CONVERTING JUNK INTO TRIPLE-A: HOW A EURO RESCUE PLAN MIGHT LOOK

UNDER one of the bailout plans for Eurozone banks mooted yesterday, rescue funds from member states would be leveraged through the region’s bailout fund and the European Investment Bank (EIB). The EIB denied that it has been asked to involve itself: doing so would be a political hot potato because it would put the EIB’s guarantors – non-euro states like the UK – on the hook for losses. Other forms of this plan would operate similarly, however, with the ECB taking the role of investors lending to the special purpose vehicle (SPV) and the EIB cut out of the loop. This would keep non-euro states out of the equation but is likely to encounter fierce ECB opposition.

GREECE
Under this scenario, Greece would default in an “orderly” way, imposing harsh haircuts on banks holding its bonds, some of which would then need the rescue outlined in the diagram. If Athens still required funds, they would likely come from the new euro bailout fund to be set up in 2013.

ECB
The European Central Bank

EIB
The European Investment Bank, backed by all 27 EU member states

EFSF
The European Financial Stability Facility, the euro’s bailout fund

SWFs
Bond investors, most likely non-European sovereign wealth funds from China or the Middle East

1. CASH-FOR-EFSF BOND EXCHANGE
The EFSF would borrow money by selling bonds to investors, allowing its to leverage its capital (currently €440bn and due to rise to €780bn) to deploy to the EIB’s SPV for rescues

2. CAPITAL INJECTION
Using new cash from the EFSF, the EIB capitalises a new SPV, making the EIB’s guarantors (EU states) liable for any losses

SPV
A new Special Purpose Vehicle would end up holding a collection of junk bonds, with losses covered by the EIB and by proceeds from sales of its own bonds to investors

3. CASH-FOR-SPV BOND EXCHANGE
The SPV further leverages its capital by selling special new SPV bonds to investors. Like the EFSF bonds, these are attractive because they have good credit ratings (being underwritten by triple-A solvent states) but give a higher coupon rate.
Investors
Other buyers of the SPV’s bonds, such as solvent banks and bond investors

4. JUNK BONDS-FOR-SPV BOND EXCHANGE
Shaky Eurozone banks are bailed out, offloading their junk government bonds in exchange for triple-A rated SPV bonds at an agreed rate

Eurozone Banks
Banks whose solvency is threatened by haircuts on their government bond holdings

5. LENDING FOR SPV COLLATERAL
Eurozone banks would post their brand new triple-A rated SPV bonds as collateral for any emergency lending from the ECB, allowing the ECB to be insulated from some of the losses on junk sovereign bonds.

Source: Macro Man Blog, City A.M. analysis