The EFSF Opens for Business … But Will it Make a Profit?

Come next Friday October 14, Malta, the final European state to approve the EUR 440B European Financial Stability Fund, will have given their assent. This is no mean feat – organising and winning approval from 17 separate parliaments in three months is quite an accomplishment. The EFSF will be open for business …

What should we expect? The main objective is to lower interest rates on offer to distressed countries such as Greece, Ireland, Portugal and, to a lesser extent, Spain and Italy. The logical action is to buy up the discounted bonds of these countries, squeeze out the shorts and provide liquidity to nervous holders. The EFSF can borrow at AAA rated levels to buy these bonds – as such, it has been labelled “the Mother of all Hedge Funds”.

What will happen? My guess is that it will take the EFSF a few weeks to get the courage to enter the water. But, when they do, they will meet little resistance. The only shorts in the market are those expecting the EFSF to fail to get approval, immediate default and contagion – despite their doubts, these investors will quickly reverse their positions, recognising the EFSF is here to stay. Similarly, the presence of the EFSF in the market will embolden existing holders who will be less likely to sell at low prices.

The EFSF will either quietly start buying bonds across the curve or announce a public tender. The former approach would soak up cheap securities, while the latter would seek to backstop the market at a demonstrably higher price. I think that they will do the former for a month or so, and then announce a tender.

The EFSF’s main problem, as I see it, is being able to show a profit! Its profit measure is how much it can buy at rates higher than its cost of funds. Theoretically, if the EFSF can buy up all of Greece’s debt at 40 cents on the Euro, it will wipe out 60% of its debt, in turn saving the authorities EUR 180B relative to having to make good on the outstanding. As soon as it hits the market, however, prices will jump on very little volume. It will successfully drive down interest rates, albeit without spending much of its war chest … and therefore produce little profit.

What should existing bondholders do? Absolutely nothing – your bonds are going up and they will mature at par.

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