EFSF Partial Protection Certificates No Panacea

Last night, the Eurogroup announced further details about the two mechanisms through which the EFSF is to provide assistance to troubled sovereigns. I'll focus on the Partial Protection Certificates in this post and discuss the Co-Investment Fund in a separate post.

The Eurogroup intends for the EFSF to issue Partial Protection Certificates (PPC) in conjunction with bond issuance for distressed sovereigns. The few available details can be found in the Terms and Conditions document published on 29-Nov-11, but some of the more relevant provisions are troubling.

1. As the name suggests, each PPC will offer only partial protection, from 20-30%, "to be determined in light of market circumstances."
2. Each PPC will be issued by a Luxembourg special purpose vehicle (SPV), which "would not be legally connected to the EFSF or Member States."
3. "The certificate gives rise to a claim in the event of a Member State credit event under the full ISDA definition, which covers (i) failure by the Issuer to make full and timely payments of amounts scheduled to be due in respect of one or more bonds, subject to grace periods; or (ii) repudiation or moratorium;or (iii) restructuring. These losses will be determined based on the ISDA procedures."
4. "The SPV will settle the claim by cash or by EFSF bonds."
5. "...the claim is unfunded until the time of a call.  Upon investors’ request it could be considered, that claims would be funded at the outset."
6. "The investor will be required, at time of claim or settlement, to demonstrate that they hold outstanding sovereign bonds of that Member State of at least the same principal value as the original bond covered by the Certificate."

These terms present some considerable concerns.

First, investors will ask whether the PPCs would have helped the holders of Greek debt. A PPC of 30% in theory places a floor of 30% on the value of a bond. Greek private sector involvement (PSI) has required a "voluntary" contribution of 50% from investors. It appears that a PPC of 20-30% would have been of no use whatsover to a holder of Greek debt.

The Eurogroup would respond to this critique by noting that the PPCs can be detached and traded separately. But the terms and conditions clearly specify that a PPC needs to be re-attached to a bond in order to be redeemed. It appears very likely that Greek bondholders would have been asked to contribute 50% toward Greek assistance irrespective of any PPCs that might have been issued in conjunction with Greek bonds.

Second, the credit quality of the PPCs themselves appear highly questionable. The PPCs are to be issued by an SPV with no legal connection to the EFSF or to Member States and to be unfunded until the time of call. And the PPCs can be settled with EFSF bonds. If Member States fail to fund the SPV at the time of call, or if the SPV otherwise is unable or unwilling to pay on claims, what legal recourse is available to holders of PPCs? And if one of the larger Member States has defaulted or restructured, what value is an EFSF bond likely to have?

And this brings us to the third major concern: a credit event is to be determined by ISDA using standard terms. But in the case of Greece, we've seen that Member States have been able to engineer a 50% restructuring of debt without triggering a credit event as determined by ISDA. If Member States can extract a 50% restructuring without triggering an ISDA credit event, of what use is a PPC whose payoff is determined by ISDA terms?

These concerns are not details to be addressed at some later date. They address the ability of the PPC program to add any credit enhancement whatsoever. My sense is that PPCs as designed are virtually worthless, and I expect most investors will reach a similar conclusion.