European Rates Insights

RATES STRATEGY | EUROPE

EFSF 2.0, 3.0 and beyond

We analyse many but not all of the EFSF-based proposals for leveraging and increasing the firepower of the bailout fund in tackling the ongoing eurozone sovereign debt crisis. We assess their likelihood of being implemented and consider whether they would comprise a possible regime-shift for eurozone markets. We focus on three broad categories: proposals that appear to have few hurdles to being implemented; less probable options; and leverage-based options. While the most elegant solutions have no official sanction, we think the necessary political resolve is yet to be forthcoming, and the technical issues are challenging if not insurmountable for many of the legal workarounds, resulting in the need for yet another round of parliamentary approvals. Consequently, we see a significant risk that the market, looking for large headlines and enhanced flexibility, will be disappointed at least in the short run. The search for a steady state solution In analysing the eurozone debt crisis, the key challenge is to assess the likely path towards a steady state solution, defined as the market no longer being concerned about future default risks on government debt at least over a timeframe that is meaningful to immediate asset allocation decisions. We have highlighted three broad alternative steady state solutions: 1. Full fiscal union and the issuance of Eurobonds with a joint and several liability structure or at least unconditional credit risk transfers to stronger countries for a extensive period of time (for sustainability to be reestablished). 2. Aggressive policy reflation, whereby the ECB significantly expands its balance sheet and its SMP programme. (Given the requirement of EU governments to recapitalise the ECB, this option ultimately begins to blend into option 1.) 3. Default and debt restructuring in selected non-core countries and possible end of the euro area. Option 1 is not under consideration at this juncture since all forms of recent fiscal or credit transfer appear to come with strict conditionality. As for the possibility of Eurobonds, it has been dismissed by the AAA countries and the German Constitutional Courts ruling that uncapped liabilities accruing to the German state from its participation in the EU is unconstitutional. Option 2 may be a possible solution to the crisis, albeit with drawbacks, but our economics research team does not believe that the ECB is close to accepting the significant increase in credit risk on its balance sheet and the distorting influence on its monetary policy that this option would entail. The ECB is not programmed for full-blown monetisation and the bar is extremely high for any major steps in this direction. For these reasons, the possibility of further debt restructuring in selected countries has become increasingly likely and in recent weeks has underpinned investor risk allocation decisions. The consequences would depend on the ability of EU politicians to isolate other periphery countries and European banks. This may prove virtually impossible without significant credit risk transfers, so ultimately European politicians will need to pick one of the three outcomes: fiscal union, monetisation or major restructurings risking the end of the euro area. Renewed impetus to achieve a more lasting EFSF-based solution Given these parameters, EU policy proposals for addressing the crisis have focused more on delaying a possible denouement rather than resolving the crisis. However, over the past week a renewed impetus has emerged from EU

29 September 2011 Fixed Income Research Contributing Strategists Nick Firoozye +44 (0) 20 7103 3611
nick.firoozye@nomura.com

Dimitris Drakopoulos +44 (0) 20 7102 5846

dimitris.dralopoulos@nomura.com

Alastair Newton +44 (0) 20 7102 3940

alastair.newton@nomura.com

Des Supple +44 (0) 20 7102 2125

des.supple@nomura.com

Equity Research Contributing Strategist Jon Peace +44 (0) 20 7102 4452 jon.peace@nomura.com

This report can be accessed electronically via: www.nomura.com/research or on Bloomberg (NOMR)

Nomura International plc See Disclosure Appendix A1 for the Analyst Certification and Other Important Disclosures

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29 September 2011

policymakers in terms of trying to find a steady state solution and a vast array of proposals have been outlined. In this note we analyse many but not all of the EFSF-based proposals and assess their likelihood of being implemented and whether they comprise a possible regime-shift for eurozone markets. We focus on three broad categories: proposals that appear to have few hurdles to being implemented; less probable options; and leverage-based options. The final group of options is particularly important since, should recent unsubstantiated speculation that the EFSF might be leveraged into a 2-3trn fund prove accurate (though this has been denied by Spanish and German government spokespeople), then we would need to alter our bearish outlook on the debt markets of the European periphery while a central headwind would be removed from equity markets. Leverage-based options are unlikely for now as they would require a significant change in views by the ECB and/or EU governments. However, we doubt that leverage-based options are likely to be implemented. Leveraging the EFSF or an SPV via the ECB is simply another way of requesting that the ECB expands its balance sheet meaningfully, absorbing increased credit risk and potentially undermining its separation principle between interest-rate policy and liquidity support. Meanwhile, in order for market-based leverage options to be viable, EU governments may have to absorb markedly increased contingent liabilities which they currently appear unwilling to do. Implementation of a leveragebased option therefore first requires changed assumptions about the ECBs willingness to expand its balance sheet and/or EU governments being willing to absorb increased contingent liabilities. These are questions that have been framing the eurozone crisis for the past 18 months. A possible option EFSF indemnified ECB SMP losses Of the options that could be implemented, the most elegant and most efficient in our view would be for the EFSF to indemnify the ECB against losses on its SMP programme. This would ensure more efficient use of EFSF resources and would address one of our key areas of concern the inability of the EFSF 2.0 to, as planned, take over the ECBs SMP programme next month. This option does not comprise a steady state solution and would be unlikely to meaningfully alter strategic investment asset-allocation decisions, but could at least provide further leeway in which efforts to achieve a more lasting resolution might be found. This poses a risk to market sentiment as expectations have been inflated to the point where many investors are anticipating leverage-based options which could provide financial resources at or above 2trn. Moreover, as is the case with the majority of the ideas presented below, the most elegant proposals require passage of yet another set of bills by the 17 eurozone member countries and thus further delay any comprehensive solution.

The current plans for EFSF

The current plans for the expansion and adaptation of the EFSF are based on implementing the Council Resolution of 21 July (see EU Council Surprises) subject to ratification by all 17 eurozone member countries. In broad terms, EFSF 2.0 will be enhanced by: Increased capacity: The EFSF will have a lendable/investible capacity of 440bn. It can loan all it borrows (given the new over-collateralisation rule of 165% it needs no inefficient cash buffers, see Rates Flash: The CDO at the heart of the Eurozone for details on valuation of the new structure). In the early years of the lending programme, there is also the capacity for the EFSF to expand beyond its 440bn cap due to the accounting treatment of the debt which it issues. In particular, the notional value of its debt is capped, with the interest being guaranteed but uncapped. This minor point

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leaves some leeway to leverage capacity in the context of the upcoming Greek debt exchange where the guaranteed collateral will be measured at 1 the PV of 30-40 cents on the euro rather than the ultimate face value . Precautionary programmes: The EFSF will be able to lend to sovereigns not in IMF packages as a precautionary measure. Although such lending is also meant to be done under strict conditionality, it is unclear at this time what this could entail. Bank recap: The remit of the EFSF will be expanded to allow it to lend money to countries not in an IMF programme in order to finance a recapitalisation of their banking systems. Under the original EFSF, funds could only be lent to countries for the purpose of bank recapitalisation if they were already in an IMF programme, (e.g. Ireland). Funds cannot be lent directly to banks but only via sovereigns which may subsequently support their own banking systems. Secondary market purchases: EFSF 2.0 has already been made more flexible in the sense that the fund would be able to purchase bonds on the secondary market for both programme and non-programme countries (where previously it could only disburse funds for loans or purchase primary issuance).

The planned changes are presented in Figure 1, which shows the enhanced capabilities together with the increased size.
Fig. 1: EFSF planned changes, before and after 21 July summit
1.0 2.0 2.0 after 21 July EU Sum m it

EFSF version

Cash buffers Direct lending Prim ary m arket intervention Secondary m arket invervention Bank recapitalisation lending Precautionary facilities

Yes Yes No No No No

No Yes Yes No No No

No Yes Yes Yes Yes Yes

Total guarantees Lending capacity Over-guarantee

440bn <255bn 120.0%

779.783bn 440bn 165.0%

779.783bn 440bn 165.0%

Source: Nomura, EFSF, Eurogroup working group

Implementation risks: EFSF 2.0 needs all 17 parliaments to approve it The bills being passed by each EAMS parliament all involve a major overhaul of EFSF 1.0 to allow for bond purchases and pre-emptive aid to non-package receiving countries, which may be earmarked for particular institutions, e.g. banks. They also include certain efficiencies with rewriting the language of guarantees (previously countries guarantee limits covered both coupon and principal payments, while now they are meant to cap only the principal payments, as
1

For instance, if the EFSF issues zero coupon bonds for the debt exchange, then it will commit the full notional amount in terms of its total capacity usage. If, on the other hand, EFSF issues an accretive bond for the debt exchange, it accounts for a mere 30-40% of the notional (i.e. the PV of AAA zeros) at the time of the exchange, rising to par only in the distant future.

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mentioned above). While certain disbursements are feasible under EFSF 1.0, major efficiencies are only feasible with EFSF 2.0 and it would seriously limit capacity for future bailouts if large commitments (e.g., the Greece debt exchange) were undertaken using EFSF 1.0. Should parliaments wish to proceed without one of the original 17 EAMS, they would probably have to pass entirely new bills in the countries which have thus far ratified it (including Belgium, France, Greece, Ireland, Italy, Luxembourg, Slovenia, Spain, Finland, and Germany), effectively dismantling the remainder of EFSF 1.0 and starting an entirely new institution. We will not go into detail regarding the numerous risks to this parliamentary approval process which takes place over the next fortnight, but clearly the market risks are asymmetric during this process since the market is generally assuming that the EFSF will receive universal ratification, and a failure by one country to do so could significantly impede the Troikas efforts to stabilise the debt crisis in Europe (see Economic and Political Events Calendar in Europe: Sept-Nov 2011).
Fig. 2: EFSF planned increases
Initial EFSF m axim um guarantee Com m itm ents ( m n) 12,241.43 15,292.18 863.09 Am ended EFSF m axim um guarantee Com m itm ents ( m n) 21,639 27,032 1,525 1,994 7,905.20 89,657.45 119,390.07 12,387.70 7,002.40 78,784.72 1,101.39 398.44 25,143.58 11,035.38 4,371.54 2,072.92 52,352.51 440,000.00 409,574.52 255,439.12 13,974 158,488 211,046 21,898 12,378 139,268 1,946 704.33 44,446 19,507 7,727 3,664 92,544 779,779.01 725,996.12 451,538.43

Countries

Austria Belgium Cyprus Estonia Finland France Germ any Greece Ireland Italy Luxem bourg Malta Netherlands Portugal Slovakia Slovenia Spain Total Total m inus step-out Total AAA
Source: Nomura, EFSF, Eurogroup working group

Structural weaknesses of EFSF 2.0

However, as we outlined recently, Asymmetric market risks in Europe, even if EFSF 2.0 is approved by all 17 national parliaments, we have significant concerns about the capacity of the expanded fund to stabilise sentiment in the eurozone. In particular, we have significant doubts that the EFSF in its current format will be able to take up the baton of the ECBs SMP programme as planned.

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EFSF too small to take over from the ECBs SMP In spite of the many changes agreed and in particular the sizeable increase in the EFSFs capacity (see Figure 2), it is unclear whether the EFSF is suited for the job or jobs which are required of it. For instance, banking recapitalisation alone could cost 200bn, although this depends very much on the economic scenario (see the European Bank Recapitalisation section below) while it is estimated that the size needed to restore confidence to the BTP and SPGB markets could push the limits of its now agreed capacity with least 122bn of BTPs and 46bn of SPGBs to be rolled in 2012 (out of a total outstanding size of 1,560bn for BTPs (and CCTs/CTZs/BOTs/RepItaly) and 634bn for Bonos (and Letras/agencies, e.g. FROB, ICO, Renfe, and RTVE). We highlight the many ideas proposed to increase capacity and discuss various ways of using the capacity differently for greater impact. EFSF insufficient flexibility The EFSF will also not be as responsive to the ECB in terms of market intervention. The EFSF will need to pre-fund its market interventions or loan programmes. Moreover, uncertainty still exists regarding how the EFSF would determine which markets it will intervene in and in what size. In terms of the disbursal of new financial support packages, these do not require uniform agreement between participating countries and instead simply require a vote in favour or abstention by Ministers of Finance representing two-thirds of all guarantees. While we view this as positive, we see a risk of creeping parliamentary oversight of the process of package approval. Due to the Constitutional Court ruling (see Bundestag at the helm and Constitutional Court Ruling: Approval with Strong Caveats), Germany will give powers to the Bundestag Budget committee to decide on new packages and is debating giving powers to the entire parliament for approval if time is permitting. Finland already required parliamentary approval for all new packages. Drawdowns have to be approved by the same procedure although the consultation with parliaments is apparently not required.

Proposals for an EFSF 3.0

Given the concerns noted above, the current plans for expanding the EFSF do not comprise, in our view, a strategy that has a realistic chance of stabilising sentiment in the eurozone. Policymakers share these concerns, which have resulted in numerous proposals to restructure the EFSF even before the expansion has achieved parliamentary approval. These plans tend to focus on increasing the size of the EFSFs financial resources, whether though increased funding or the granting of leverage and/or improving the funds flexibility. Below we discuss these proposals, and group them according to their likelihood of being implemented.

The more realistic proposals for EFSF 3.0

The EFSF indemnifies the ECBs SMP This is one of the more recent proposals, and appears to be gathering some support among European policymakers. It involves the EFSFs resources being used to guarantee the credit risk associated with the ECBs bond purchases. This would have several advantages: The ECB is more flexible in being able to time its market intervention since it does not need to pre-fund and can decide quickly which bonds to buy and in which size.

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The ECB remains wary of absorbing the credit risk for the SMP programme onto its balance sheet, and hence we think it would welcome this proposal. This proposal would entail a more efficient use of EFSF resources. Under the current programme, over-collateralisation means that 726bn in guarantees provide 440bn in lending/investible resources. However, under this proposal it matters little whether the guarantee is effectively AAA or not. Consequently, the EFSF would guarantee a total of a maximum possible amount of 726bn of losses on the SMP as a first-loss piece. However, it is worth stating that the actual resources that could be deployed for the indemnification could be considerably less than 726bn since out of this number have to be taken previous commitments to sovereign bailouts (as much as 147bn) and any potential bank recapitalisation. If the existing 157bn of SMP purchases are also to be indemnified, the headroom for the continuation of the SMP programme would be further reduced. Of course, if instead of full indemnification, the proposed option is merely a first-loss tranche, then this would allow greater ability for the SMP to continue albeit with increased credit risk for the ECB.

Given these factors, we think this proposal could be a more effective policy than EFSF 2.0. It would also ease market concerns regarding the bond market impact were the ECB to, as planned, suspend its SMP programme when EFSF 2.0 were active. This backstop would be more efficient as it could allow the ECB to announce a programme, i.e. commit for a certain level of intervention over a certain period of time. This is essential to allow investors to get in and out of the market. In the current framework, there is no guarantee that the ECB will remain active in the market in a months time as its intervention is conditioned on a set of unobservables. More political backing means that the ECB can alter the conditionality of its intervention, which could be far more productive as a market stabilising mechanism. This would be a break with the current framework. The ECB has clearly been able to use the SMP and its other programmes to impose conditionality as can be seen by its threats to withdraw funding from Ireland and Portugal as preludes to their accepting packages. Similarly, the ECB imposed effective conditionality in halting Irish bond purchases during the run-up to the election when Fine Gael was threatening to haircut senior unsubordinated bank debt, or in halting Portuguese bond purchases after the Socrates-lead government failed to secure a new budget. Vested with the duty to impose stability with some strings attached and little worry of a possible hole in its balance sheet, the ECBs SMP could be particularly effective in routing any future contagion. But there is also a basic trade-off between the conditionality of the intervention and convincing the market that support will remain the trade-off is tilted towards the former option at the moment but we see a possibility of rebalancing. Any marketbased intervention policy can be a more effective backstop for markets if the conditionality of the interventions is relaxed, but this would not provide a solution to the crisis in our view. There would be no conflict between goals if each sovereign to be supported had mere liquidity rather than solvency issues. Indeed, the ECBs track record of muted buying even for programme countries (e.g. Ireland and Portugal) has been relatively unsuccessful in stabilising spreads. Instead, the market has tended to view the SMP programme, linked with solvency concerns, as an opportunity to exit long positions, and until solvency concerns have been assuaged, there appears little desire to replenish bond holdings with fresh purchases. Ultimately, guaranteeing the SMP interventions is a seducing measure, likely to bring some relief in the periphery especially if it allows the ECB to further expand its buying.

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But a more ambitious SMP (with less conditionality attached to it) cannot be taken for granted given the political opposition. Bundesbank President Jens Weidmanns opposition to recent SMP purchases, which is widely thought to parallel resigning ECB board member Juergen Starks sentiment, is the source of significant division within the ECB. Furthermore, questioning of the legality of the SMP by German President Christian Wulff has resulted in further disquiet in the German press, especially with the Constitutional Court challenges to the SMP failing for reasons of jurisdiction alone, and may indicate a growing reluctance to rely on ECB discretion alone. This resistance culminated in the recent experience of the ECBs SMP programme, where BTPs were purchased during a period of market stress, but just before the Italian austerity votes; the subsequent deletion of key revenue-raising measures after spreads had settled highlighted the risk of SMP-based support being manipulated for short-term political gain. Consequently, there is a significant risk that if such a backstop mechanism is implemented, it will only be a way to carry on current interventions and not step them up in any ultimately stabilising manner. As a final note, due to institutional constraints of some of the correspondent national central banks which undertake the actual bond purchases, the SMP bond purchases have been limited to 10 year final maturity. While there are no hard and fast rules here (and old habits may very well change), ECB interventions have resulted in significant long-end steepening historically. Should this indemnification be actively pursued, it may only help shorter-maturity investors with long ends likely to steepen. Bringing forward ESM debut While clearly not a plan to improve the EFSF or enhance it, the notion of introducing the EFSFs successor, the ESM is potentially meaningful. The ESM is a more flexible structure (see Term sheet on the ESM and Treaty Establishing the European Stability Mechanism and The ECB Monthly Bulletin, July 2011, p 72ff), can be increased in size relatively quickly (by Board of Directors with only the German and Finnish finance ministers having to refer back to their respective parliaments), involves greater protection to creditors and counterparties (as we mention above in the section on repos), and can more easily issue various debt instruments on the capital markets (i.e. more readily leveraged). But the possibility of moving forward the planned launch from June 2013 to June 2012 should give little reason for markets to rejoice as it would have no short-term impact. Moreover, even this move forward runs counter to the timeline for the proposed amendment to the Treaty (still to be debated in parliaments). For this proposal to meaningfully affect market sentiment, ESM may need to be implemented far sooner than mid-2012. It is also worth noting that while the ESM is more flexible than the EFSF and affords more means of leveraging, it does not in and of itself provide additional financial resources. Once again, this prevents this proposal from being a path to a steady state solution for the eurozone debt crisis.

Less likely variants of EFSF 3.0

Increase the size of the guarantees The EFSF bill has been approved by several countries already and caps the requisite guarantees at 726bn, which limits the loanable amount to 440bn, given the 165% over-collateralisation (and AAA guarantees backing all loanable amounts). Once EFSF 2.0 is passed, the total amount guaranteed can be changed by a two-thirds majority as we have previously noted.

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Yet, the risks of increasing the guarantees are not negligible since there is a natural implication of deteriorating credit quality in AAA countries and market fears could threaten these ratings. Admittedly, we believe that a doubling of the EFSFs investible/lendable resources to 880bn (which would entail guarantees of 1,452bn) would not necessarily imperil Frances AAA rating. We have estimated that a doubling of the EFSF would add 3% to Frances debt/GDP on a probabilistic calculation which would not necessarily trigger a downgrade of France hence the EFSF. If, however, peripheral area loans both current and prospective (i.e. to Greece, Ireland, Portugal, Spain and Italy) defaulted with 100% probability (and market-standard 40% recovery rates) this would lead to a 12% debt/GDP increase, far from minor but not sufficient grounds for a downgrade. However, while a doubling of EFSF is possible, we would be concerned that fear of a loss of AAA rating could preclude a further expansion beyond this level. This is important, since in order for the EFSF to increase in size to a level that was sufficient to make the market more confident that a powerful financial backstop could limit contagion, we believe that EFSF funds would need to be tripled at least. Governments appear to have little appetite for such a large expansion, and indeed for even a doubling of the EFSF. Keep EFSF as it is and formally increase everyone else Until now there is an agreement that the EU provides two-thirds of support packages and the IMF one-third, with the EUs two-thirds coming from a variety of sources including EFSF, EFSM and bilateral loans from non-euro area member states. There are various options to increase the firepower by changing this ratio, including: Change EU and IMF contributions to one half each, which could add another 250bn. This would increase the total firepower from 750bn to 1trn. This could also be further supported by a larger contribution by BRICS or G20. Add more EU countries either into the EFSF directly or in some other formal bilateral framework. There are sizeable AAA countries in EU27 including Sweden, the UK and Denmark (Sweden and Denmark together would form the fifth biggest euro area country). All of them have already contributed through bilateral loans to Ireland. If such contributions could be formalised going forward, it could increase the total firepower. Poland has also mentioned it might help with bilateral loans. Increase EU capacity from individual sovereign commitments. In particular, in the case of a banking sector recapitalisation, if France recapitalises its own banks or does so in conjunction with EFSF guarantees, it could expand the EFSF total capacity. Like the bilateral loans, this increase could be on a case-by-case basis. It would have the most bearing on banking recapitalisation (covered in more detail below).

However, we do not attach a high probability to this scenario being implemented (save for repeats of the past, the involvement of countries in smaller bilateral loans) due to the limited likelihood of additional funds being provided from other sources. We doubt that emerging market countries would be willing to invest a large part of their FX reserves in the EFSF mechanism, especially since the fiscal costs of enlarged balance sheets (the translation effect of stronger EM currencies and lower yields on FX reserves than on a central banks domestic liabilities) put steady pressure on FX reserve managers to maximise returns. Similarly, it seems improbable that the US or UK would contribute to the EFSF, leaving the IMF as the only viable lender. That may be possible, but seems unlikely given the Funds already deep involvement in the euro-crisis and the increased focus of the new IMF Managing Director on replenishing the Funds financial resources.

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Increase lendable capacity so EFSF becomes an AA entity With relatively few AAA sovereigns in the world, it may become overly limiting to expect EFSF to be an AAA supra. There would still be capacity for an AA entity to issue larger amounts. This could also be attained through part-guarantees (i.e. subordinated or mezzanine debt) or EFSFs new ability to issue bonds with lower than 165% over-collateralisation both explicitly allowed in the Framework Agreement (see EFSF Framework Agreement and Amended EFSF Framework Agreement). EFSF would effectively issue both AAA and lower quality classes of bonds, technically feasible in EFSF 2.0. There has appeared little appetite for the AAA countries to be associated with an AA rated mechanism for supporting the eurozone, reducing the viability of this proposal. Also this is a far less effective way of boosting the resources of the EFSF than by indemnifying the ECB losses on its SMP programme. This is because an expanded EFSF would still face the problem of having to pre-fund its bond purchases and there is also no established system for determining which bonds to purchase. Monoline insurer The EFSF provides a guarantee to private investors to buy peripheral debt, covering say the first 50% of losses, thereby doubling its leverage (as suggested by the CEO of Allianz see link). This is a variant of a plan to issue Brady bonds on behalf of a troubled sovereign (much as is planned for the upcoming Greek debt exchange). This may grant market access where it was previously infeasible given appropriate levels of credit enhancement. Technically, embedding insurance into a bond structure as opposed to actual collateral involves an entirely different set of legal obstacles. In the case of insurance, the EFSF guarantees the payment of principal (or some portion thereof) on a peripheral debt issue, while in a Brady, the EFSF lends a zero-coupon or accretive bond to the peripheral to be embedded. While economically equivalent, the insurance concept is more likely to fall foul of Article 125 (the no bailout clause). Given the hurdles in changing the EFSF into an insurer, this approach seems to offer few benefits if any over the already viable solution of issuing Brady bonds, technically feasible under EFSF 2.0. Establish a TALF One proposal is that the ECB establishes a system similar to the Feds Term Asset-backed Securities Loan Fund or TALF. The TALF was introduced because the Fed accepted only US Treasuries as collateral in its open-market operations and this system therefore allowed for a broader array of collateral to be introduced, with the US Treasury indemnifying the Fed against losses on these new repos. The ECB, by contrast, accepts a wider range of collateral types and, barring a small number of examples, there has never been a shortage of acceptable collateral. The ECB currently is indemnified against losses on repo operations handled by the ELAs in Greece and Ireland (and Germany and Belgium briefly during the initial stages of the financial crisis. While a system-wide indemnification plan (also known as a facility for addicted banks) would be a desirable prelude to large events such as the Greek restructuring it is not a solution in and of itself.

Leverage-based options
If the EU were to develop a viable system for the existing resources of the EFSF to be leveraged, then this could lead to a meaningful change in the outlook for European markets. Leveraging the EFSF into a 2,000-3,000bn fund would, if the plan came to fruition, fundamentally change the risk-reward outlook for non-core European debt as the capacity to throw a firewall around the periphery and provide

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lasting market support for Italian and Spanish debt, for instance, would be sizable. While such a proposal could prove to be little more than a delaying tactic unless underlying solvency risks were also contained, such a large pool of resources would nonetheless be able to postpone fears of an ultimate eurozone breakdown for a timeframe that is meaningful to the market. Moreover, if the problems in Spain and Italy indeed prove to be liquidity rather than solvency concerns, as we believe to be the case, then a fund which focused on buying the debt instruments of these countries could generate attractive returns for EU countries. Hence, below we analyse some of the options for introducing leverage into the system. The flaws in the leverage option Unfortunately, as we discuss below, we believe that the large array of leverage proposals tend to rely on ancillary assumptions regarding the willingness of the ECB to utilise its balance sheet or the political will of EU governments to accept increased contingent liabilities via guarantees. In this respect, core EU governments and the ECB are less willing to sanction leverage than was the case in the US during the financial crisis. There is the additional concern that leverage plans will need to be structured in a manner that is consistent with the German Constitutional Courts ruling against unbounded liabilities. Finally, there is a question mark beside some of the leverage assumptions which have been proposed. Even if the 440bn funds of the EFSF are levered 5 times to create a 2trn+ fund, assuming the Greek debt swap plan goes ahead, then up to 147bn of the 440bn resources of EFSF 2.0 will already have been allocated to bailout programmes for the periphery. We also assume that around 200bn of EFSF funds may be needed for bank recapitalisation. If so, then the amount of EFSF resources that could be allocated to a leveraged fund could be closer to 200bn. Leveraging this 5 times would provide 1trn, which while a sizable number does not provide the shock and awe that many in the market may be expecting. Under this scenario, a 2-3trn fund would require 10-15 times leverage. Below, we analyse some of the leverage-based proposals and highlight some of the themes noted above. Leverage option #1 Turn EFSF into a bank and face ECB for repos The idea of leveraging the EFSF via ECB repos has been recommended by academics and practitioners (see Gros and Meyer, Refinancing the EFSF via the ECB, CEPS Communications) with the idea widely distributed among EU policymakers. The EFSF is a Societ Anonyme by Luxembourg law and can, through new articles (only feasible through passage of EFSF 3.0), register as a bank. It would require appropriate equity injections in order to adhere to local regulations. It could then be eligible to face the ECB, repo-ing its bond purchases through the ECBs open market operations. As we mentioned above, unless the structure is changed radically, it would give the ECB little comfort against losses. Moreover, due to its size and limited capital structure (i.e. senior guaranteed bonds and repos) it would require settlement of sizeable amounts through the open market operations and consequently, be likely to displace regular banking operations. Unless the EFSF is provided with term repo financing, then this leverage option would involve a significant maturity mismatch (akin to an SIV or ABCP) whereby hold-to-maturity bond purchases of up to 10-years would be financed with short-term repos. The most obvious drawback of this proposal is that it is simply a less direct way of the ECB expanding its balance sheet by purchasing debt directly and is ultimately a means of monetising the debt (which the ECB may be forced to do anyway). By financing the EFSF, the ECB would still absorb credit risk on its debt collateral

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unless the EFSFs losses were guaranteed by governments, which would negate many of the leverage benefits of this proposal. Moreover, should the ECBs balance sheet be expanded, it would be more difficult for the Bank to maintain its separation principle by distinguishing its interest rate policy from its liquidity provision. As such, the conduct of monetary policy would be influenced. For these reasons, leverage options involving the ECB ultimately rely on the ECB being willing to accept a significant increase in credit risk on an enlarged portfolio, and to ease its stance on the separation principle. This option is possible, but we do not think the ECB is close to such a sea-change. Hence, we would view ECB leverage-type options as a detour from the broader question of determining if or when the ECB will more aggressively use its balance sheet. On a practical note, leveraging the EFSF via the ECB has been publicly opposed by Bundesbank President Jens Weidmann and German Finance Minister Schaeubles spokesman Martin Kotthaus among others, with ECB governing council member Lorenzo Bini Smaghi coming out in favour of leverage of some sort. Leverage option #2 SPV backed by EFSF repos with ECB This option has been widely discussed in the press after a CNBC report on the matter (see link). It involves the setting up of yet another SPV as subsidiary to the EIB (much like the micro-finance/SME funding EIF currently is) with initial investment/seed capital from EFSF. This SPV would be charged with issuing its ECB-eligible debt (presumably with the part-guarantees of EFSF), the proceeds of which would be used to finance bond purchases. While the scheme appears simple enough, there are several variations. In particular, the debt could be: Self-issued bonds, repoed directly with the ECB for funding. Proceeds of this sale-repo arrangement would be invested in sovereign bonds. Issued in exchanged for sovereign bonds. The market then undertakes repos of the SPV bonds with the ECB. Covered bond backed by sovereign bond assets, possibly sold to the ECB. The SPV would instead be a (possibly Luxembourg-based) Covered Bond issuing bank or ACS and could issue public covered bonds or lettres de gage (backed by peripheral bonds). With the ECB considering restarting its covered-bond purchases (see link) as a means of injecting liquidity into the Pfandbriefe markets, this may be the vehicle for such injections.
2

We note that this arrangement is actually a variation on Leverage option # 1, but rather than repo-ing assets (such as BTPs and SPGBs) with the ECB, the SPV plan involves repo-ing liabilities/bonds. Moreover, this only affords leverage if the SPV issues more than 440bn of bonds, so this is really a variation on the idea of issuing AA securities. It also relies, as noted above, on the ECBs willingness to undertake increased credit risk if the liabilities issued by the SPV are not fully guaranteed or on eurozone sovereigns to accept increased contingent liabilities if the liabilities of the SPV are indeed guaranteed. Being a combination of several other ideas, this appears a particularly convoluted means of achieving much the same ends. While this would not mean that it should be ruled out (if we use the introduction of the EFSF as a guide), we see this option

Self-issuance of ECB eligible securities as a means of raising liquidity from the ECB is commonplace among liquidity-constrained banks such as Spanish Cajas which issue Cdulas, and Greek, Irish, and Portuguese banks which typically issue government-guaranteed securities. We note that the ECB has instituted recent rule changes which limit an institutions total funding via self-issued unsecured bonds to 5% of the total collateral pledged to the ECB (see link).

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of partial indemnification of repos as reasonable in theory although this indemnification is more easily implemented through other means. We note as well that while the EFSF 2.0 can provide loans (or purchase bonds) and in the process of giving support possibly transfer EFSF debt to a member state, (possibly to be used as assets for a new institution), the EFSF cannot be charged with providing equity injections into any SPV and many of the SPV-related proposals technically require passage of EFSF 3.0. Leverage options #3 market based repo financing. EFSF can issue a wide range of instruments (save equity) to leverage. It can be leveraged via repos, CP, subordinated debt, or bond insurance. There has never been an obstacle to the EFSF issuing other forms of debt subject to a vote by finance ministers and many leverage options exist in EFSF 2.0 itself. These could include. Non-guaranteed debt or subordinated debt. Repos or liquidity lines (to the open market via bilateral repo or through clearing houses). Partly-guaranteed (effectively a mezzanine tranche in the CDO of guarantees, loans and bond purchases backing any new issue), or debt backed by a lower over-collateralisation amount (i.e. less than 165%) Bond insurance or other credit enhancement, external backstop, e.g. from Norways oil fund, to SAFE to a Middle-East SWF.

The downside of any such leverage is the structure itself and may prevent marketbased solutions from being cost-effective, given that the EFSF has no equity. In particular, in a wind-down, senior debt-holders are likely to be paid by guarantors, 3 but guarantors claims replace those of senior debt holders. Consequently, any unguaranteed debt could face far greater losses, and the residual claims of repo counterparties will rank pari-passu to either senior debt or guarantors once repo collateral is exhausted. This should give subordinated debt holder and repo counterparties little comfort that guarantors will be fighting for scraps in a winddown and consequently large spreads or haircuts (if bilateral repos) are likely to be applied. Alternatively clearing houses could be used to handle repos, but admissibility of the EFSF as a member of a clearing house where clearly collateral quality and EFSF solvency are highly correlated may be a question and ultimately, clearing houses charge large haircuts to all counterparties. A practical consideration is the guarantee status of the liabilities of the EFSF or of some separate SPV entity yet to be set up. If the liabilities are not guaranteed then appetite to buy the liabilities could be limited. The initial investment of EFSF capital could provide a first-loss buffer, but after that investors would be buying assets whose value is tied to a blended pool of peripheral debt. Clearly, haircuts on collateral would likely be large, and the yield on associated debt instruments issued could be increasingly high as leverage increased. Consequently, we believe leverage options, although feasible under the current structure have relatively modest limits (i.e. leverage above two times may result in counterparties anticipating far greater potential losses and resisting further expansion). Alternatively, governments could guarantee losses on the liabilities issued by the EFSF or some other type of entity, but once again that requires a significant change in EU governmental support for additional fiscal resources. Were the

If guarantors pay off the debt, they receive an implied right of indemnity (under contract law) or subrogation (under equity law) of their claims (also known as protection by belt and braces, both equity and contract law) and guarantors will take the place of senior debt-holders, being effectively pari passu to residual claims of repo counterparties, both far superior to any subordinated debt.

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guarantees to be provided, this leverage option could be analysed in a similar manner to simply expanding the size of the existing EFSF 2.0.

European banking recapitalisation EFSF 2.0 as TARP

In the section above, we often noted how the resources available for the EFSFs support of the bond market or for providing funding to countries will be limited by the likely need for bank recapitalisation. We will now analyse the possible size of bank recapitalisation needs in the eurozone. Former Bundesbank President Axel Weber now gives lectures on how 750bn would have been enough if used in the right part of the capital structure. But EU leaders instead invested in preference shares (to protect taxpayers) and are effectively propping up asset values (via sovereign rescue packages), both misuses of funds that likely would have been sufficient to recapitalise troubled banks through equity injections after sovereign debt write-downs. Given the significant monies already spent, bank recapitalisation at this time may be necessary but will likely be far more costly than had this been done previously. European bank recapitalisation Part of the expanded remit of the EFSF 2.0 is to recapitalise European banks via lending to their governments, effectively mirroring the use of TARP II in the US. Given that any material sovereign debt restructuring would bankrupt local lenders given their significant holdings of local debt (see Figure 3), we would expect a portion of the EFSFs funds to be used to recapitalise weak small periphery lenders (as effectively already seen in Ireland). However there is growing call from the IMF and many other global policymakers to follow the US TARPs example and inject precautionary capital in a co-ordinated way to multiple eurozone lenders to strengthen confidence and funding concerns.
Fig. 3: EU bank peripheral debt holdings as a percentage of CT1 capital
4

300%

Sovereign exposure % CT1 2011e (EBA base)

Italy 250%

Spain

Greece

Ireland

Portugal

200%

150%

100%

50%

0%

UCG

ALPHA

BARC

HSBC

BMPS

CASA

Source: EBA, Nomura estimates

As part of the many uses of the US TARP programme, the Capital Purchase Programme injected $205bn of the $700bn in TARP monies into preferred stock and equity warrants of US banks with eight major groups receiving as much as $25bn each. The weakest lenders including Bank of America and Citigroup also received direct equity injections and asset guarantees under other TARP initiatives.

Personal correspondence

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BPOP

ESFG

PAS

RBS

BNP

NBG

BBVA

PEIR

POP

LLOY

BCP

BKT

SAN

BofI

EFG

SAB

UBI

BPI

SG

ISP

AIB

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While this did not halt the decline in the equity valuations of US banks, it likely prevented some outright failures in the US by helping to restore confidence in the US financial industry. In a recent study "EU banks capital needs" (7 September) we looked at how much capital European banks might need under various scenarios based on the 90 banks in the EU stress tests. We estimated that to raise EU banks to a minimum core Tier 1 of 7% under Basel 3 (or higher if demanded by local regulators or under GSIFI requirements, and to mark to market GIIPS debt) the total capital need of EU banks would be just under 200bn. This is exactly the figure calculated by the IMF in its recent Global Financial Stability Report. If Europe experiences a moderate recession over the next two years as indicated in the adverse example of the stress test, this sum would rise to 350bn (the fourth column in the Figure 4). In the worst case of a default of all five countries with a 40% recovery rate, the capital needs climb as high as 675bn, or two-thirds of the core capital base, just from first order effects alone. A much more severe recession which would probably ensue could raise this figure higher.
Fig. 4: EU bank capital requirements under various scenarios

700 600

EU bank capital shortfall EURbn

UK

500
400 300 200

Spain Scandi Other Italy Greece Germany

100
0
Basel 3 minimum + GSIFI requirements + Moderate recession + MTM of GIIPS sovereign debt + 21% GIIPS impairment + GIIPS default (40% recovery)

France

Source: EBA, Bloomberg, Nomura estimates

Thus we could envisage that perhaps at least half, and potentially all of the remaining EFSF funds could be consumed by European bank recapitalisation. While this would help strengthen the financial system, the dilution could be devastating for bank equity shareholders, depending on the form of capital supplied. This would leave limited resources for the EFSF to provide liquidity support to Spain and Italy, perhaps accelerating a debt restructuring, which its creation was intended to avoid. In this event it could make sense for the stronger governments like France and Germany to recapitalise their banks directly (like in 2008) rather than deplete the funds of the EFSF, although this would need to be done in a co-ordinated way to avoid destabilising those banks which had not received capital support.

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DISCLOSURE APPENDIX A1
ANALYST CERTIFICATIONS We, Nick Firoozye, Dimitris Drakopoulos, Alastair Newton, Jon Peace, and Desmond Supple hereby certify (1) that the views expressed in this report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this report, (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report and (3) no part of our compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

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