Summit Brings Decision for Embattled Sovereigns ‘Bailout’ Fund

Last week, European Union (EU) officials finally came up with some answers to the ongoing sovereign debt conundrum the market has been looking for, although somewhat lacking in details.

Nonetheless, the Euro Stoxx 50 benchmark equity index gained a whopping 5.34 percent to close at 2,462 for the week. As usual, the euro closely tracked the wider equity market and closed at 1.42, up 2.21 percent for the week.

50 Percent “Haircut” on Greek Bonds

Greece missed several budget deficit targets and is suffering from strikes including a shutdown of the Ministry of Finance. Greek bonds expiring in one year yielded close to 190 percent and traded as low as 42 cents on the dollar on some days last week.

One of the points to resolve during the EU summit last Wednesday was to make Greece’s debt load of 350 billion euros ($500 billion) and 160 percent of 2010 GDP more manageable. The solution is to increase the so-called “haircuts” on Greek bonds and restructure them to reduce the principal and interest that needs to be repaid. This then allows the country to consolidate its economy and start growing again.

In July, it was agreed that this haircut, which private sector financial institutions had to take was 21 percent. After the situation in Greece had deteriorated sharply in the last couple of weeks, EU officials came out of this Wednesday’s summit with a more credible solution of a debt reduction of 50 percent, still lower than the “haircut” the bond market is currently pricing in.

Bilateral loans between the EU and the International Monetary Fund (IMF) and Greece as well as the Greek bonds that the European Central Banks (ECB) holds will not be affected by this restructuring. Since those holdings are worth 150 billion euros ($214 billion) at par, the actual cut will only be 100 billion euros ($143 billion) and bring down the country’s debt-to-GDP ratio to 113 percent, which is still considered too high for a country whose economic situation is deteriorating rapidly.

Proof for this skepticism is found in the market for Greek bonds, where all but the shortest maturities (zero to two years) trade below the 50 percent, some even as low as 25 percent.

EU’s Enhanced “Bailout” Fund

Another one of the major issues to be resolved at the eurozone summit was the final size of the European Financial Stability Facility (EFSF). All 17 countries that comprise the eurozone had previously agreed to guarantee the issuance of bonds of the EFSF up to 440 billion euros ($629 billion), which was then to be used to help ailing sovereign nations or distressed banks.

It soon became clear that this 440 billion euros would not be enough, especially if Italy and Spain also needed to seek assistance. Those two countries are on schedule to issue more than 1 trillion euros ($1.43 trillion) of debt to the end of 2013, mainly to roll over existing debt, but also to fund chronic budget deficits.

In order to also provide more security to Italy and Spain, the EFSF can now be modified in two ways.

It can now use the remainder of the 440 billion of guarantees—roughly 100 billion euros ($143 billion) has already been pledged to Greece, Portugal, and Ireland—to provide a first loss insurance of new issuance of other troubled nations. If the EFSF takes the first 20 percent loss on any new bond issued by Italy or Spain, for example, then the amount to be insured is five times the 340 billion euros ($486 billion) remaining, or 1.7 trillion euros ($2.43 trillion).

The other option is to “leverage” the guarantees of the mainly AAA-rated countries (Germany, Austria, Netherlands, Finland, and Luxembourg), with private sector money to reach similar volumes as with the first loss insurance. Since European private financial institutions are already overleveraged, China and Brazil have been rumored to be interested buyers of EFSF paper, but official sources have subsequently denied this.

Even with the enhanced EFSF, Citigroup’s Willem Buiter sees problems: “The insurance mechanism is not foolproof or disaster proof. There is no guarantee that, in a panic, the most generous terms on which the insurance could be offered (say, for free) would be attractive enough to bring in sufficient private buyers of the insured sovereign debt.” He also mentions that the underlying economic risk and losses that can be absorbed is still limited to the 340 billion euros left after Greece, Ireland, and Portugal have been serviced.

Quiet Week Ahead

After a turbulent couple of weeks, this week will be relatively quiet, despite a G-20 meeting in Cannes, France, starting Nov. 3, where many of the European issues could resurface again.

We will also see the new president of the ECB, Mario Draghi of Italy, make his first rate decision on Thursday after the Federal Open Market Committee meeting in the United States on Wednesday and the United Kingdom GDP report on Tuesday.