EFSF: How not to structure a CDO
The EU’s plans for the EFSF are a retrospective masterclass in everything that went wrong with structured credit.
If the plans for the European Financial Stability Facility (EFSF) announced by EU leaders after their summit in late-October appear frightening, that is because they bring to mind horror classic The Return of the Living Dead. The scheme heralds the emergence from the grave of such structured finance frighteners as structured investment vehicles (SIVs) and synthetic CDOs – instruments that wreaked havoc in the market meltdown of 2007. This kind of financial engineering may have been a byword for all that was wrong with the pre-crash credit markets, but it has now returned rehabilitated as the solution rather than the problem.
That shows how disparate governments are. If one were tasked with designing a CDO that would be guaranteed to fail (and John Paulson and Goldman Sachs were otherwise engaged) it would be hard to come up with a better structure than what the EU is proposing for the EFSF.
By guaranteeing a first-loss piece of between 20% and 25% of future sovereign issuance from peripheral countries, the idea is that the fund – still only €440 billion in size – will calm the nerves of SSA investors, who will then return to the markets and resume buying as usual. But who will pay for this guarantee? The EFSF itself, which is funded by, er, Europe’s sovereigns. This will fill the fund’s boots with ‘assets’ that should in theory be highly rated but will probably turn out to have much higher default probability than their rating suggests. They will come from a small, select band of sovereign issuers and also be highly correlated.
The icing on the cake is the suggestion that the guarantee itself will be in the form of a credit default swap (CDS). This introduces the all-important synthetic element to the CDO and the attendant mark-to-market volatility. The fact that the EFSF will write the ‘protection’ could be particularly unattractive to investors. It is like buying CDS protection on the Greek sovereign from a Greek bank. Remember, those investors that did hedge their Greek exposure in the CDS market are now finding out the harsh realities of just how ineffective this tool can be in a distressed situation.
Not content with committing the EFSF to guaranteeing first-loss risk on sovereign issuance, the new plan seems also to commit it to guaranteeing the first loss on issuance from a new SPV that will be established to invest in – sovereign bonds. The default correlation between the two exposures is therefore dangerously close to one. This SPV will need to raise real cash from investors. That could be a tall order. But again, structured finance has the answer. If the SPV cannot raise the funds required in the term markets, it could maybe look to fund itself short-term.
By now the alarm bells should be ringing loudly because this is what the SIV market consisted of before it blew up so spectacularly at the beginning of the credit crisis. Indeed, the fact that this vehicle is being referred to as a SPIV (some sort of unholy combination of a SPV and a SIV?) should make quite clear the very dubious nature of what is being proposed.
All this frantic structuring cannot disguise the fact that the EFSF cannot bail out eurozone sovereigns and/or banks without incurring a material deterioration in its own risk profile. And that means that all the first-loss guarantees in the world will not entice investors to fund it. Which investors will be happy to take on the risk of a fund with undefined commitments to stand behind issuers of deteriorating credit quality?
Good luck with those business trips to China, Mr Regling. Welcome to your new job, Mr Draghi. Yet again Europe’s buyer of last resort – the European Central Bank – will have to step up to the plate.
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