30 March 2012
“The Mother of All Firewalls”. The Eurozone combines its stability mechanisms to EUR 800 bn
Introduction
Since the second Greek bail-out was agreed in February this year, the international community has been urging the Eurozone to take action to contain the sovereign debt crisis from spreading. Although the immediate threat posed by Greece has been contained, the Spanish and Italian economies are still considered weak. All eyes have now turned towards the Eurozone’s financial stability mechanisms with the head of the OECD, Angelo Gurria, perhaps echoing the markets’ sentiment best, stating in his calls to the Eurozone to bolster its stability funds:
“The mother of all firewalls should be in place… It’s something you’re telling the markets: I’ve got the firepower and, if I need to, I’m going to use it” .
The ‘magic number’ EUR 1tn appeared to be the general consensus, among the international community and a number of Eurozone members alike, as the minimum amount required to sufficiently stave off the risk of contagion. With the EFSF’s lending capacity diminished by recent bail-outs, the pressure was on to fix the firewall.
Germany’s chancellor, Angela Merkel, head of the Eurozone’s largest and most influential economy, has, however, always been reluctant to change the plans regarding the Eurozone’s stability mechanisms, let alone to increase their firepower. However, on 30 March 2012, the Eurozone finance ministers did agree to combine the European Financial Stability Facility and the European Stability Mechanism (the Eurozone’s fledgling permanent financial stability fund) in the hope of creating a firewall strong enough to contain the sovereign debt crisis.
In this update, we take a look at the Eurozone’s stability mechanisms, what they are and how they work and what the new combined funds will mean in terms of size and capacity to contain the sovereign debt risk.
Eurozone Stability Mechanisms
The European Financial Stability Facility
On 9 May 2010, the 27 Member States of the European Union agreed to create the European Financial Stability Facility (EFSF). The EFSF was incorporated on 7 June 2010 as a private company under the laws of Luxembourg (a Société Anonyme). The EFSF was created to preserve the financial stability of Europe’s monetary union by providing financial assistance to Eurozone Member States, if needed. Created as a temporary facility in lieu of a permanent stabilisation mechanism (in the form of the European Stability Mechanism – see below), it technically terminates automatically on 30 June 2013. However, since the EFSF was activated in 2011 in connection with a series of bail-outs (see below), it will now remain in existence until such loans have been fully repaid (or the Member States agree otherwise).
The EFSF’s scope of activity includes the authority to :
• issue bonds or other debt instruments on the market to raise the funds needed to provide loans to countries in financial difficulties;
• intervene in the debt primary and secondary markets;
• act on the basis of a precautionary programme; and
• finance recapitalisations of financial institutions through loans to governments including in non-programme countries.
Although the EFSF works closely together with the IMF and its financial assistance programmes mirror those of the IMF, unlike the IMF, the EFSF does not enjoy preferred creditor status. Private investors may be reluctant to provide loans if there were too many preferred creditors, defeating one of the objectives of the fund which is to assist Member States to return to the normal debt markets.
The EFSF is authorised to issue bonds for a maximum amount of EUR 780 bn, which corresponds to a EUR 440 bn lending capacity .
The EFSF can only act:
• after a support request is made by a Eurozone Member State;
• a country programme has been negotiated with the European Commission and the IMF in liaison with the ECB;
• that programme has been accepted by the Eurozone’s finance ministers; and
• a memorandum of understanding has been signed .
Very simply summarised, the EFSF works by issuing bonds backed by (usually AAA rated) Eurozone Member States guarantees with the EFSF lending that money to those Eurozone Member States (“Lender State”). They then, in turn, on-lend that money (so-called “back-to back” lending) to the relevant debt-stricken Eurozone Member States (“Borrower State”). It is important to note that, from an accounting perspective, this means that the amounts “drawn” under the EFSF, therefore, ultimately both register on the Lender State’s and the Borrower State’s balance sheets, increasing both their debt levels.
The EUR 440 bn lending capacity is boosted by the European Financial Stabilisation Mechanism (EFSM) which can issue loans up to EUR 60 bn. These funds are obtained by the European Commission raising funds on the market using the EU budget as collateral. The combination of these two funds means that the initial temporary Eurozone “firewall’s” maximum lending capacity is EUR 500 bn.
The EFSF was activated for the first time on 28 November 2011 in connection with the EUR 85 bn Irish Bail-Out. Since then both Portugal and Greece (for a second time ), have requested assistance, respectively amounts totalling EUR 78 bn and EUR 130 bn. As a result of the EFSF’s participation in these bail-outs (totalling EUR 200 bn), the facilities’ capacity has diminished to EUR 240 bn; nearly half of its total capacity. This has been seen by many, including the main international and economical institutions such as the IMF and the OECD, as insufficient safeguard against contagion in the Eurozone.
The European Stability Mechanism
The European Stability Mechanism (ESM), as intended at its creation, is the permanent replacement of the EFSF. It was given a legislative base in December 2010 by way of a simple, two-line amendment to the Treaty of Lisbon which avoided the further need for Member State referendums. In addition to the amendment, a separate treaty establishing the ESM was signed on 2 February 2012 .
Follow the link to download a copy of the treaty:
EN»»
PT»»
Under the current terms of the ESM treaty, unlike the EFSF, the ESM is not a private company. It will be an intergovernmental institution established under public law. It is expected to come into force in July 2012 or as early as sufficient Member States ratify the treaty. Initially, it was foreseen that the ESM would run parallel to the EFSF for one overlapping year and then replace the EFSF in 2013.
The ESM’s scope of activity is the same as that of the EFSF (see above) and it too requires a support request and country programme agreed with the European Commission, IMF and ECB before it can act. Its overall lending capacity is capped at EUR 500 bn. Unlike the EFSF, it lends directly to Member States requiring support, avoiding the need for additional debt to be registered on the balance sheets of Lender States. Loans issued by the ESM will enjoy preferred creditor status but will be subordinated to the IMF’s claims.
As mentioned above, initially the ESM was to replace the EFSF in 2013. However, the need for the EFSF to be activated called into question (i) how the EFSF and the ESM would now work in practice and (ii) what the overall lending capacity of the funds should be given the current sovereign debt crisis.
The Firewall
Once the dust had settled on the second Greek bail-out, the attention turned to how to prevent any further contagion in the Eurozone (and potentially beyond its borders). Most experts agreed that a “bazooka” or “firewall” of financial stability support would be the best medicine (or perhaps vaccine in this case) for the sickly Eurozone economy.
An internal discussion among Eurozone members ensued regarding the future of the funds. Germany did not see the need to increase the firepower of either fund as it would make no difference in their opinion. But many finance ministers wanted to see the EFSF merge with the ESM rather than it being replaced by it. This could potentially increase the ESM’s firewall to EUR 740 bn of “fresh lending” capacity. The international community also persistently urged Eurozone ministers to consider putting a mega-firewall in place to contain the risk of contagion.
Come March 2012, Eurozone finance ministers were ready to take a decision on the future of the financial stability funds and the need for a bigger firewall. However, ministers looked likely to clash over its size when they met in Copenhagen at the end of the month.
On March 30 2012, an agreement was reached to combine the EFSF and the ESM as follows (summarised):
• The ESM’s time-table will be brought forward, which effectively means that the paid-in capital will be made available more quickly with two instalments to be made in 2012, two in 2013 and a final instalment in 2014 .
• The ESM will be the main instrument to finance new programmes as from July 2012.
• The EFSF will only remain active in respect of financing programmes that have started before that date (i.e. the bail-outs to Ireland, Portugal and Greece totalling EUR 200bn), although it can technically dip into the EUR 240 if it needs to until mid-2013.
• The combined overall ceiling for ESM/EFSF lending will be set at EUR 700 billion (ESM EUR 500 bn + EUR 200bn already paid out by the EFSF).
• In addition EUR 49 billion out of the EFSM and EUR 53 billion out of the bilateral Greek loan facility have already been paid out to support current programme countries.
Follow the link to download the official Statement of the Eurogroup dated 30 March 2012: http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ecofin/129381.pdf
The Eurogroup goes on to explain in the statement, that, when you add everything up. “All together the euro area is mobilising an overall firewall of approximately EUR 800 billion, more than USD 1 trillion”.
Conclusion
Critics have been quick to point out that, in fact, nothing has really significantly changed other than that the ESM time-table has been brought forward; that this is, in fact, not the “mother of all firewalls” that Mr Gurria and the international community at large were hoping for.
However, Eurozone ministers are now hopeful that the significance of combining the two stability funds and showing that the numbers “add up”, will be sufficient incentive for the participants to double the IMF fire fighting reserves next month at the Spring Meetings of the IMF and the World Bank.
[1] Statements given on 27 March 2012
[2] For more detailed information on the EFSF please refer to its website: http://www.efsf.europa.eu/about/index.htm
[3] A2 - http://www.efsf.europa.eu/attachments/faq_en.pdf
[4] This is explained by the credit enhancement structure which includes an overguarantee of up to 165%.
[5] EFSF FAQ’s: http://www.efsf.europa.eu/attachments/faq_en.pdf
[6] The first Greek bail-out took place prior to the EFSF being incorporated and it therefore falls outside its scope.
[7] The information in the following section is based upon legislation and information otherwise available in the public domain in force at the date of this update. It is does not take into consideration any changes to relevant legislation that have not been made public at this time.
[8] Amendment Art 136 Treaty of Lisbon: “The member states whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality”.
[9] The Treaty on the Functioning of the European Union
[10] Technically two treaties have been agreed in this respect, with an initial treaty being agreed on 11 July 2011. However, only the later version is expected to be ratified and implemented.
13 March
Greek PSI deal completed
Introduction
On 24 February 2012, Greece opened the Private Sector Involvement debt swap deal (PSI) to bondholders. Essentially the deal involved a swap that meant bondholders would have to accept a 53.5% cut on the face value of their bonds which, in real terms, meant a loss of approximately 75% on their investment. The deal will be the largest financial restructuring in history, dwarfing the Argentinean restructuring in 2005 valued at EUR 33.3 bn and even the Brazilian restructuring back in 1988 which was, until now, the largest restructuring at EUR 47.3 bn. The offer closed on 8 March 2012.
For the deal to be a success, certain thresholds would need to be met and decisions to be taken:
• at least 50% of bondholders needed to participate for the quorum requirements to be met;
• 66% needed to actually tender their bonds for Greece to be able to activate the Collective Action Clauses (CACs) if necessary;
• if Greece activated the CACs, it could achieve a maximum of 86% participation - which is all of the Greek law bonds issued;
• A minimum of 95% participation in the total PSI deal (Greek law and non-Greek law bonds) is required for Greece to be able to reduce its debt to 120% of GDP – the target for obtaining the second bail-out package that Greece needs to avoid default.
Greek PSI Deal Successful
On Friday 9 March, Greece announced that the PSI deal had been successfully completed with 85.8% (or approximately EUR 152 bn) of the EUR 177 bn in Greek law bonds being tendered. This meant that the threshold of 66% had been, allowing Greece to activate the Collective Action Clauses which would force the remaining Greek law bondholders to accept the terms as well.
In addition, in the meantime, Greece confirmed it had received tenders for around 69% of the non-Greek law bonds, bringing the total of tendered bonds under the PSI deal up to approximately EUR 197 bn or 95.7% of the total face value of the bonds subject to the deal . To view the official press release, click here.
The markets soared and the deal was hailed as a success by Greece, Eurozone finance ministers, the IMF and the ECB. Greece claims it is to be a new beginning and Eurozone finance ministers hope it is a beginning to the end of the Eurozone’s financial crisis.
However, experts remain skeptical whether this will fix the problem or whether it, in fact, is just buying time. Most experts still believe that Greece will either need a third bailout later down the line, or will be forced to default and leave the Eurozone anyway. Only time will tell.
CDSs Triggered
An important consequence of Greece activating the CACs, is the consequential impact it could have on the Credit Default Swaps (CDSs) issued in connection with the bonds, carrying an estimated aggregate value of EUR 2.43 bn. For more detail on the issues surrounding the CDSs, please see our update.
Late on Friday 9 March, the ISDA’s EMEA Determination Committee ruled that the activation of the Collective Action Clauses had triggered a Credit Event and that an auction will be held through which the net pay outs under the Greek debt will be determined. The net cash payout on a CDS upon the occurrence of a Credit Event, is the face value of the CDS minus the recovery value of the underlying bonds as determined at the CDS auction. For example, if the CDS auction results in a recovery value of 25%, the aggregate amount payable would, in this case be 75% of EUR 2.43 bn: EUR 1.82 bn. The auction will be held on 19 March 2012.
Although the decision of the ISDA Determination Committee was expected, it has still been hailed as an important decision in confirming the nature and role of CDSs in respect of sovereign debt. Had the ISDA ruled otherwise, experts argue that CDSs would have become incredible and unreliable as a financial product and could have resulted in troubled Eurozone countries seeing their bond yields rise as investors try to find an alternative way to hedge their risk. Again, see our update on Credit Default Swaps for more information in this respect.
For the official statement by the ISDA EMEA Determination Committee, clique here.
Second Bail-Out Package Approved
As a result of the completion of the PSI deal (and Greece meeting the other requirements), European finance ministers agreed, on 12 March 2012 at a conference, that Greece's EUR 130 bn second bail-out package should proceed. The official approval will be issued on 14 March 2012.
4 March
The Greek Credit Default Swap
The latest additions to the Greek debt saga and the Eurozone crisis are the Credit Default Swap holders and the ISDA. But who are they and what is their role?
What is a Credit Default Swap (CDS)?
A CDS is most simply described as a type of insurance against the risk of a default on a debt issued by a third party (the reference obligor). Technically a CDS is a financial swap agreement whereby the seller of the CDS agrees to compensate (usually the face value of the underlying instrument) the buyer in the event of a (loan) default or other credit event in respect of an underlying instrument issued by a reference obligor. In exchange for this protection, the buyer pays the seller a fee or “spread” expressed as a percentage of the notional principal amount .
For example: if Country A has issued government bonds to B, then B could ask to buy a CDS from C to cover the risk of A not being able to repay the bond when it matures. Party B and Party C then enter into an agreement whereby B agrees to pay C a fee and C agrees to pay the value of the bond in the event that A goes bankrupt or doesn’t repay the bond. A has nothing to do with the CDS itself.
It is also possible to purchase CDSs without owning a related underlying instrument. These types of CDSs are called Naked CDSs. A CDS buyer is then speculating on the default of the underlying instrument and betting he can buy it at a cheaper rate when it does default. The EU agreed to a ban on Naked CDSs in respect of sovereign debt at the end of 2011 .
CDSs were first “invented” in the 1990´s and played a large part in the financial melt down in 2008 when large American insurance companies could not fulfil their payment obligations in respect of CDSs issued in connection with mortgages which had subsequently turned sour.
Oddly enough, although the current CDS market is estimated to be worth around USD 32 tn this year, CDSs are not traded on any official exchange and are unregulated by any (national or international) governmental body. The International Swaps and Derivatives Association (ISDA), which is made up of high profile banks, hedge funds and investment houses , acts as a governing body and publishes guidelines and standard documentation.
How does it work?
During the lifetime of a CDS (usually around 5 years), the buyer will pay the spread to the seller. A payment under a CDS is triggered by a so-called “Credit Event”. These Credit Events are usually the direct insolvency of the entity or state issuing the relevant underlying instrument or a default in payments thereof . When a Credit Event occurs, depending on the terms of the CDS, the buyer receives the agreed compensation payment (usually the face value of the underlying instrument) and ownership of the underlying instrument is transferred to the seller.
Why is this relevant to the Greek Debt Crisis?
When the private investors bought Greek sovereign (and other) debt, it is fair to assume that at least a large portion of them purchased CDSs to hedge their risk. However, on 24 February, the Greek PSI restructuring offer was launched [CREATE HYPERLINK TO UPDATE ON THE TERMS OF THE DEAL] which “invited” bond holders to swap their current bonds for new bonds which, among other things, included a 53.5% face value write down of their debt. The ECB (which is currently estimated to hold around EUR 177 bn of Greek debt) is also required to swap its bonds, but under the terms of the restructuring, it would not be subject to the debt write down.
This led Greek debt CDS holders to ask two questions. In summary:
1. whether the holders of Greek bonds had been subordinated to the ECB as a result of the fact that the ECB would not participate in the write down, which would constitute a Credit Event? and
2. whether the 50% debt write down – which could technically be deemed a failure to make payment on the underlying instrument – could itself constitute a Credit Event.?
If either (or both) of these situations would constitute a Credit Event, then it would result in the payment of billions of Euro’s to CDS holders, reminiscent of the 2008 CDS melt down. Some experts have speculated that an event like that could further destabilise the financial markets, others believe that it has already been “priced” into the Greek market.
If neither situation would constitute a Credit Event, then the role of the CDS, at least certainly with regard to securing sovereign debt, could be severely damaged. In addition, if bond holders can no longer hedge their risk sufficiently, this could, in turn, send government bond yields in the weaker Eurozone countries rocketing (again) as lenders pass on the additional cost of the risk.
On 1 March 2012, the ISDA’s EMEA Determinations Committee unanimously ruled that neither of the two questions submitted constituted a Credit Event .
To view the full statement click here.
While the ISDA has not given a formal explanation for its ruling, most experts agree that it is based on the fact that the PSI restructuring is on a “voluntary” basis - and this is an important distinction.
Greece has made it clear that it will not hesitate to use special Collective Action Clauses (CACs) which will force bond holders to participate in the PSI debt restructuring. If these CACs are triggered participation will no longer be voluntary and it is very likely that the ISDA EMEA Determination Committee will find themselves, once again, looking at the Greek CDSs and being forced to take a decision which may, not only have consequences for the future of CDSs, but also have knock-on effects for Greece and the rest of the Eurozone.
It is important to note that the ISDA EMEA Determination Committee left the backdoor open for themselves. In their statement they say: “that the situation in the Hellenic Republic is still evolving” and that they reserve the right to change their minds if new facts come to light (i.e. the results of the PSI restructuring offer).
Officially the term of the PSI restructuring offer ends on 8 March. In the meantime, bondholders are prowling around, eyeing each other up. The terms of the offer mean that if there is less than 66% take up, then the CACs cannot be triggered and the PSI restructuring will not be able to take place – a key requirement for the bail-out funding. If Greece doesn’t get the money it needs under the bail-out to pay the EUR 14.5 bn due this month, then default would seem imminent. The cost of a disorderly default of Greece is currently estimated at over EUR 1 tn and bond holders can whistle for their money with the rest of Greece’s creditors. However, if over 90% take up on the deal, then it is likely that the remaining bondholders would get paid out fully anyway so many bondholders may prefer to sit tight and hope everyone else will accept the offer. Something of a prisoners dilemma.]
2 March
On 2 March, the 25 of the 27 EU members committed to the new “Fiscal Compact” concept, signed the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union.
The Treaty, which is technically an intergovernmental treaty and not an EU instrument (due to the UK and the Czech Republic not wishing to sign up to it), was introduced in December 2011 by Germany and France. The signed treaty is the result of a concerted effort by the Eurozone and the majority of the other EU members to impose fiscal and financial discipline among themselves.
The main elements of the Treaty include:
the introduction of the “balanced budget rule” which effectively means that that national budgets should be balanced or in surplus; this principle will be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5% of GDP;
the balanced budget rule is to be incorporated into national (constitutional) legislation;
the European Courts of Justice may impose a penalty of up to 0.1% of GDP, payable to the ESM, if the balanced budget rule is not transposed to national legislation correctly or within the given timeframe;
an automatic correction mechanism will be triggered in the event a government deviates from the balanced budget rule;
there will be reversed qualified majority voting in respect of the decision whether to place a country in an excessive deficit procedure; and
the treaty also includes provisions on the coordination and convergence of EU Member State’s economic policies and on governance of the Eurozone. In particular Euro Summit meetings will take place at least twice a year.
Now the Treaty has been signed, it must now be ratified by the Member States. In some cases, such as Ireland, this may require a referendum to be held. Provided at least 12 parties to the Treaty ratify it, the Treaty will enter into force on 1 January 2013.
