Note: The following essay published in mid-July has continued to attract enormous interest, several thousand hits, including from the very institutions mentioned in the text! For this reason I have decided to fix typos and add one new comment, which is that the most efficient way for the fund to work is merely to operate as a standby guarantor and loss insurer for Euro Area state borrowing of a kind that in the UK or USA would be facilitated off-budget and off-balance sheet by using treasury bills and asset repo swaps, but which in the Euro Area cannot because the member states’ money market operations have been given over to the ECB.Original July text version amended:
This EFSF, €440bn + €310bn IMF contribution, is the Euro Area's equivalent to TARP.
Klaus Regling is the chief executive of the European Financial Stability Fund (EFSF), two years after he stepped down as the European Commission’s most senior economy official. He is German, reflecting that Germany is supplying up to €148bn in debt guarantees, the largest slice of backing for the fund. The German national debt agency will help the fund to arrange the guarantees in July.
Sometime later this month (July 2010) the fund will become 'active' in theory when at least 90% of state guarantees are finalised. After borrowing, however quickly, or however long it takes, and then once it is able to begin lending it can issue loans only until June 13, 2013, i.e. only for three years, which is not nearly long enough to be realistic.
The 12 man tag team who will manage this will be in Luxembourg, probably in the glasshouse of the EIB.
Euro governments provide guarantees to secure a Triple-A rating for EFSF and it will then with European Investment Bank (EIB) and Bundesrepublik Deutschland Finanzagentur (BDF) raise the funding to back the loans.EFSF will borrow from markets to provide financial rescue funds to any indebted euro zone government needing cheaper debt - except the loans won't be cheap, not at all, and not when reputational risk of accepting IMF austerity packages is included, if that is what they will be?
If all €750bn is raised this year (v.unlikely) it will equal half again as much as all government gross borrowing in Europe in 2010 or all net borrowing after repaying maturing debt.
Who is going to write all the Medium Term Note paperwork along the lines of what private sector lenders normally require, with supporting financial account projections, a host of assurances, and then negotiate the borrowing rates?
Law firms and investment banks of course, I imagine, for a generous % fee. The scale and complexity of this is beyond both EIB and BDF in terms of their deal size experience, relationships, and their predictive analytics systems.
It is unlikely the borrowing can transpire on the basis of a few covering letters and government signed assurances, not when the Euro system's continuity is less than 100% certain, and not even though the total programme period is short, only three years?
This is another reason why governments want banks to borrow longer term, and to reduce competition for short to medium term needs such as to finance the EFSF.
The EFSF will have a staff of 12, a fact I shall repeat several times because I find it most incredible (worse than the 15 at UKFI ltd who manage £60bn of government bank investment in London, or the 15 who manage €20bn of structured finance at legacy Fortis). Tell it to any banker who knows what's involved professionally to staff up MTN programmes, even when using external advisors, and they will laugh until it hurts.
EFSF will have the help of EIB, IMF, ECB and BD Finanzagentur, so we hear. Are 12 core staff enough even merely to contract and relationship manage all of that, or enough even just to do PR and coordination, that is assuming they have a detailed roadmap of what to do, which I have good reasons to doubt?
The US similar scale of financial package, TARP, was staffed by 120 in 2008, then by 150, then plus another 200 staff on stability issues (by 2010), and that was only in the US Treasury. More staff were employed on TARP by the Federal Reserve and by its FDIC subsiudiary.
TARP is qualitatively different from EFSF, but only if one thinks that government finances are easier to understand than those of large financial groups, or that making agreements over loans and conditions with governments is easier than with banks or insurers or automobile manufacturers.
It may not be the case that all of this huge amount will be required. It may be that EFSF will not have to commit all its funding. No doubt the proponents of TARP thought the same until the Lehman Brothers was spectacularly allowed to fail.TARP took from Spring to Autumn of 2008 to get approved. The legislative process helped to detail it more fully - compared to the few pages setting out EFSF for political approval over a weekend rather than over 6 months in the case of TARP.
TARP allocated $250bn for buying preference shares of distressed banks, for example, but only spent about $180bn on that. Some loans amortised and the money rolled over.
Unexpected crisis funding came up, however, such as AIG, then FM&FM and GMAC. EFSF cannot be sure what unexpected requirements it may be called upon to deal with.
The ECB can help in providing liquidity support for EFSF if there are unexpected delays or other technical problems, much as it did recently by retiring nearly €500bn of liquidity on the one hand while extending €800bn on the other hand.
Perhaps the IMF standby contribution will not be called upon?
For EFSF's borrowers (governments in financial distress) there is only so much preferred stock in banks that can be bought without shareholder protests and nationalisation and European Commission approval hurdles involving considerable political overheads and politically arguing the economic uncertainties. Similarly, if buying bank assets (outright into ‘bad banks’), toxic or not, that should also be capable of being financed as a repo swap at central banks.
In the US example, about $400bn of TARP was allocated to buy banks' loanbook assets and another $50bn to cover against bank insolvencies (funding gap finance and capital shortfalls).
Unlike EFSF, which is trying to be a tiny office operation, TARP involved large (professional) staffing – with teams from US Treasury, Federal Reserve & FDIC, plus an audit unit, the Special Inspector General for the Troubled Asset Relief Program (SIGTARP). EC programmes will require a similar independent audit agency – but, who will do this; is one being established, or is this the IMF's job?
In the US, there was also Congressional Oversight Committee on the job, but where is the European Parliament in this matter?
This is all complicated by the Euro Area for which the EFSF is to exclusively apply being light on governance, it being only a big sub-section of the EU?
How much authority should the European Commission and European Parliament have over a Euro Area somewhat exclusive matter? Are important institutional and democratic accountability or constitutional borders and ‘Chinese Walls’ being ignored, fudged or constitutionally overthrown?
Thank goodness, direct borrowers and indirect (underwriting) lenders are both OECD governments who may therefore be trusted entirely to remain solvent, absolutely…or not?
Regarding the USA's TARP, SIGTARP reported to Congress that it found that "Inadequate oversight and insufficient information about what companies are doing with the money leaves the program open to fraud, including conflicts of interest facing fund managers, collusion between participants and vulnerabilities to money laundering" - strong stuff, no punches pulled, and all in glaring light of day (media coverage and Congressional oversight).
The Euro Area Council (like the EU Council) deliberations are not transparent, and, of course, the ECB and IMF are both NGOs whose democratic accountability (transparent decision reporting) are not legendary.
When the IMF lends on the basis of an agreed austerity package it has, in the past, turned up the gas (stiffer austerity conditions) to provoke the indebted emerging market governments to default on interest or payments so that the IMF can then legitimately claim on insurance cover and also exert penalty interest rates. That would not be an appropriate tactic in dealings with any OECD countries, let alone for EU states. But, the question arises, what, if any, penalties are actually envisaged for dealing with default? The answer is probably none since matters will not be allowed to get to that extremis point; there is too much flexibility available.
The underlying borrowers, the banks who borrow from their governments, may face domestic penalties asserted by their national governments and regulators should they default or misapply the funds, and perhaps as recommended quietly by the IMF?
The history of TARP is instructive and should be closely examined by all involved in EFSF. The Senate Congressional Oversight Panel created to oversee the TARP concluded on January 9, 2009 (when it was also concerned about refloating the property market and maintaining or raising bank lending in the economy to help recovery), "In particular, the Panel sees no evidence that the U.S. Treasury has used TARP funds to support the housing market by avoiding preventable foreclosures" and "Although half the money has not yet been received by the banks, hundreds of billions of dollars have been injected into the marketplace with no demonstrable effects on (bank) lending."
These are problems already being discovered internationally, not least in the UK where there is an embarrassing mismatch between survey data among corporate and small firm borrowers and what banks are publicly saying they are doing most assiduously to lend more. Who believes the banks in this matter?
Such issues are not explicitly part of the EFSF, except that the manner whereby banks improve and build on their state-aided solvency and therefore of the underlying economic recovery underpinning both the banks return to predictable profitability and the predictability of governments ability to repay loans to schedule will be of very considerable interest.
IMF, ECB, EIB, EC and member states' central banks or Germany's Debt management agency do not have models, however, to be able to track the feed through effects (and none likely to be available for 1-2 years). There will be a lot of finger-in-the-air forecasting based on short term macroeconomic data – but three years is not long enough for macroeconomic data (or macro-prudential data) to be sufficiently revised (retrospectively) to be reliable i.e. accurate.
Germany's glass HQ of its debt management agency.Herr Dr Regling expects the eurozone’s €440bn fund to be given triple-A rating by August to allow it to borrow most cheaply (at German Bund or French Government Bond rates). But, triple-A is a long term solvency rating. We may be dubious about such ratings for such a short term programme. Therefore the ratings will merely be an aggregation of the member states' guarantees i.e. their sovereign ratings.
It is, of course, most likely that the three year time-frame will be extended to ten years, and then we can expect the EFSF to transmogrify into an indefinitely long term emergency resource.
One has to wonder what board, governance, staffing, systems of analysis, policy documents and procedures will be in place, and by when, to safely command a fund worth five times one year’s total European Commission budget?
Regarding when (more than how) the European Financial Stability Facility will operate, Regling as CEO dutifully answered: “We will be ready to act whenever the politicians tell us to act.”
We may imagine that this fund can only become speedily operational by trusting to the professional good sense of governments (the borrowers), and relying on how they in turn on-lend to stricken banks.
Each transaction that becomes a state aid scheme for banks will require detailed assessment by Commission experts followed by discussions to reach agreement with national supervisory regulators, central banks and governments. That may or may not interfere with the speed of granting EFSF loans.
The IMF will also be involved to dictate how budget austerity measures are affected. And the ECB in each case to make systemic risk assessments of banking market impacts in the Euro Area, and in each state and significant region.
That would be sensible but oh so cumbersome. Such cumbersomeness is why the European Commission backtracked on engaging two sets of panel experts last Autumn (at a cost of a few €millions to do asset valuations of banks' loan collateral and predictive economic valuations over the cycle including competition issues). The EU state aid scheme assessment process and agreed legal requirements were set back a whole year at least. And now we cannot be sure exactly how all this validation and approval processing is to work? In effect, the process has been pushed back to member states, while in Brussels, DG Competition DG rules the roost. In fact, several DGs have become blurred, fuzzy and merged and yet are still floundering to find a solid baseline of policy-making and procedures.One problem is lack of tools (models with appropriately full sets of economics and banking data). Another problem is lack of internal Commission confidence and self-belief in its internal ability to organise - any and all of that is serious.
Such self-doubts do not figure at the high levels of President van Rompuy and CEO Regling. They have yet to appoint a board for the fund. Hopefully, the cost of lawyers, accountants, raters, loan underwritings, external advisors, other insurance etc. will not approach 4% as is typical of M&A - i.e. €7-15bn a year maybe over 3 years, which is far more than enough to ensure the big 4 audit firms and bulge bracket investment banks will be getting themselves enthroned in this massive fund - an outcome, for lack of expertise, organisational resource working to detailed planning, and adequate support systems, on the professional scale that any such enormous financial undertaking would normally require to be put in place.
I ask, should the fund not have been handed to the ECB, out of which departmental adjunct the Euro Area Council could then build its own fully equipped meta-treasury (money market operations) department?
Setting up EBRD, EIB and other such institutions took years. They never started with just a football team size.
EFSF tasks are bureaucratically and analytically onerous. It takes six months of very efficient work to get away an MTN program of say €50bn, which is huge, but which can only be done by following down well trodden paths - in effect, rolling over deals with previous lenders.
I would say, if asked, that raising €750bn takes at least one year to get underway and all of two years to book, and that would be fast error-free working.
The three year timescale (from lending to repayment) is absurd, doubly so against a back-drop of Euro governments borrowing over €1 trillion gross (excluding EFSF) this year alone.
All might go easier if governments pay a little extra to bondholders to insist that the €700bn of maturing bonds to be repaid this year should be redirected in lending to the EFSF, but that's just my naive imagining.
When Klaus Regling was a top German finance ministry official, he was responsible for negotiating regulations underpinning the set-up of the Euro, Europe’s common currency. Now he must road-fill the big holes left behind by that agreement such as the lack of a crisis resolution mechanism to rescue eurozone member states in a recession or in a financial crisis of the very type the Euro was originally conceived to safeguard against.As chief exec of EFSF, Regling may hope that this will be “more show than tell” and that the fund will be little used in practice, as his political masters, the finance ministers of the European Union, no doubt hope. His governance, staffing and organisational infrastructure (the lack thereof) should not reflect that hope.
Knowing the money markets as I do, I know that they will seek to test the EFSF to destruction.
Why do we think Regling and the Euro Area Council sponsors think EFSF may be involve more marching than fighting? Because, Regling told the FT on the 13th, “We don’t know whether there will ever be a financial operation” and “Finance ministers hope not. But it was very important that this facility was created. It has had a positive impact on the markets.” If ever anything was a red rag to the markets, it is surely just such braggadocio statements.
German voters, we are told many times, are worried the EFSF will become a a system for fiscal transfers from wealthy states of EU North to the profligate EU South. If the northern voters knew what keeps them employed they would welcome such transfers, but that’s not how they have been led to think. Potential investors are, according to the FT, skeptical about the high credit rating that Herr Regling is confident the stabilisation fund deserves. This is just silly. Everyone should welcome the development in theory and not fuss about the ratings; who trusts ratings agencies anymore anyway; publicly not the ECB, European Parliament, or the EC, and not the big banks?
Herr Regling is anxious to reassure everyone - good. He said in an interview in Frankfurt, “This is a crisis mechanism. The EFSF is a temporary arrangement ... That is very different to creating a permanent fiscal transfer mechanism.” Who will give me positive odds on that? Actually, this is not an obvious bet for the reason that reputational damage of borrowing from EFSF and incurring IMF austerity measures, or just the whiff of same, could prove a major disincentive.
Herr Regling (great name; it means formal rite of passage, to put discipline into a physical change, also invocation of a spirit, and as head of EFSF about whom there will be an opera one day, Regling von den Nibelungen): He is my age, 59, Chief executive of EFSF since July 1, served as head of the German finance ministry’s international policy department; played a role in the euro's introduction and drafting the EU Stability & Growth Pact.
At the time (mid to late ‘90s) when I visited his economists in Brussels, when I was curious why the Euro was being planned and introduced without the help of any external consultants, they told me it would be a disaster to delay the Euro's introduction, a disaster not to do it at all, and a disaster to go ahead with it! But, after 5 years, they said, we should all have learned how to reform it and make something better.
Now, ten years on, we are only starting, if at all, to reform the S&GP. I calculated in 1997/8 that, over the first 5 years of the Euro, banks would lose €500bn in gross trading profits and eke that back out of higher loan margins and fees and charges from mainly small firms first, then from big firms later, and consequently unemployment would rise in Europe by 5 millions against trend – these forecasts proved to be most accurate.
Today, 29% of Euro Area unemployment is in Spain. Will the EFSF make a dent in that or elsewhere? Will Regling and the EFSF (in the details of its operations) in effect change the workings of the Stability & Growth Pact sufficiently to form the basis for permanent reform? Is Regling up for this?
Regling worked as an economist for 35 years, including for the European Commission and the IMF. He was well known in Bundeskanzler Helmut Kohl’s government in the 1990s, and has close ties to many senior officials in Berlin therefore as well as in Brussels. Maybe he can carry enough persuasiveness backed by the €750bn to bring about major reform? The first such reforms should include not measuring deficits and debts merely gross, not net, or in ratios only to GDP, not GNP, and not by ignoring the general stance of each of the EU economies (such as three basic types: trade deficit credit boomand property-led, trade surplus-led net industrial or energy exporters, or roughly external balance neutral)!On the European principle that what ten Americans do one European can do, EFSF will operate from a Luxembourg office with c.12 staff, with Germany’s debt management agency serving as the “front office”. Even the UK's FI Ltd. to oversee arm's-length ownership of RBS and LBG banks have three more staff than this! Has ever so much money been managed by so few?
€750bn is more relatively 'free' funds than IMF, BIS or most central banks have, and they need more than 12 people just to set up and maintain the simplest of computer systems! EFSF will obviously be a spreadsheet, email and otherwise paperless office. Any advisors bidding to provide some heavyweight analysis in support of EFSF will have an easy procurement process to negotiate. In an office of 12, nothing can be done except on a buddy system grapevine.
Malta will provide €400m. If I know Malta that can’t be without a few jobs for Maltese, at least 2 surely? But, if extended to the 18 other guarantors, on that basis, the staffing alone should be 1,000, and by then we might get a serious organisation doing seriously detailed work?
The EFSF has been described all round as a “shock and awe” package to reassure markets over mounting sovereign debt. But, money and bond markets are not in the game of receiving reassurance - they are in the game of cage-rattling the Euro system to seek to keep bond yields volatile to thereby profit by.
As far as the financial markets are concerned, provisions have been built into the facility to ensure that it gains triple A status from the credit rating agencies and could therefore borrow at most favourable interest rates. Hmmm? What is the risk management policy? Where in the EFSF is there an ALCO and independent risk officers, pr the computer systems for tracking, and all such matters that any rating agency would look at before rating a bank?
Of course, EFSF is only supposed to be on the model of an SPV (Special Purpose Vehicle) as in a asset-backed securitisation bond issue i.e. a few lawyers and accountants supported by external bankers, more lawyers and accountants and auditors.
EFSF will have standby liquidity for smoothing cash-flows just like a real SPV, and a cash reserve built up from fees charged to countries using the facility. While, as another cushion, member countries have also guaranteed to pay up to 20% more than their agreed shares of the fund. We can imagine 5% fees (say €20bn - €35bn), which would be a substantial standby fund, but might that not defeat the object of providing cheap funding? A 1% fee would be hardly enough to do more than pay for external advice, underwriting and insurance costs.
Investors have questions about the structure of the EFSF - who is their counterparty? - and about the solvency of EFSF's debtors - and the precise details of each state guarantor's guarantees?
The prospectuses (not prospecti) will be hundreds of pages on which will ride the security for hundreds of millions of Euros per page perhaps? It is not suddenly a ten pager if EFSF has a triple-A rating tomorrow. How long will it keep that, and what is the probability of a series of downgrades over the next three years? There are few people capable of answering that question systematically.
Herr Regling said ministers have promised to do whatever is needed to make sure he gets triple-A. There's the rub. What can that be and are there limits? Total guarantee means the contributing governments have to take the potential debt onto their books – but, that they won't do. The whole point of this is that EFSF should be off-budget, off-balance sheet, hence the SPV format, an insolvency-remote vehicle – but, is it? Such status (risk grading) is normally achieved not by assessing collateral (or guarantees for all losses) but by assessing the credit quality of the underlying assets, the beneficiary borrowers, and here we enter the world of macroeconomics as well as each borrower country's banking sector (relative to the economy in which it operates).
Are the 12 staff of EFSF professional financial geniuses or paper-shuffling Eurocrats, or both?
Will IMF forecasts or ECB liquidity guarantees furnish sufficient underwriting to each borrower state's central bank or finance ministry? There are unpredictable creditor as well as debtor risks.
We have a complexity here of risk and constitutions and time factors and governance all of which needs to be explained in excruciating legally binding fiduciary detail.
Lenders to EFSF have their own ALCO rules and risk assurance process to navigate.
Not even the ECB can issue standby postdated encashable cheques or depository credit to the value of €100s of billions, can it?
How is all this to be short circuited and managed by a staff of 12, imagine Seven Samurai and five support staff? The main work is to be done by Germany's Debt Management Agency and the EIB (European Investment Bank).
Herr Regling has sought to reassure the markets that the German Constitutional Court in Karlsruhe will not decide to uphold complaints that the EFSF facility violates the German constitution and or EU treaties. Right! Legal Risks; must be page 612 of the prospectus. He admitted that doubts about the court’s future ruling were an important issue in the assessment of the rating agencies. Right, Moody's, Fitch and S&P have risk models, not for what happens before EFSF gets triple-A and starts borrowing, but for afterwards when suddenly some loans might be called in early?
But, Regling thinks a ruling against the facility is “highly unlikely” to have any practical effect on potential bondholders, because German participation in the scheme had been formally approved by the Bundestag in Berlin.
And some early motions failed, but that's not to say further motions could not be put. If the EFSF does lend to any government, it will be at a premium to its cost of borrowing: Regling said this would be “comparable” to the charge on Greece of 300 basis points when it borrowed €110bn from Eurozone governments earlier this year. OK, but then in assessing the on-lending as bank state aid, the rule is no favours; loans must be priced at market rates. The hope must therefore be that the prevailing market rates come down, and then that the loans are fixed-rate for three years, which could mean substantial profit for the EFSF - could it? Yes, the premium (profit) would accumulate and should be repaid to governments guaranteeing the funds loans, confirmed Herr Regling personally.
The EFSF will operate in Luxembourg with a dozen staff, and Germany’s Debt Mmanagement Agency (Bundesrepublik Deutschland Finanzagentur) that is used to managing up to €40bn a quarter in issuance (in packets of €5bn) will function as a “front office” for the EFSF, issuing any bonds, while the European Investment Bank (€232bn capital, €103bn loans to infrastructure projects and small firms, 1,000 staff) will provide “back office” accounting and legal functions.
Let's hope the EFSF does not become a lender generating €700bn in borrowings and loans – it could overwhelm these hitherto cuddly, and ethical if somewhat prosaic, banking institutions. It would be unpleasant to witness them haggling across the table with a bunch of salivating investment bankers like me.
Here for the less scrupulous salesmen is the EIB's org chart:
At German insistence, Eurozone governments agreed to give the EFSF only a three-year life. Herr Regling said the facility would close after three years if it made no loans, which sounds like the best incentivisation to make loans. “If there is a financial operation its life will be extended until the last loan is repaid,” he said. Herr Regling told the FT the fund is a temporary crisis mechanism but could be extended beyond its intended three-year lifespan if any loans to eurozone governments remained outstanding beyond June 2013.
Let’s hope no one involved becomes unusually rich?
Governments can borrow if they agree to adopt reform programmes designed by the IMF, European Commission and the European Central Bank. This extends the role of both the Commission and ECB in ways that I expect borrowers would fiercely wish to resist, hence any borrowing will be a clear signal of desperation!
Furthermore, borrowing states will pay a charge comparable to that levied on Greece when granted an emergency bail-out this year, i.e. 300bp! “It does not mean there is an ATM machine. Everyone agrees that countries only get money when they accept conditionality,” Regling added. With the results of stress tests on European banks imminent, Mr Regling said the fund would not be used directly to shore up ailing banks, but that governments drawing on the facility can use the money for bank recapitalisation. And, presumably, to replace funding provided earlier?
But, again, the issue arises that borrowing from EFSF may be such a last resort that any states borrowing from it will suffer downgradings in every other respect, because this would signal extreme cash-flow problems, and therefore the cost of doing so could be unpredictable and many times higher across the rest of the economy?
Greece is already in such a junk rating position. Can we imagine Spain, Portugal, Ireland or Italy going down this route. I suggest not.
The Spanish Cajas simply doubled their liquidity recently from ECB to about €130bn instead of seeking it from the Spanish government, who might then think to apply to the EFSF.
Herr Regling does not believe in transparency and would therefore resist political oversight such as by the European Parliament. But it is very unlikely that we will not all find out immediately who needs this expensive money (despite IMF conditions) as soon as any requests are formally made or merely informally discussed!
Note that one way to use the money (or the triple-A promise of it) is as surety guarantees, as standby insurance, to underwrite countries' borrowings. But the fund itself is so far merely or mainly guarantees. Hence a publicly announced set of state gurantees becomes potentially a meta-set of further guarantees for state borrowing.
Note for constitutional legal eagles: There are interesting issues to be explored in the loss of constitutional separation of powers and responsibilities between the ECB and European Commission, and other fudging that is another reason for calling EFSF a temporary emergency measure. I for ione predict that EFSF or something very like it will become permanent and still be here ten years from now.
see also (1 October 2010): http://www.qfinance.com/blogs/ian-fraser/2010/10/01/we-need-a-stronger-efsf-to-stop-the-piigs-from-slip-sliding-away-sovereign-debt-crisis
