The euro zone's bailout wheeze will require smooth sales patter. Finance ministers are trying to thrash out a structure for special purpose investment vehicles which will boost the firepower of the European Financial Stability Facility bailout fund. But investors are already wary of EFSF bonds. They will need to be persuaded that SPIV bonds are low-risk government debt, not financial alchemy.
The typical SPIV will have three types of liability: senior bonds, a layer of riskier mezzanine paper, and a tranche of equity, supplied by the EFSF. The rate at which the SPIV lends depends on the relative thickness of the tranches – and the return that investors demand.
Assume the EFSF puts up 20 per cent of the cash. It should charge the highest rate. But the bailout fund might accept a below-market rate similar to the EFSF's funding rate of 3.5 per cent. Buyers of the mezzanine paper, which could account for maybe 30 per cent of the total, may be happy with a 9-per-cent return.
That leaves senior debt funding the least risky half of the SPIV's balance sheet. In theory, the SPIV could absorb a 50-per-cent haircut on the underlying sovereign debt and still repay the senior bonds. As a result, investors might only demand a yield of say, 3.2 per cent – a modest premium over German debt. This would allow the SPIV to lend at an annual rate of 5 per cent, excluding fees.
However, investors might conclude the senior bonds are just risky sovereign debt, repackaged in a complex vehicle. After all, the EFSF's own borrowing costs relative to German bonds have jumped recently. And yields on Italy's 10-year bonds spiked to new euro-era highs on Nov. 7 as Prime Minister Silvio Berlusconi denied he was about to resign.
If buyers of SPIV bonds demanded a 5-per-cent yield, the SPIV's lending rate would jump to 5.9 per cent. The euro zone could bring down the rate by putting up more of the capital, but that would quickly exhaust the EFSF's resources.
The alternative would be to persuade countries like China or Brazil to buy mezzanine paper with a return of, say, 6 per cent. Though emerging markets are wary, they might yet participate through the International Monetary Fund. But they would be bound to demand a political quid pro quo. The euro zone had better polish up its sales pitch.
Calculator: SPIV's secret sauce, Reut.rs/sY11KE