where the money comes from, thus avoiding the need to put the plan to electorates. Because action is needed *now*, and there just isn't time there just isn't time to vote on this. Europe is unlikely to change its history of doing what it likes, regardless of voters' wishes.

17 comments:

Sleeper said...

In your diagram you show the SWFs lending to the EFSF and not to the SPV, but in the text you suggest the SWFs will lend to the SPV. Nothing to prevent both happening, but my understanding is that the SWFs want to lend to a joint and severally guaranteed body, which is presumably the EFSF. Although it could pass that guarantee through to the SPV.

The other question in all of this is recapitalising the banks - presumably you're expecting this to be done at the national level. Fair enough, but one way to centralise monetary and fiscal policy via the back door would be to have the bank stakes owned by a federal body.

cpmppi said...

Sleeper,

Apologies if that was not clear. The point was that SWFs are not going to lend to an entity (be it EFSF or the SPV) unless the bonds are AAA.

And yes, we'd agree with you on the recapitalisation... it can be done nationally, but many governments clearly cannot afford this (hence the EFSF being allowed to buy bank stakes in the latest legislation). Having EFSF or the SPV or whoever owning bank stakes addresses the problems of banks that have crossed borders, as you point out, moves us closer to de facto economic union.

Hotairmail said...

Well, clearly the whole purpose of the design from a French and German point of view was to 'share' the burden with their British comrades. Now if Blair were in charge I'm sure he would succumb to pleading (and threats) to show 'solidarity'.

I just hope this lot have a better idea of what is really going on than the last shower.

abee crombie said...

technical in Eurostoxx finally starting to look positive.

my philsophy has been that when all the EuroTarp stuff is in the news along with the fear you buy, when everyone is happy, you sell... but a bit scared going into October. Could just be another quarter end pump and dump

Anonymous said...

C says'
Abee you might end up being right about the "pump and dump",but looking across different asset classes that move against each other it looks to me like we might have overcooked the pot and be due some reversal of moneyflow on profit taking set against a wait and see Eurocrat decision process.
Even if macro is slowly deteriorating it's possible for markets to get too far ahead of it and that's what it feels like to me.

Patrick VB said...

Hello cpmppi,
Looking at the second diagram, in which there is no EIB involvment, I see you left the ECB buying bills from the EIB/SPV; I suppose this is a cut/paste mistake, or is there something that I missed?
Best regards,
Patrick VB

Nemo Incognito said...

Well, now that we've filled in the gap to last week's range conviction is fading.

Silver? Yours.

Polemic said...

Patrick well spotted you are right. We are trying to change now.. though shame the one on ft alphaville will remain wrong!

Thanks

Leftback said...

Plastic bazooka on show for now, TMM? That kind of weapon melts quite quickly when exposed to the Mediterranean sun.

This doesn't feel good. T bills haven't budged. USTs and bunds aren't off much. This is hedge fund CICO.
Cash in, cash out. Exit rally for trapped commodity longs?

Dollar strength to return? Sell commodities?

Anonymous said...

When you read things like this it makes you wonder if we will ever have to worry about your diagram chap. Split opens over Greek bail-out terms:
http://www.ft.com/cms/s/0/69902e72-e926-11e0-af7b-00144feab49a.html#axzz1ZBHa1Fj8

db

Leftback said...

Back into the trenches, TMM. Sell the news. What's that? There wasn't really any news?

This rally was started on TV by a story leaked by the man called Lies Man. Poor Mr Shorty.

We have been raising cash all day.

Anonymous said...

C says'
LB it's a weak close for equity and volume didn't look that positive either so discretion the better part of valour ?

Anonymous said...

C says'
thanks for the FT link ny the way now we know why the market did a swoon.And theirin remains the risk to getting any risk on.These f...g numpties could not agree when xmas was !!
It's easy ,step aside until they know when xmas is.

Leftback said...

It's December 6 in Germany for Saint Nick. Not sure about Greek Orthodox. Rather illustrates your point.

As far as LB is concerned, these stable wide trading ranges are Christmas.

Leftback said...

In a RORO market you have to GIGO.

Anonymous said...

@LB,

ROR - Raugh out roud. LOL

Anonymous said...

"...it took some time before the political class realized that the Fed...owned the downside of a portfolio of $29 billion of possibly dodgy assets."

Everyone that paid attention knew that that was the plan from the outset. The day after the decision was announced, the WaPo wrote:

"J.P. Morgan was unwilling to assume the risk of many of Bear Stearns's mortgage and other complicated assets, so the Federal Reserve agreed to take on the risk of about $30 billion worth of those investments."