The EMF has been created, long live the EMF!

In an anticipation to the next Council, the European authorities have published on March 21, 2011, a detailed termsheet on the operation of the ESM [1] starting in 2013. This document does not surprise the markets, almost everything was already mentionned in the past decisions and past releases of the Eurogroup and ECOFIN. It is nevertheless an opportunity to review the mechanism of ESM, to provide comments and note that EU leaders have largely been inspired by the IMF.

• The total size is € 500 billions. No increase relative to the current situation, since the sum of the two current devices equals the same number (440 EFSF [2] + 60 EFSM [3]).This size seems adequate since it allows, in addition to support to Ireland and Greece (which is out EFSF), the refinancing of Portugal, Spain and the next two years of Italian debt maturity.

• More details on ESM status. It will be an intergovernmental organization, under public international law created by a treaty ... like the IMF. Such a status will promote the rating of the issuer and its perception by the market, while EFSF is still seen by some as a huge CDOs. This status remains slightly below the one hoped by the European Parliament who campaigned for the creation of a Community institution. The reasons behind this choice are mainly accounting, since the debt of a community organization should be proportionally consolidated by the members of the eurozone, unlike an intergovernmental organization. We bet that analysts and rating agencies will ignore this subtle accounting distinction and will integrate the ESM into conditional liabilities of the members of the eurozone.

• ESM Governance seems adequate. Important decisions are taken following the rule of "mutual decision" (unanimity of those who do not abstain), which may seem restrictive, but is actually quite common in community organizations and should not limit the action capacity of the ESM.

• ESM rating will be AAA. Given the issues (unsolved so far) faced by the EFSF to have a response capability of 440 billion euros, while maintaining a AAA rating, some have suggested - quite a bad idea in our opinion - a AA rating. The ESM will be rated AAA and it was achieved thanks to a new concept created by European leaders: the negative leverage! To lend a maximum of € 500 billions, the ESM will have a capital of € 700 billions ... mainly in the form of uncalled capital. The financial structure will be extremely strong, since the undertaking given by AAA states to provide capital is enough to get the expected 500 billions euros. That is the explanation of "negative leverage". This pattern is much closer to the pattern applied within the IMF than the one of EFSF. It has wisely been decided that the ESM may call the uncalled capital following a decision by simple majority in case of observed loss on an asset.

• The range of available tools is not yet finalized. The final termsheet appears simplified compared to previous discussions, since only two types of interventions are envisaged: short-term and medium-term loan and a purchase on the primary market. However, and it is a new and important announcement in relation to March 11 (and the strong German government’s stance), the door is open the use of new tools (CDS, secondary market).

• The process and pricing are clarified. The process of granting ESM facilities is clarified and it does not contain any significant surprises. Once a process of macroeconomic and fiscal adjustment approved and the contribution of private sector estimated (more details on this below), the ESM will discuss the terms of the facility with the state concerned. The Commission, with the IMF and in consultation with the ECB will monitor developments over time of macroeconomic adjustments required. The process seems copied from the IMF’s one. In terms of pricing, the rules of the game are remarkably clear and consistent, which will surely be appreciated by the Irish as they do not have the same cost structure as the Greeks: the price is set at the cost of funding of the ESM increased by 200bps, plus additional 100bps for the part of the loan that exceeds three years.

• The private sector contribution is the topic on which markets were waiting for answers by the EU leaders.Here Again, few surprises as most points already figured in the decision of the board of last December.
 Before granting a loan, the Commission and the IMF, in conjunction with the ECB, should estimate the "sustainability" of the country’s debt. With no surprise, the IMF methodology will be used.
 If the debt is sustainable, the creditors will simply be encouraged to hold their exposure, like what the IMF (I know I repeat myself) has established in Eastern Europe with the Vienna initiative. The idea behind is to avoid, what would call a game theory specialist, a non-cooperative and suboptimal behavior: no bank has any interest in full exposure removal by others but all have interest in being the first to fully remove exposure, which could lead to massive fire sales that could threaten the stability of the Euro
 If the debt is unsustainable, the document provides more insights to the decision of December 2010 by defining the criteria in used for a potential restructuring negociation with creditors. The only criterion to remember is the one related to fairness, which indicates that the solutions to reduce the "net present value"of the debt should only be used as a last resort.

• Our analysis of private sector contributions is as follows. This principle of burden sharing is absolutely necessary for the accession of Germany to the device. However, the leaders sought to give it the "softest" tone possible by insisting on some practices that are compatible with market expectations and could avoid defaults: equity, talks with investors, insertions of CACs [4], etc.. We believe that it is posisble to restructure Greek debt but, first, if it should occur it will happen before 2013 and, second, it will be through a non-coercive exchange offer. Note that the comment stating that the "unsustainable" debts "are "unlikely" has been deleted from the final document. This could reflect a slightly more negative view about the situation of some countries. Recall, however, an important element. When the IMF intervened in Greece, It granted what is known in the jargon of the IMF as an "exceptional access" which may be granted if and only if several conditions are met:

• (a) there is a strong need for uncovered financing
• (b) the debt is considered sustainable in the medium term,
• (c) the IMF believes that the country can regain access to capital markets and
• (d) the probability of success of the adjustment program is high.

The IMF has concluded positively on all these points, which shows that Greece’s debt is considered sustainable. In fact, it is unlikely that the EU institutions come to the conclusion that a country of the Union, which is subject to the Stability Pact and the supervision of the community authorities, has come to such an extent that its debt is unsustainable without a prior intervention of the Union. This case seems very unlikely.

• The objective of integrating CAC has been reiterated - for those who have missed a part of the movie. We have already written that the CACs are not new but are just an old politician trick: to turn old into new. In 2003, the president of the ECOFIN, Mr. Christodoulakis announced that all EU countries would have CACs in their bonds before the end of the year ... For instance, Greek issuances under English law (but not under Greek law) include CAC, with thresholds of 66% (issuances before 2004) or 75% (post 2004). Same in the U.S, Italy, etc...Decision has been taken for the future ESM to use a very standard format, already used worldwide and to apply it uniformly in Europe. The only relevant pending question seems to be the super-majority threshold chosen (we’re also not sure it will be the same everywhere in Europe, the termsheet remains ambiguous on this point). Common sense, as academic research published on this topic, suggests that the Germans would be in favor of thresholds close to 50%, while the Greeks, Irish, etc.. would militate for thresholds close to 85% or more. Who will win? We see a threshold at 75%, close to the market practice.

• The facilities of the ESM will be "senior" relative to private debt and subordinated relative to IMF debt. Again, nothing new. All have already been said, but it is an opportunity here to address this aspect of the ESM which has received few comments in the press. If the goal of ESM is to avoid the "default" of states, we can say that this subordination is not of great practical significance. But the reality is somewhat different. First, recall that the ISDA definition of "Restructuring event", which can trigger a CDS includes (iv) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation ". The preferred position of the ESM has been confirmed and this is probably the only real bad decision taken by EU leaders as it will increase two key factors of the crisis of the sovereigns: the bearish speculation on the CDS and the fragility of ratings.