Wednesday, 30 November 2011

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.

Thursday, 17 November 2011

Legal Issues of ECB Lending to the IMF

News reports suggest that officials from the ECB and the IMF have been discussing a plan in which the IMF would purchase EMU member state sovereign debt using loans from the ECB. In fact, rallies in the euro and in equities earlier today have been attributed to this story.

This plan would be an unlikely development for a number of reasons, particularly given the legal prohibition against monetary financing of member states by the ECB.

ECB financing and the IMF

As recently, as 9-Nov-11, the ECB issued a legal decision clarifying that a member of the European System of Central Banks (ESCB) could provide monetary financing of a Member State's obligations to the IMF, consistent with Article 7 of Regulation (EC) No 3603/93 issued by the Council of the European Union.

However, the suggestion here is not to provide financing to a Member State to give to the IMF. Rather, the proposal reported today is to providing financing to the IMF to give to Member States. And this is an issue that the ECB already has addressed.

ECB already has ruled out this aproach

The ECB offered a legal decision on 17-Mar-11 in which it stated that lending by the ECB to the ESM would not be consistent with EU Treaties and Statues. To see whether the logic of that decision applies to the IMF, it's useful to carefully consider the relevant two paragraphs in the decision.

"With respect to the role of the ECB and the Eurosystem, while the ECB may act as fiscal agent for the ESM pursuant to Article 21.2 of the Statute of the European System of Central Banks and of the  European Central Bank (hereinafter the ‘Statute of the ESCB’), in the same way as under the Union’s  Medium-Term Financial Assistance Facility, the EFSM and the EFSF, Article 123 TFEU would not  allow the ESM to become a counterparty of the Eurosystem under Article 18 of the Statute of the ESCB.

On this latter element, the ECB recalls that the monetary financing prohibition in Article 123 TFEU is one of the basic pillars of the legal architecture of EMU both for reasons of fiscal discipline of the  Member States and in order to preserve the integrity of the single monetary policy as well as the  independence of the ECB and the Eurosystem."

As mentioned in my last post, Council Regulation (EC) No 3603/93 of 13 December 1993 interprets Article 123 of the Treaty for the Functioning of the European Union (formerly Article 104 of the Maastricht Treaty) so as to preclude monetary financing via third parties. The EU decision applies this logic to the ESM as a third party and concludes that the ECB is not permitted to lend to the ESM. Application of the same legal argument to the IMF would be expected to lead to a similar decision.

The Views of Bundesbank President Weidmann

In fact, Bundesbank President Jens Weidmann addressed this issue directly in an interview published with the Financial Times at the beginning of the week.

FT: Some in Washington have suggested the ECB could lend, directly or indirectly, to the IMF, which could then help Italy. Would you rule that out as a possibility?

JW: Again, the crucial point is that the eurosystem is not permitted to lend to eurozone member states – no matter whether this is done directly or indirectly by using the IMF as an intermediary.

The bottom line

The Treaties, Statutes, Regulations, and Decisions of the EU prohibit monetary financing of Member States, directly and indirectly -- a point reiterated just this week by the President of the Bundesbank. As a result, it seems today's story is a canard -- a trial balloon with the intent by mid-level finance ministry functionaries to find some creative solution to the debt crisis. My sense is that they'll need to keep trying, as this proposal appears very unlikely to be implemented.

Sunday, 13 November 2011

Legal Issues Involving the ECB as Sovereign Lender of Last Resort

With plans for the EFSF floundering, there are increasing calls for the ECB to buy large quantities of Italian sovereign debt in an attempt to reduce Italian bond yields and retain Italy’s access to the primary debt market. For example, Portuguese President Anibal Cavaco Silva called last week for the ECB to act as a lender of last resort with a “foreseeable, unlimited intervention.”

While these calls are understandable given the current circumstances, recent indications suggest these calls are falling on deaf ears. Regardless of the various economics arguments for and against the ECB adopting a role as lender of last resort for Member States, there appear to be compelling legal issues arguing against this, beginning with the statute that enabled the European System of Central Banks.

The Statute of the European System of Central Banks (ESCB)

The Statute is a protocol attached to the Maastricht Treaty, agreed in February 1992. Article 18(1) of the Statute permits the ECB and the national central banks of the eurosystem to purchase securities to achieve the objectives of the ESCB, while Article 18(2) gives the ECB the ability to establish principles governing these purchases. These Articles are fairly short and are worth repeating here.

Article 18

Open market and credit operations

18.1. In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may:

— operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in Community or in non-Community currencies, as well as precious metals;

— conduct credit operations with credit institutions and other market participants, with lending being based on adequate collateral.

18.2. The ECB shall establish general principles for open market and credit operations carried out by itself or the national central banks, including for the announcement of conditions under which they stand ready to enter into such transactions.

It’s worth noting that while Article 18 gives the ECB fairly broad powers to buy and sell securities, it places a constraint on the purpose for which these market transactions can be conducted. In particular, these powers have been granted “in order to achieve the objectives of the ESCB,” which are specified in various documents, including the Maastricht Treaty.

The Maastricht Treaty

The powers granted the ESCB by Article 18 of the Statute are further constrained by Article 104 of the Maastricht Treaty, now article 123 of the Treaty for the Functioning of the European Union (TFEU). The first paragraph of Article 104 prohibits monetary financing of EMU Member States and deserves careful consideration.

Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

It's important to note that the prohibition in this paragraph is of purchases that are made “directly” from EU sovereigns. The lack of an explicit prohibition against secondary market purchases has been seized upon by those advocating that the ECB act as a lender of last resort for Member States by purchasing significant quantities of sovereign debt in the secondary market. However, secondary market purchases for this purpose appear to be restricted by a regulation issued in 1993 by the Council of the European Union as part of the implementation process for the Maastricht Treaty.

Council Regulation (EC) No 3603/93 of 13 December 1993

In EC No 3603/93, the Council addressed the issue of secondary bond market purchases by clarifying the definition of the phrase, “other type of credit facility” in paragraph 1 of Article 104 of the Maastricht Treaty (Article 123 of the TFEU). The relevant article appears below with the key text highlighted in bold for easier reading.

Article 1

1. For the purposes of Article 104 of the Treaty:

(a) 'overdraft facilities' means any provision of funds to the public sector resulting or likely to result in a debit balance;

(b) 'other type of credit facility' means:

(i) any claim against the public sector existing at 1 January 1994, except for fixed-maturity claims acquired before that date;

(ii) any financing of the public sector's obligations vis-à-vis third parties;

(iii) without prejudice to Article 104 (2) of the Treaty, any transaction with the public sector resulting or likely to result in a claim against that sector.

In its Convergence Report of May 2010, the ECB also addressed this issue. In a section titled, Prohibition on Monetary Financing, the ECB commented on Council Regulation (EC) No 3603/93, noting “the prohibition includes any financing of the public sector’s obligations vis-à-vis third parties.”

Intent matters

The effect of the Maastricht Treaty, the ESCB Statute, and the associated Council Regulation is to permit the ECB to purchase sovereign debt in the secondary market with the intent to “achieve the objectives of the ESCB” but to prohibit secondary market purchases with the intent to provide monetary financing of Member State budgets.

This interpretation appears to be shared by the ECB, as evidenced in various ECB opinions. For example, in a legal opinion dated 25-Mar-10 on independence, confidentiality and the prohibition of monetary financing (CON/2010/25), the ECB indicated, “The prohibition of monetary financing prohibits the direct purchase of public sector debt, but such purchases in the secondary market are allowed, in principle, as long as such secondary market purchases are not used to circumvent the objective of Article 123 of the Treaty.”

And to underscore the importance of these restrictions and its commitment to them, the ECB also wrote in that section, “The monetary financing prohibition is of essential importance to ensuring that the primary objective of monetary policy (namely to maintain price stability) is not impeded. Furthermore, central bank financing of the public sector lessens the pressure for fiscal discipline. Therefore the prohibition must be interpreted extensively in order to ensure its strict application...”

The Securities Market Programme

The ECB has repeatedly stressed the limited and specific purpose of the SMP. For example, in the ECB Decision to establish the SMP, it cited “...severe tensions in certain market segments which are hampering the monetary policy transmission mechanism and thereby the effective conduct of monetary policy oriented towards price stability in the medium term.”

With this in mind, the critical issue at the moment is whether the ECB believes significant purchases of Italian debt would be to enable the effective conduct of monetary policy or to provide monetary financing for a Member State. Reasonable people can and do differ on this issue, at times considerably. For example, Axel Weber, at one point the presumptive successor to President Trichet, and Jürgen Stark, the ECB Chief Economist, were so strongly opposed to the SMP in its current form that they resigned earlier in the year.

With President Trichet having just ended his tenure as ECB President, it’s useful to consider the views of the new President, Mario Draghi.

The views of President Draghi

At his inaugural press conference as ECB President on November 3, Mario Draghi was asked a pointed question by a journalist. “Are you prepared now to make a commitment that you will do whatever is necessary to keep the euro area in one piece, including – if necessary – becoming the lender of last resort to governments?

Draghi’s response was instructive. “I have a question for you: what makes you think that the ECB becoming the lender of last resort for governments is what is needed to keep the euro area together? No, I do not think that this is really within the remit of the ECB. The remit of the ECB is maintaining price stability over the medium term.

From this response, it appears Draghi is not inclined to support additional purchases of Italian debt for the purpose of providing monetary financing for Italy. 

The Bottom Line

The clear legal intent at the establishment of the monetary union was to avoid monetary financing of Member State budgets, and President Draghi appears committed to upholding this principle. 

It appears reasonable to expect that moderate purchases of Member State debt will continue for the specific purpose of facilitating the transmission mechanism for monetary policy. But calls for the ECB to contravene the enabling treaties, statutes, regulations, and decisions of the monetary union appear to be falling upon deaf ears. Regardless of any economic arguments to the contrary, the legal issues simply don’t appear consistent with the ECB assuming a lender of last resort function with respect to Member States. If the market refuses to provide additional financing for Italy at some point, it appears the Italians will have to look elsewhere for assistance in financing their budget.

Thursday, 27 October 2011

Behind the headlines: smoke and mirrors

The headlines from last night's EU summit are positive, as are reactions in the equity and currency markets, but a careful reading of the EU summit statement gives a more sobering picture.

The 50% figure for private sector involvement (PSI) is large, involuntary, and comes with no greater guarantee of finality than did the 21% figure announced fourteen weeks ago. The structure of the bond exchange has yet to be determined, and we don't know the extent to which various parties will participate. (The presumption is that this level of PSI won't trigger CDS, but I wouldn't be surprised if this view was challenged at some point.)

We're told that credit enhancement will be provided so that Greek collateral will remain eligible for Eurosystem liquidity operations, but we don't know the form this enhancement will take.

We're told that eurozone member states "solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signature." But we're given no reason to expect investors will be treated any better in the future than they're being treated in the case of Greece.

The enhancements to the EFSF "will be done without extending the guarantees underpinning the facility." No additional financial resources are being provided. They're simply spreading existing resources more thinly.

With respect to the new insurance aspect of the EFSF, leaders state, "Purchasing this risk insurance would be offered to private investors as an option when buying bonds in the primary market." This raises a host of questions. How much do they intend to charge for the insurance? How will this price be determined.? More important, why should investors expect that the EU will perform on these insurance agreements? After all, who is taking first losses in the case of Greece?

The EU hopes to cajole "private and public financial institutions and investors" to enlarge the resources of the EFSF by co-investing in special purpose vehicles. How would these vehicles be structured, and what sweeteners, if any, would be provided to entice investors to participate?

Along these lines, EFSF head, Klaus Regling, is traveling to Beijing later this week to entice additional investment, and reports suggest Sarkozy is planning to call Hu Jintao today in hopes of eliciting support. But when thinking of Chinese involvement, it's useful to note comments made by Gao Xiching, President of the China Investment Corporation at an IMF meeting on 24-Sep-11. "A lot of people blame the Chinese for saving too much money and not spending so that made it possible for the European friends and the American friends to borrow. Yeah -- that's true. So we are going to spend more. But when we spend more, we're going to pull money out of your system." These sorts of comments do little to raise hopes for significant Chinese involvement.

The EU summit statement also indicates,  "Legislative work on the Commission proposals for a Common Consolidated Corporate Tax Base and for a Financial Transaction Tax is ongoing." The issue of corporate tax is no less contentious now than it has been for the past few years, with Ireland expressing particular objections. And while the financial transactions tax may be less contentious, at least within Europe, it would be harmful to European banks and more generally to the European economy, which needs the financial system to function more efficiently rather than less efficiently.

The EU and the European Banking Authority (EBA) state the need for guarantees on bank liabilities to support the term funding of banks and, in particular, to prevent banks from deleveraging as existing term funding arrangements mature. But banks are having difficulties because of the risks of sovereign insolvency. Are we to believe that sovereign guarantees of bank liabilities are going to improve the creditworthiness of banks at this point? And of course we're told this is an issue that the Commission "should urgently explore," with no further information available.

Banks will be required to have tier 1 capital ratios of 9%, but we're told that any plan for achieving this "must ensure that banks’ plans to strengthen capital do not lead to excessive deleveraging." How are regulators going to prevent deleveraging, short of nationalization? (Speaking of nationalization, reports suggest Greece will need to nationalize a number of its banks as a result of these measures.) 

The EBA refers to the expectation that banks will withhold dividend and bonus payments, to reach these capital targets. Will every problem in Europe be met with a call to withhold bank bonuses? Is there a view that banks can reach 9% capital ratios by lowering employee compensation? In what other industry would this constitute a reasonable microeconomic analysis?

The bottom line is that the EFSF is not getting more resources, and it's existing resources will be spread more thinly, via two vague approaches involving an insurance scheme and/or special purpose vehicles. Bank shareholders are being raided while the EU demands that banks raise additional capital. And banks are expected to respond without deleveraging.

I believe the measures announced overnight in the EU summit statement do very little to help the situation and quite possibly will serve to exacerbate the crisis. The reaction in financial markets appears to be considerably more favorable, but my sense is that this response is likely to follow the previous pattern, with initial relief and optimism giving way to concern  and skepticism as the details of the announcements are analyzed in coming days and weeks.