EFSF and France in downward spiral

Fri Oct 21, 2011 6:53am EDT

Related Topics

* Supply, ratings doubts weigh on EFSF/France credit spreads

* OAT/Bunds spread hits 118bp, euro record wide

* Investors dubious on EFSF, insurance plan questioned

By Michael Winfield

LONDON, Oct 21 (IFR) - The European Financial Stability Facility's spreads have seemingly established a destructive correlation with France, with the prospect of a beefed-up EFSF hurting France's spreads and Triple A rating, and therefore the EFSF.

The fact that investors are demanding fixed income assets pay an attractive spread above French bonds has resulted in the EFSF's outstanding EUR13bn of debt widening as well as impacting other issuers such as the European Investment Bank and the European Union.

France's move this week to an all-time euro high of 120bp over Germany has occurred as doubts over its ability to retain its Triple A status have surfaced. Meanwhile, policymakers are struggling to convince investors that the EFSF remains fit for purpose, or what exactly that purpose is.

OAT spreads versus Bunds have doubled between the beginning of July - when talks to upsize the EFSF's lending capability to EUR440bn began - and end of September when they hit 72bp as a result talks of the EFSF being leveraged to as much as EUR2trn.

A vicious circle has been created in which the widening of either France or the EFSF is followed by the other weakening further.

This week's added 24bp widening in the OAT/Bund 10-year spread has also been accompanied by the EFSF's secondary debt widening in relation to Bunds by 32bp.

Investors in the inaugural and subsequent EFSF's deals are nursing substantial losses. The five-year trades both sold at mid-swaps plus 6bp - were quoted nearer to plus 70bp by the end of the week, and the 10-year deal priced at plus 17bp, was in the mid-80s over swaps.

Adding to the difficulties for the EFSF is that it is due to be in the market as early as next week and is understood to favour a 15-year transaction.

Potential investors require EFSF's new issuance terms to be attractive compared to the French curve as many longer dated investors are French insurance companies.

THE EFSF AS ESIM

Another twist is the potential for the EFSF to be able to buy secondary debt, assuming a country is solvent and maintains solid fiscal and current account targets, has a stable banking system, and the ECB and deputy finance ministers agree.

A leaked document also suggested that the EFSF would have the ability to sell bonds back into the market, hold to maturity, sell back to the issuing sovereign or use them for repo purposes with commercial banks.

Another idea on the table is the transformation the EFSF into a new structure called the European Sovereign Insurance Mechanism (ESIM).

But according to Tamara Burnell of M&G Investments in her Bond Vigilantes' blog, "monoline insurers have a somewhat tarnished track record in recent years [with] the fundamental problem being persuading investors that they would ever be able to call on the insurance policy provided by the EFSF/ESIM/ESM when they actually need to," wrote Burnell.

RBS analysts think this approach has some logic, but the effect of, "the insurance contract merely transfers the risk into another part of the system and sometimes concentrates it in dangerously high proportions."

SILVER LINING

At least there is a potential silver lining in proposals that the EFSF insures sovereign debt, in that it would avoid the necessity of pre-funding.

Uncertainty over how much EFSF paper is in the pipeline has contributed to investors' fears, as well as growing unease about its structure - especially in light of the leveraging proposals.

Leverage via an insurer model -- either the ESIM idea or the BNP Paribas counterplan which would see it write CDS -- would also seemingly deal with the question of Italy and Spain potentially being in need of assistance though.

"Applying a leverage of five (a 20% first loss guarantee) would imply covering maximum total issuance of EUR1.55trn of sovereign debt [compared to] an estimate of Italy and Spain's sovereign gross financing needs until Q2 2013 of around EUR900bn," according to Citigroup.

Nevertheless, nine out of 10 fund managers and strategists at firms running more than USD2.5trn in assets said they were either unsure of or had no interest lending to the bailout fund, according to a poll of asset managers conducted by Reuters this week.

And eight of 10 managers polled said they would not even consider buying its bonds unless spreads were at least double current levels of around mid-swaps plus 50bp-65bp. In addition, three of those eight ruled out buying EFSF debt unless spreads swelled beyond triple digits.

Jamie Stuttard, head of institutional bond portfolio management at Fidelity in the UK suggested that despite the plethora of different proposals being suggested this week ahead of the fast approaching deadline, the main change that is needed will take longer to achieve.

"In conjunction with a proper Greek restructuring, the EFSF assuming an insurance roll and a feasible bank recapitalisation plan, there is a need for a proper fiscal framework which will need a reconciliation of the multiple different fiscal visions Eurozone policymakers have," he said. (Reporting by Michael Winfield, Editing by Alex Chambers)

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