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October 24, 2011 7:11 pm
A big bazooka is needed. But instead eurozone leaders are likely to produce a cap gun that lacks a silver bullet to deal with the crisis, according to investors.
One of the biggest worries is that, in seeking a short-term fix to the problems of Italy and Greece, European leaders could be building up longer-term problems for eurozone government bond markets.
Some investors are nervous about proposals for Europe’s rescue vehicle, the European financial stability facility, to offer guarantees or first loss insurance on debt sold by Italy and Spain at auction or to set up a new fund to do the same.
“I don’t think anyone is thinking through the medium-term implications of any of these solutions,” says Sushil Wadhwani, head of the eponymous hedge fund and a former member of the Bank of England’s rate-setting monetary policy committee.
“What you don’t do is this halfway house where you offer this pathetic guarantee. It is ineffective and costly,” he says.
His concern, and that of other investors, is on a number of fronts against the insurance proposal, which could offer protection to investors for the first 20-25 per cent of losses in Italy or Spain. One worry is that a two-tier eurozone bond market would result with guaranteed debt trading alongside non-guaranteed debt.
Because the insurance proposal would only apply to new debt issued at auctions – so-called primary issuance – investors are concerned about how the secondary markets, where the bonds are then traded, will react.
“If you have two tiers of bonds, what does it do in terms of liquidity? It’s all about primary issuance, so what are you going to do about the secondary market?” asks one of the eurozone’s biggest bond investors.
Backers of the plan have a twofold answer.
First, the plan is meant to deal with a liquidity problem and ensure the likes of Italy and Spain can run smooth auctions.
But, second, they hope that the yield gap between the two tiers might narrow as investors seek higher-yielding securities.
Another concern of investors is whether the guarantee itself is meaningful.
Mr Wadhwani says bondholders are likely to lose far more than the 20 per cent they would have insured.
“We know from the history of sovereign defaults that recovery rates are nowhere near 80 per cent,” he says, pointing to research that suggests it is typically nearer 50 per cent.
But others have an even bigger worry: would the guarantee be honoured were Italy to default?
Italy is the world’s third-largest bond market with about €1,900bn ($2,645bn) in debt outstanding. Proposals from Deutsche Bank, one of the supporters of the insurance proposal, argue that about €200bn-€250bn of money from the EFSF could be used to insure about €1,000bn of bond issuance – equivalent to Italy and Spain’s gross financing needs for the next three years.
Another problem for some investors is that insurance would explicitly raise the question of credit losses in eurozone government bonds.
Currently, Spanish 10-year bonds trade at their face value, or 100 cents in the euro, but their Italian equivalents have a price of 92 cents in the euro.
In recent years, sovereign debt investors have had to face up to the fact that government bonds are no longer risk-free, but some question whether they can yet properly price in the chance of default.
The sheer size of Italy’s bond markets though leads some to question whether in the extensive fallout following a potential default, European policymakers would want to hand money over to private sector investors.
Gary Jenkins, head of fixed income at Evolution Securities, says: “I find it difficult to believe that under a scenario where a country such as Italy . . . has just gone bust that the EFSF would be able or indeed willing to pay bondholders.”
Some supporters of the insurance proposal, such as Paul Achleitner of Allianz, argue that one of its appeals is that it will most likely not be needed. But, as one investor says, one of the lessons of the eurozone crisis is that authorities have consistently introduced devices, including the EFSF itself, arguing that they will never be used.
Analysts at Credit Suisse also fret that the proposal could increase the correlation between government debt in the periphery and core of the eurozone, as well as between sovereigns and banks. “Talk of leveraging the EFSF we think is in danger of exacerbating rather than solving the sovereign crisis in Europe,” they wrote on Monday.
Not everyone is so negative about the outcome. Andrew Balls, head of European portfolio management at Pimco, a subsidiary of Allianz, says: “The insurance proposal is something that can be useful as part of a comprehensive package.”
There is little clarity about the second option for the EFSF – of setting up a special fund to attract global investors including perhaps the International Monetary Fund – but many investors believe it would have some kind of guarantee scheme similar to the insurance proposal.
But with both proposals seen as highly complicated, perhaps the biggest risk is how and even whether any of the changes to the EFSF will be made, coming so soon after its last revamp was rubber-stamped this month. Mr Balls believes that should make investors cautious on stepping back into the likes of Italian and Spanish debt.
“Given the record of the past two years, it makes a great deal of sense to be very cautious in terms of implementation risk,” he says.
Additional reporting by David Oakley
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