Among euro zone leaders' list of nightmare scenarios, investors refusing to fund the European Financial Stability Facility ranks quite high. The day hasn't yet come, but the bailout fund's decision to scrap a €3-billion bond issue will leave politicians decidedly edgy.
The main reason for postponing the bond issue – required to help fund Ireland's bailout – was the turmoil caused by Greece's surprise decision to hold a referendum. Since Monday, the spread between 10-year EFSF bonds and German bunds of the same maturity has widened by 30 basis points to 155 basis points. That's a startling degree of volatility for what is supposed to be a near risk-free instrument. If the EFSF had pushed ahead, it risked sending a signal of desperation while leaving investors nursing losses and setting a high benchmark for future issues.
The plan now is to proceed in the next two weeks, after the G20 summit of leading nations has hopefully eased tensions. Even if that doesn't work, the EFSF can afford to sit tight for a bit longer. It doesn't need to issue any more debt to finance Portugal's bailout this year, and Ireland has about €11.6-billion of reserves to cover the €3-billion it was expecting from the EFSF.
But market volatility is only part of the problem. The delay has also highlighted weaknesses in the EFSF, which has sufficient resources to bail out small countries, but is being rapidly retooled as the euro zone struggles to contain the widening crisis. Governments now want the EFSF to help underpin new debt issues by countries such as Spain and Italy, and to seed leveraged special purpose investment vehicles that could buy bonds or recapitalize banks.
Investors no longer know how much debt the EFSF will issue, and how steeply it will be leveraged. Even before Greece dropped its referendum bombshell, EFSF bonds were feeling the strain: As recently as July, the spread over German bunds was just 60 basis points. Until some clarity emerges over what the EFSF will actually do, investors will be wary.