Today I re-read this piece that Wolfgang Munchau published in the FT on September 28th. Titled “The Truth Behind the EFSF” at Eurointelligence and “Could Any Country Risk a Eurozone Bail-Out?” at the FT, it concludes that countries that tap the facility will have to pay interest rates of about 8 percent. If this were true, then countries like Ireland could face very substantial financing costs even after seeking help from this fund, which would make successful stabilisation all the harder.
Looking into this issue, it seems to me that Munchau’s assertions about borrowing rates from the EFSF are not correct. By my calculations (see below) the EFSF borrowing rate would be a bit below 6 percent. Now this is still very high but given the large sums that would be involved if the facility swings into action (financing budget deficits and bond redemptions for three years) this difference is likely represent a significant amount of money.
Munchau calculates his 8 percent figure as a 4 percent cost of fundraising for the EFSF plus 350 basis points for administration charges and lending margins and an additional 50 basis points related to the fact that the EFSF will be holding back some of the funds raised as a “cash buffer.” While fundraising costs, administration charges and lending margins and the cash buffer do all come into calculating the correct borrowing rate, my read of it is that Munchau’s calculation isn’t accurate on any of these three figures.
I’ll admit, of course, that this stuff is pretty complicated, so let me start with providing the official sources and then people can tell me if I’ve got it wrong.
Let’s take the calculation bit by bit.
EFSF Funding Costs: The facility has a very complicated structure that might be worth describing in detail in a different post. The key thing, however, that impacts its funding cost is that it has been given a AAA rating by all the ratings agencies. The framework agreement tells us that
The interest rate which will apply to each Loan is intended to cover the cost of funding incurred by EFSF and shall include a margin (the “Margin”) which shall provide remuneration for the Guarantors.
The framework agreement is silent on what the likely cost of funds will be but the FAQ is clear about which rates are considered the benchmark for costs of funding and what the margin will be
The blueprint for EFSF support – although not binding – is the financial aid package to Greece where, for variable-rate loans, the basis is three-month Euribor, while fixed rate loans are based upon the rates corresponding to swap rates for the relevant maturities. In addition there is a charge of 300 basis points for maturities up to three years
Now, despite its AAA rating, the financial strength of EFSF will be seen as a function of its backers, some of whom are better credits than others. So, word has it that the fund will not be able to borrow at rates as low as the German government. However, these benchmarks look reasonable to me.
The German government is currently borrowing over 3 months at a yield of 0.48% and over 3 years at a yield of 0.93%. For comparison, the 3-month Euribor rate is currently 0.985% and the 3-year swap rate is 1.57%. If anything, these may be higher than the cost of funds that the EFSF can obtain.
Certainly, I can’t see what underlies Munchau’s premise of “Let us assume the EFSF raises the €1bn at an interest rate of 4 per cent” which implies a huge gap between the borrowing rate of the AAA-rated EFSF and prevailing interest rates for high quality borrowers.
An up-front service fee (the “Service Fee”) calculated as being 50 basis points on the aggregate principal amount of each Loan shall be charged to each Borrower and deducted from the cash amount to be remitted to the Borrower in respect of each such Loan.
My interpretation of this service fee is that it is a just a once-off charge and would not be repeated every year. So, for instance, you could divide the service fee by three when calculating the combined interest rate on a three-year loan.
Cash Buffer: So far, so good. However, there’s some bad news coming. To obtain the AAA rating, the EFSF operates so that its backers guarantee 120% of the amount that is disbursed. So, if you’re borrowing €100 billion, the EFSF raises €120 billion on the bond market and keeps back €20 billion as a cash buffer.
This is covered in the framework agreement as follows:
The Service Fee and the net present value of the anticipated Margin, together with such other amounts as EFSF decides to retain as an additional cash buffer, will be deducted from the cash amount remitted to Borrower in respect of each Loan (such that on the disbursement date (the “Disbursement Date”) the Borrower receives the net amount (the “Net Disbursement Amount”)) but shall not reduce the principal amount of such Loan that the Borrower is liable to repay and on which interest accrues under the relevant Loan.
Ok, so your eyes are glazing over at this point. Did you spot the bad news? As I see it, the bad news is that the section on “shall not reduce … amount … on which interest accrues” implies that if you’re receiving X in disbursed funds and the headline rate is R, you’re not just paying interest of X*R, you’re paying interest of 1.2*X*R. (Admittedly, it’s a bit confusingly written so maybe there’s another interpretation.)
Putting It All Together: So, all that explained, here’s my formula for what a 3-year loan would effectively cost (I’d imagine that Ireland would, if necessary, get a multi-year fixed loan that rather than a variable rate.)
Effective Interest Rate = 1.2*(3-year swap rate + Margin + Annualised Cost of Once-Off Service Fee)
Plug in the current 3-year swap rate of 1.57%, the margin of 3% and annualized cost of 0.167% (= 0.333*0.5%) and we get
Effective Interest Rate = 1.2*(1.57 + 3.0 + .167) = 1.2*4.737 = 5.68.
Note that in my calculation, the cash buffer element raises the interest rate by almost one percent which is higher than the half percent assumed by Munchau. However, the other elements of the calculation point to a lower cost of borrowing than Munchau has assumed.
Munchau’s conclusion that it is “hard to conceive of a situation where a country would both borrow from the EFSF and live happily ever after” may still end up being correct but I don’t think the borrowing rates are as punitive as he has projected.