Quick view: P for Ponzi: Europe’s EFSF gets a rating

So, what’s new?
The EFSF has just been awarded triple A ratings with a stable outlook by the three largest ratings agencies. This on a day that peripheral government bond spreads widened aggressively once again (Portugal up 27bps in yield at the time of writing, Ireland up 20bps – almost as much in a day as the margin they used to trade above Bunds between 2000 and 2007). The timing comes immediately before a potentially difficult fortnight for the eurozone, during which we expect general strikes, political challenges and further new issue supply, which will continue to test the countries of the eurozone periphery and the resolve of Germany in the core.

So what do we, as European fixed income investors, think of the ratings announcements?
There are four key points, which we examine in more detail below:
• The stable outlooks from the agencies look behind the curve
• The EFSF rating will be tied to the underlying rating, just like a CDO
• The EFSF is seen by eurozone politicians and ratings agencies as the panacea to sort things out
• Government involvement in financial engineering is a concern

A stable outlook?
The stable outlook upon which the agencies unanimously agree is incongruous with the fundamental data on the creditworthiness of each of the guarantor countries. Furthermore, a comparison with market direction and velocity suggests the agencies are, once again, behind the curve. In terms of raw fundamentals, all eurozone countries are on track to breach the Stability and Growth Pact this year2. Even with Europe’s chequered history on fiscal discipline, that is a poor result for 2010. Indeed, we have a situation in which every single country is borrowing more (not only more than was borrowed in total debt stock last year, but more than has been enshrined in eurozone treaties) – how can that possibly be called stable? With the 1930s-style government balance sheet deterioration we are seeing two to three years after the last banking crisis (a parallel well drawn by Kenneth Rogoff and Carmen Reinhart), it begs the question as to what conditions would cause the ratings agencies to give a negative outlook?

Hard fundamental facts suggest pan-eurozone government debt dynamics are far from stable

In Moody’s opinion, for example, 15 of the 16 underlying participating countries have stable ratings outlooks. These include Portugal, Ireland, Greece and Belgium, whose CDS spreads are included below.
CDS spreads in the eurozone – markets do not agree with the ratings agencies

The CDS market clearly does not agree with Moody’s, S&P and Fitch (and as we noted above, the fundamentals clearly do not agree either.) Someone – either the CDS market or the ratings agencies
– is very, very wrong. Based on past performance (fundamentals matter, markets anticipate, ratings agencies tend to lag), where would you place your bet?

The EFSF rating will be tied to the underlying rating, just like a CDO
It is important to understand that the guarantee structure of the EFSF is very different to many existing supranational issuers. Some supranational issuers, such as the European Investment Bank (EIB) for example, have a joint and several guarantee. This means bondholders have contractual rights to pursue the strongest guarantor for coupons and principal under the terms of the issuer’s guarantee structure and bond documentation.

The EFSF does not enjoy this same support. At the EFSF, each country guarantees 120% of their share. This means that under existing documentation, the strongest country cannot be held accountable for guaranteeing the full amount of issuance, just 120% of their share alone. As such, countries other than Germany are key to the AAA/Aaa rating of the EFSF. Should those countries lose AAA/Aaa status, the EFSF rating will also be under threat. Should those other countries be in a position of serious weakness, EFSF coupon payments will be in a position of serious weakness.
Structured finance market participants will be well aware of this: such a sensitivity of the overall to the underlying is a very similar phenomenon to CDOs. Financial engineering cannot magic a good overall rating out of too many poor constituents. The demise of securities that had monoline guarantees of subprime CDOs (where both the guarantor and the underlying enjoyed triple A ratings from all three ratings agencies) is worth remembering. As Moody’s point out, ‘the creditworthiness of issuance programmes would be particularly sensitive to changes in the ratings of Aaa countries with large EFSF contribution keys, i.e. Germany, France and the Netherlands’. Moody’s have a point here.

So how safe are the triple A ratings of Germany, France and the Netherlands?
Germany has many features of a ‘top notch’ borrower. Leaving aside its projected fiscal deficit this year, the structural lack of domestic demand, the sensitivity to the global trade cycle and political instability given the unpopularity of the Merkel coalition (which has seen the incumbent coalition lose state elections and lose a President), Germany’s creditworthiness still remains far superior to the other large eurozone governments. This leaves it deserving of a rating that gives distinction.
The Netherlands has among the highest consumer debt in the eurozone as the tax regime remains advantageous to property speculation. Nevertheless, with a strong external surplus and leading multinational exporting corporations, the Netherlands is not in a bad spot.
France, however, is the potential Achilles heel of the EFSF’s triple A rating over the next few years.

Consider the following:
• The European Commission forecast France’s annual deficit to be higher than Portugal, Italy or Malta in 2010 (see the following chart)
• The French government has not balanced its books since 1974
• Sarkozy’s attempts to engineer Thatcher-style structural reforms have met with overwhelming popular resistance. Sarkozy lost his majority in the Senate chamber earlier in 2010 and his Budget Minister, Eric Woerth, continues to be investigated for fraud
• According to some studies of consolidated total liabilities, the post-retirement obligations facing the French state (the underfunding of the Fonds de reserve pour les retraites) put the country’s finances in one of the worst consolidated positions in Europe

The bottom line is that financially engineered collective structures without joint and several guarantees follow the direction of the weakest links. This does not suit the eurozone and yet any other solution – involving Germany alone – would overwhelm their AAA/Aaa status.

The great white hope of the EFSF
The EFSF is seen by eurozone politicians and ratings agencies as some sort of panacea to resolve
all the problems of the eurozone government debt crisis and draw some sort of line under the affair.
In S&P’s words, ‘we consider EFSF to be the cornerstone of the EU’s strategy to restore financial stability to the eurozone sovereign debt market’. Yikes. How about improving the fundamentals as a cornerstone of restoring financial stability?
First of all, markets should have learned by now that the era of implicit guarantees (buying bonds of failed bond issuers because the bank/company/country in question is in some way too big to fail) is over as an investable thesis. It might have worked during the Greenspan era – in a benign external environment in a world of plentiful capital and consequence-free investment mistakes -, but a postfinancial crisis environment is not the same. There is no longer the financial appetite or political appetite to bail-out every failed issuer.
Second, the idea of issuing debt to bail out debt is clearly circular (and has echoes of Charles Ponzi). Indeed, if you put the EFSF mechanism into Microsoft Excel, the program wouldn’t take it.

Circular references have a logical fuse.
Third, the resolve of German taxpayers to finance the periphery forever, and without any democratic due process and accountability, clearly cannot be taken for granted. Decisions in Brussels about where hard-earned German taxes should be sent will, at some stage, provoke more opposition than the state electoral defeats and Presidential resignations that we have seen earlier this year. (No taxation without representation is not a new banner!)
Even though the German banking system is itself entangled in the web of European government debt cross-holdings via its large and levered non-German government bond holdings – diverting German taxpayer funds beyond German borders, and weakening Germany’s credit profile, both seem a high price to pay when the domestic banks might still need extra capital injections anyway.

Further complications of financial engineering (FE)
Once entities go down the route of financial engineering, it can be difficult to stop. S&P write, ‘the stable outlook reflects…EFSF’s policy of investing both the reserve and the buffer in ‘AAA’ securities at all times.’
The concept of buffers and reserves are sensible, but eurozone governments are now in the fixed income investment industry. When they invest both the reserve and the buffer, are they investing in Germany 10yr at 2.375% or Spain, which is still inappropriately rated Aaa by Moody’s?
Option A – borrowing at Germany + a spread over Bunds to buy Germany – is a negative carry trade and requires financing. Option B however, buying Spain [insert alternative positive carry investment idea here] clearly introduces a circularity and systemic risk that is surely not a good idea. How is any capital hole, whether mark to market or write down, financed? The buffer and reserve mean that required issuance will be much larger than the actual liquidity requirements of the failed EU government in question. All of this is arguably not good for Bunds.

A final comment – governments as monoline insurers
Moody’s point out, ‘the cash reserve will ultimately provide remuneration for the guarantors, but will initially be retained by the EFSF as loss-absorbing capital’. In a world of fiscal retrenchment, governments putting aside capital to profit from the debt guarantee business (at up to EUR440bn) is an odd outcome. It says something curious about fiscal spending priorities. New hospital? No. New transport network? Can’t afford it. Ambac-style public sector business model? Up and running. After all markets have been through, it seems a strange course of action. On May 10th, it was decided that eurozone government contributions to the EFSF would at first be notional only. Now it seems that, with little improvement in peripheral Eurozone borrowing spreads, hard cash may be required.
As with the monoline insurance industry’s approach to guaranteeing AAA/Aaa securities pre-2007, there seems to be little planning to discuss what would happen next if the guarantees bankrupted the guarantors. ‘Good France / Bad France’ seems more of an unsettling prospect than the ‘Good Bank / Bad Bank’ plans mooted for many of the failed monoline insurers, Irish banks and so on.
Moody’s, at least, expand on this topic. The agency’s expectation is that, should the EFSF be unable to service its debt requirements, Germany, France and so on, would double down. So, a big danke and merci to the taxpayers of those countries. But when those taxpayers sit down and think hard and carefully about that 3am idea of their unelected pan-eurozone political elite (van Rompuy, Barrosso, Rehn and so on), they might just begin to ask, in the cold light of day, is this really what they want?

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1 Note we use the word governments, not sovereigns: the 16 countries gave up currency and monetary policy sovereignty years ago and cannot decide, as of today, how much fiscal sovereignty to give away. For fiscal policy, the strongest eurozone countries need to decide to ‘share’ or ‘shaft’ – as UK game show host Robert Kilroy-Silk would have it. Note also, the EFSF’s power has shrunk to EUR427.6bn as Greece has already opted out of the guarantee mechanism.

2 For the first time ever. Luxembourg ran only a 0.7% deficit in 2009, but the European Commission forecast a 4.2% general government deficit in 2010.