EuroGroup Meeting Day One

The first day of the eurogroup (European finance ministers) meeting results in two decisions.  The first is the approval to the next tranche of Greek aid.  It is about 5.8 bln euros.  This is the sixth disbursement and there is no reason to think that next year's disbursements won't be the same nail-biting exercise as this year's have been.  The second decision involves the EFSF and only broad strokes appear to have been decided.  

As has widely been discussed, the EFSF form will be one of insurer rather than bank.  It will not borrow from the ECB as some had previously suggested.  Instead the EFSF will issue partial protection certificates that can guarantee up to 30% of a sovereign bond.

The French finance minister was quick to suggest that these certificates can be considered a form of "mutualization" and an early form of a European bond.  The market is unlikely to fully buy into this rhetoric.  These partial protection certificates are very similar to a credit default swap.  

The actions by European officials are purposely designed to avoid triggering credit-default swaps by making a 50%-plus haircut on Greece voluntary.  Ironically, European officials do not seem to appreciate the idea that under Greek law it appears that Greece could treat those that do not volunteer to take the 50%-plus haircuts as if they did if participation is deemed sufficient--like a qualified majority. 

In any event, way in which European officials addressed the Greek situation undermines the legitimacy of the sovereign CDS market.  Who will decide when an event took place that triggers those partial protection certificates?  We know who does in Greece's case.  A committee at ISDA, composed of representatives from banks, asset managers and hedge funds.    

It would not be surprising if a secondary market arose for these certificates.  It would also not be surprising if the value is less than what should be implied.  This also strikes one as a more complicated process and that the idea that it can be up and running next month seems to be a bit over the top.  

The special purpose vehicle--a sort of vulture (fallen angel) fund--that would theoretically draw outside investors--would buy distressed sovereign or bank assets seems also to take longer to set up than two months.  Moreover, there are a number of private sector financial institutions that are reportedly in the process of setting up their own funds that will be in direct competition with the EFSF's SPV.  The asymmetries of information and related issues suggests all sorts of technical and practical obstacles.  

In some ways, though, these are side issues.  Next week's EU Summit (Dec 8-9th) and the ECB meeting on Dec 8 is the real focus.  The short-term speculative market is short the euro.  Before this week the euro has fallen for four consecutive weeks and reached a seven week low.  The net short speculative position at the IMM was the largest in almost 18 months.  

Eurogroup head Junker also hinted at some tweaking of EFSF ability to act in both the primary and secondary markets.  The EFSF has only about 250 bln euros of uncommitted guarantees.   And if Italy needs assistance, its share of the guarantees cannot be counted on.  The EFSF has less resources than it may appear. 

The EFSF announcement, even if this analysis is correct and it is no panacea, shows European officials are still grappling with saving the project.  Next week, the ECB is likely to offer longer term financing for banks, cut interest rates, and may further loosen its collateral rules.  The EU Summit is likely to take steps toward the  fiscal union, though not sufficient to trigger QE from the ECB or the issuance of real European bonds.  It is ahead of this window of opportunity for action that may encourage a further short covering recovery in the euro, before a resumption of its downtrend.