Eurozone unveils its "big bazooka" € but devil's in the details

By bne IntelliNews October 27, 2011

bne -

Eurozone leaders emerged from a three-day marathon session early this morning, October 27 to announce they have agreed a plan of action to try to contain the sovereign debt crisis. The markets have started partying out of relief, but with details scant and agreements with those footing the bill yet to be definitively sealed, they may face a rough morning after.

Officials announced that private banks holding Greek debt have accepted a haircut of 50%, that Europe's banks will be required to boost their capital ratios to 9%, and that the bailout fund (the EFSF) will be leveraged to €1 trillion.

The deal on the Greek haircut was reached after German Chancellor Angela Merkel and French President Nicolas Sarkozy engaged in direct negotiations with the banks. The Eurozone will offer "credit enhancements" or sweeteners to the private sector totalling €30bn, reports Reuters. However, it then points out that the aim is to complete negotiations on the package by the end of the year, leaving room for uncertainty given that the last such deal - with a far softer hit for the lenders - quickly unravelled.

The good news is that representatives of the private sector have some out to stress their commitment to the plan. Charles Dallara, managing director of the Institute of International Finance (IIF), said in a statement: "On behalf of the private investor community, the IIF agrees to work with Greece, euro area authorities and the [International Monetary Fund] to develop a concrete voluntary agreement on the firm basis of a nominal discount of 50% on notional Greek debt held by private investors with the support of a €30bn official... package," he said in a statement.

"The specific terms and conditions of the voluntary PSI [private sector involvement] will be agreed by all relevant parties in the coming period and implemented with immediacy and force. The structure of the new Greek claims will need to be based on terms and conditions that ensure (net present value) loss for investors fully consistent with a voluntary agreement."

However, the proof of the pudding is in the eating, and the lenders have plenty of time to lose their enthusiasm for the huge hit they're to take once the spotlight on them fades.

Fat piggybank

Meanwhile, the €440bn EFSF will use two methods to leverage the €290bn or so it has left in the piggybank to shore up Italy and Spain. In the first instance, it will offer first-loss guarantees to buyers of new debt. Whilst that sets up the risk of a two-tier bond market, it is at least clear.

The second leveraging mechanism, to set up an special purpose vehicle (SPV) to attract funds from the likes of China and other emerging market economies with large sovereign reserves, is yet to be agreed on with the countries expected to back it. Sarkozy says he will talk to Chinese President Hu Jintao in the coming days. However, the EU and the US are likely to find it difficult to meet the huge demands that Beijing is bound to make in return for its support.

"It comes down to the question of whether the leveraged firepower of the EFSF to shield Italian and Spanish sovereign debt from the spreading contagion - as no achievable amount of new capital at this point would prevent a sovereign restructuring scenario in these countries from taking the European financial system to breaking point," says Daiwa Capital Markets.

Daiwa says that what is lacking from the summit is that "it brought no enlightenment (except for a few sketchy details) as to how exactly the EFSF's envisaged bond insurance scheme will work, although we do now know that the insurance will not be free for investors."

So while the markets rallied on the back of the deal - as they did after the previous summits - Daiwa says that without the fine print of the deal, it expects the recovery to be short-lived."

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