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Monday, October 24, 2011 11:59 AM

EU Weighs Insurance, SPIV Leverage, Needs Rating Agencies to Go Along; German-French Spread at New Record High 1.20%; Fear "of" Reaching a Deal

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Once again the bond market flashes huge warning signals even as equity prices head North. This will resolve in a major way, and the bond market is likely right.

Meanwhile the EU still looks to increase the firepower of the EFSF and that leverage is one of the things weighing on the bond market. In the latest absurd proposal, the EU may combine insurance, SPIV to boost euro fund

The euro zone should combine two proposals for increasing the firepower of its rescue fund -- an insurance model and a special purpose investment vehicle (SPIV) -- according to an EU paper for the mid-week summit obtained by Reuters on Monday.

The paper said neither option would require politically-difficult changes to the existing European Financial Stability Facility (EFSF), which has been approved by national parliaments after some problematic debates.

The euro zone wants to boost the firepower of its 440 billion euro bailout fund without putting more money into it.

Under the credit enhancement or insurance model, the EFSF could boost market confidence in new debt issued by a struggling member state by guaranteeing an unspecified proportion of the losses that could be incurred in the event of a default.

This would work via the EFSF extending a loan to a member state, which would buy EFSF bonds in return. The bonds would be the collateral for a partial protection certificate to be held in trust for the state. Both the bond and the certificate would be freely tradable, according to the paper.

Under the SPIV scheme, one or more vehicles would be set up either centrally or in a beneficiary member state to invest in sovereign bonds in the primary and secondary markets.

Its structure -- the senior debt instrument could be credit rated and targeted at traditional fixed income investors -- is meant to attract international public and private investors, according to the paper.

"The SPIV ... would aim to create additional liquidity and market capacity to extend loans, for bank recapitalization via a member state and for buying bonds in the primary and secondary market with the intention of reducing member states' cost of issuance," the paper said.

The paper said the insurance option would not work for every member state because some are no longer on the primary market, and also because some have negative pledge clauses on existing debt, which prevent them from granting new security to creditors without granting existing creditors the same level of security.

It concluded that "the leverage which can be achieved can only be determined after dialogue with investors and rating agencies.
Can't Get Something For Nothing

Every proposal to date wants to get something for nothing. France wants to print money and so does Krugman. The monetary printing non-solution would violate the Maastricht Treaty.

The insurance scheme and the SPIV scheme cause one or more of the following four problem.

  1. Increase losses beyond the size of the EFSF fund
  2. Create complex bonds investors will shun,
  3. Cost the EFSF its AAA rating
  4. Cost France its AAA rating

Nonetheless the EU is hell-bent on increasing the firepower.

Fear of Reaching a Catastrophic Deal

Wolfgang Münchau writing for the Financial Times says Europe is now leveraging for a catastrophe
It is time to prepare for the unthinkable: there is now a significant probability the euro will not survive in its current form. This is not because I am predicting the failure by European leaders to agree a deal. In fact, I believe they will. My concern is not about failure to agree, but the consequences of an agreement.

A leveraged EFSF is attractive to politicians for the same reason that subprime mortgages once appeared attractive to borrowers. Leverage can have different economic functions, but in these cases it simply disguises a lack of money. The idea is to turn the EFSF into a monoline insurer for sovereign bonds. It is worth recalling that the role of those monolines during the bubble was to insure toxic credit products. They ended up as a crisis amplifier.

Leveraging also massively increases the probability of a loss for the triple A-rated member states, who ultimately provide the insurance. If a recipient of the guarantee were to impose a relatively small haircut – say 20 per cent – the EFSF and its guarantors would take the entire hit. Under current arrangements, they would only lose their share of the haircut.

The way eurozone leaders have been handling the crisis ultimately vindicates the German constitutional court’s conservatism in its definition of what constitutes a functioning democracy. Policy co-ordination among heads of state is both undemocratic and ineffective. A monetary union may require more than just a eurobond and a small fiscal union. It may require a formal, if partial, transfer of sovereignty to the centre – that includes the rights to levy certain taxes, impose regulation in product, labour and financial markets, and to set fiscal rules for member states.

Under normal circumstances, European electorates would not accept such a massive transfer of sovereignty. I would not completely exclude the possibility that they might accept it if the alternative was a breakdown of the euro. Even then, I would not bet on such an outcome. Current policy is leading us straight towards this bifurcation point, which may only be a few weeks or months away.
Eurozone Government Bonds

  • Italy 10-Year Government Bonds - 5.95%
  • Spain 10-Year Government Bonds - 5.55%
  • Portugal 10-Year Government Bonds - 12.38%
  • France 10-Year Government Bonds - 3.32%
  • Germany 10-Year Government Bonds - 2.12%

The spread widened between every country and Germany. The French-German spread is at a new record high 1.20%, reflective of the likely use of a leveraged EFSF.

You can't get something for nothing, no matter what the fools at the EU summit think.

Mike "Mish" Shedlock
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