Clarifying The EFSF/EFSM Bond Issuance

The European Commission announced plans to sell bonds to fund the Irish bailout through the EFSF and EFSM. Each entity will issue EUR3-5 bln in 2011, and will mainly have maturities of 5, 7, and 10 years. More debt will be issued in 2012. This debt issuance was expected after the Ireland rescue plan was announced, as it was made clear that the EFSF would never “pre-fund” and instead has to wait until support has been requested, a program has been negotiated with the EC/IMF, and a Memorandum of Understanding has been signed. The Greek package was considered a stand-alone program that did not fall under the EFSF, and that is why the first EFSF/EFSM issuance is coming now after the Ireland crisis.

Just to clarify the mechanics, the EFSF (European Financial Stability Facility) was created to issue debt in order to fund loans to member countries in “financial difficulties.” The bonds issued would be backed by guarantees given by all 16 members of the euro zone, up to EUR440 bln. The related EFSM (European Financial Stability Mechanism) comes from funds raised by the European Commission and are guaranteed by the EU budget, up to EUR60 bln. EFSM bonds will only be EUR-denominated, while EFSF can be in other currencies besides EUR, but in principal will be mostly EUR-denominated.

These EFSF/EFSM bonds are not the so-called E-bonds, but perhaps can be thought of as the first baby steps on the way towards the development of an E-bond market given the multilateral guarantees behind the EFSF/EFSM bonds. E-bonds in theory would replace sovereign bonds that are currently being issued to finance euro zone governments. Instead of small, shallow, country-specific bond markets, the E-bonds would theoretically form a much larger, deeper, euro zone-wide bond market that would be the next big step towards eventual fiscal union. The notion of the E-bonds is nothing particularly new, but has come into the spotlight after Luxembourg’s Juncker and Italy’s Tremonti pushed for it at the recent EU summit. Actual issuance of these E-bonds would require a change to the EU’s Lisbon Treaty, but from a practical standpoint, Germany and other core countries are resisting the proposal because it would clearly result in higher borrowing costs for the core since the E-bonds would carry some increased credit risk coming from the periphery. Of the 16 members of the euro zone, only 6 (Austria, Finland, France, Germany, Luxembourg, Netherlands) are AAA rated and so it will take some maneuvering to get AAA ratings for E-bonds.

This is similar to the problem faced by the EFSF, since it is a AAA entity funded by 10 countries that are not actually AAA. Credit enhancements (over-guarantee of 120%, up-front cash reserve, and cash buffer) have allowed the EFSF to get AAA rating, leading one observer to liken it to an oversized CDO. But given that the AAA rating was obtained suggests that enhancements and modifications could yield a AAA rating for the E-bonds too. Note that Luxembourg’s Juncker plans to put forward a proposal to create a European Debt Agency (EDA) to eventually replace the EFSF, but the moves toward fiscal union are likely to be slow and deliberate, much like Europe’s response so far to the euro zone crisis.

5-yr CDS periphery

5-yr CDS core

10-Yr Spread To Bunds Periphery

10-Yr Spread To Bunds Core

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