ESM / EFSF: An Inverted Capital Structure

(The following is a guest post by Morally Bankrupt, a BondGirl-approved commentator on credit markets. I am posting it for him because she is uncomfortable with HTML tables. Truth be told, I never learned much about them myself; I have always figured the World Wide Web is just a passing fad. – Nemo)

I’ve been meaning to write about this for quite some time, but it’s been really hard to have the time to sit down and do it. I’ve let perfect be the enemy of good and so here I’ll try to lay out a rough sketch of what I think are some of the possible risks of the EFSF / ESM.

From Reuters:

The euro zone’s permanent bailout fund, the European Stability Mechanism … which will have an effective lending capacity of 500 billion euros, will be backed by 80 billion euros of paid-in capital and 620 billion euros of callable capital … It will offer loans at funding costs plus 200 basis points for loans up to three years and plus another 100 basis points for loans longer than three years.

What you are seeing here is what Michael Pettis described as an "inverted" capital structure in his excellent book, The Volatility Machine. What that means is that there is positive correlation between the need for funds, the cost of funds and the credit quality of the facility. This is problematic because it could cause reflexive price action in the bonds of the aid recipients, lowering the value of the EFSF holdings and furthermore deteriorating its perceived credit quality. This is also sometimes referred to as "wrong-way risk" when talking about CCPs. In other words, "the risk that different risk factors be correlated in the most harmful direction." AKA a vicious cycle.

Here’s some numbers from the June 7, 2010 EFSF execution agreement. They represent the subscription amount and percentage to the EFSF. The EFSF is just a legal entity where various countries contribute capital and become equity holders (with unlimited liability). The contributed capital and proceeds from bond issuance are used to make loans to countries that need aid. The bonds are guaranteed by the full faith and credit of the EFSF, the EFSF equity holders (EUM member states), the EU, and have the EFSF holdings as collateral. The table below is a breakdown of the contributed capital so far. Issued debt is to be overcollateralized at a rate of no less than 120% by AAA Holdings and AAA guarantees. There is also to be a cash reserve that equals the NPV of the margin of the EFSF loan and service fee. The EFSF is available to all EMU member states.

ECB Member State

Capital subscription

Contribution Key %

Kingdom of Belgium



Federal Republic of Germany






Kingdom of Spain



French Republic



Italian Republic



Republic of Cyprus



Grand Duchy of Luxembourg



Republic of Malta



Kingdom of the Netherlands



Republic of Austria



Portuguese Republic



Republic of Slovenia



Slovak Republic



Republic of Finland



Hellenic Republic






Where is the risk? Well, the risk here is that everyone is guaranteeing everyone. So, if Ireland Portugal and Greece need aid, their guarantee is pretty much worthless, and they are now users of the fund. If another state were to need aid, another piece of the guarantee would become worthless and need for funds would increase. This would increase the cost of funds, which would be passed on to aid receivers. Unless the states receiving aid are running a budget surplus, this would translate to increasing borrowing needs to cover additional debt service costs, furthermore deteriorating their quality.

Of course, losing Portugal’s guarantee is unlikely to be disastrous, but if Belgium and Spain were to find themselves in trouble too, that would put additional pressure on the remaining members, affecting their own credit quality. While it might be no more than an inconvenience to Germany or France, it could adversely affect smaller economies. It could, in essence, leave France Germany and Italy holding the collective bag. I have no clue as to the probability of this happening, but the risk is present and shouldn’t just be ignored. If we were to think of bonds as way deep out-of-the-money options (this model goes beyond of the scope of this post), you would notice that you are basically short a lot of gamma here. As the situation deteriorates, the speed at which it deteriorates increases. Of course there is the possibility that it will all work out, which is what the EU is banking on.

I’m not going to get into the gritty part of of this until I have more time, but I think the best way to think about it is as a highly-levered, short way-out-of-the-money put on the EU sovereigns. The probability of going into moneyness might be remote, but the damage in that case would be catastrophic. Buy the paper at your own risk.

4 comments to ESM / EFSF: An Inverted Capital Structure

  • I think the best way to think about it is as a highly-levered, short way-out-of-the-money put on the EU sovereigns. The probability of going into moneyness might be remote, but the damage in that case would be catastrophic.

    If one were an EU policymaker seeking to preserve the currency union, such is the ideal structure, no? An ESM whose failure would be so catastrophic that it cannot fail, thus enforcing its success by existence?

    Maybe they can throw in some backup generators and seawalls.

  • PS: It has been called to my attention the book linked is pricey. It is, and it’s worth every penny, but if you can’t find it in your local library and are curious, you can get a pretty decent preview on google books. It’s a fantastic book, but unless you’re interested in the sovereign bond business, it’s likely to be overkill.

  • @Inefficient Frontier
    If I were a policymaker seeing to preserve the currency union I would look to offer a radically different kind of structure. Making failure catastrophic does not ensure success. There is many examples of this throughout history, Argentina’s indexation of claims to gold, Mexico’s indexation of claims to the dollar, Ireland’s recent guarantee of all bank losses. TBTF works when there is a larger balance-sheet to absorb the impact, but who absorbs the risk when there isn’t one? The EFSF can absorb Greece and Ireland, but if Portugal, Belgium and Italy were to seek aid as well, would the EFSF be able to handle that? And, if it wasn’t, would the remaining guarantors be able to? Would they be willing to?

    Mutually assured destruction is a strategy that can back-fire in a very ugly way.

  • csissoko

    MB: On making failure catastrophic, you left out the gold standard and the commitment the central banks made to it in the late 1920s when it was clearly in trouble after the first world war.

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