SOV CDS, EFSF, And The IIF

Much has been written about the impact of the IIF’s “voluntary” haircut program. I maintain that not only isn’t it a Credit Event, but it shouldn’t be one, because the banks are receiving something in return for doing it (or not having something taken away).

One of the obvious consequences of the EU and IIF decision to pursue this restructuring is the need for banks to manage their balance sheets and exposure “old school”. They cannot fully rely on CDS and markets will treat net exposure numbers with skepticism. So banks will sell bonds/loans and unwind their CDS positions and manage their exposure the old fashioned way, by adding or reducing to their bond/loan position.

That impact seemed obvious to everyone other than the EU and IIF. Many expect sovereign CDS to become worthless, and although that was my initial reaction, all that will change is the “basis”. CDS will trade tight relative to cash and the basis will be impacted. That has occurred in Greece for example where the basis went from 100 to 93, largely because CDS got tighter and bonds didn’t move or went down a bit in price. CDS still has value for several reasons. Hedge funds or other true private holders don’t have to agree to the plan, so they can retain bonds and the “basis” package will still function for them. The scale of Greek debt is so big, and the NPV reduction is small enough, that Greece may still have to default in the near term, and banks would be unwilling to take a further reduction “voluntarily”. The CDS still has value as no plan is even officially proposed yet, let alone agreed to.

The first real unintended consequence is impacting the EFSF and has nothing to do with sovereign CDS, but everything to do with “voluntary” write-downs. What bank (or IIF member) would buy EFSF bonds knowing that the EU would ask for voluntary restructuring on these bonds ahead of anything else. Since the EFSF is complicated and relies on guarantees, it would be the easiest debt for the EU to restructure if needed. The facade that guarantees aren’t debt but are useful is part of the problem. Guarantees aren’t as good as a real obligation. If France or Germany runs into any problems and needs to change their debt profile, the EFSF would be the first target. It doesn’t really count as their debt, in their minds, so it would have limited impact on market perception (again, in their minds). We have always questioned how likely the EFSF is to honor its obligations if required, but the new question is how quickly would these be restructured.

So the first real unintended consequence of the IIF/EU voluntary plan is to make banks in particular, but all IIF members, scared to own these bonds. They are already long all the sovereign debt they can handle, and not only would this be adding to their exposure (which they would have to account for somehow) it is in an extremely weak form, most at risk of being “voluntarily” forced to restructure. I guess that is the nature of unintended consequences, they have consequences that are unintended.

Hedge funds and real private money won’t touch EFSF as a long term holding. It is so complex, constantly devolving, and run by someone without the skills to manage what EFSF has become. Private investors can buy a mix of sovereign bonds to create the risk/return profile they want, and the EFSF just is too confusing, has too much potential future change risk, that it isn’t appealing. Sure, from time to time, if it gets cheap to France some funds will buy EFSF, short France or something, but EFSF bonds don’t make sense for real private money.

So the pseudo-private money (EU banks, EU pension funds, and EU insurance companies) are reluctant to buy EFSF bonds because they already have too much sovereign exposure, and the EU is likely to force “voluntary” changes on EFSF debt before it would on actual outright sovereign debt. Real private money is confused by the structure, the ever changing purpose, and managements express desire to make non-commercial decisions at off-market prices.

Who does that leave? Only sovereign wealth funds and other supra-national entities. EFSF is the bond only a mother could love. Whatever happens this week, is likely to have consequences down the road, that haven’t been thought about and may be worse in the end than letting the system clear itself.