At 1:40 p.m. today, the S&P 500 was up 3 points. The CNBC report below ignited a strong rally into the close. Institutions and hedge funds did not seem to be all that impressed - volume on the NYSE fell 26% today. Here is the text taken from the CNBC website:
CNBC HAS LEARNED FROM A TOP EUROPEAN FINANCIAL OFFICIAL ABOUT A DETAILED PLAN THAT IS CURRENTLY IN THE WORKS ON LEVERING THE MONEY FROM THE EUROPEAN FINANCIAL STABILITY FACILITY. THE PLAN WOULD USE AS WE UNDERSTAND IT SOME OF THE EFS MONEY TO SHORE UP BANK CAPITAL VERY SIMILAR TO A TARP. NOW THE VERY NEW PART THAT WE ARE HEARING IS THAT THE PLAN WOULD ALSO USE SOME OF THIS MONEY AS SEED MONEY FOR A EUROPEAN INVESTMENT BANK THE EIB IS A BANK THAT IS OWNED BY THE MEMBER EUROPEAN GOVERNMENTS THAT DOES RECONSTRUCTION PROJECTS. NOW UNDER THE PLAN THE EIB WOULD FORM A SPECIAL PURPOSE VEHICLE AN SPV THIS WOULD ISSUE BONDS AND PURCHASE SOVEREIGN DEBT WITH THE BONDS IT USED SO IT WOULD TAKE THE CAPITAL FROM THE EFSF LEVER IT UP THESE BONDS COULD ALSO BE USED AS COLATERAL AT THE ECB. OUR UNDERSTANDING IS THE PLANS FOR LEVERING THE EFSF ALREADY WELL ADVANCED.
After a market-moving announcement like this one, it is a good idea to look at the fundamentals and technicals and ask, “If I did not know about this announcement, would I buy into this market?” We will take a look at the state of affairs tonight and tomorrow morning. Our bias is to not overreact to a report like this, but we want to review things with an open mind.
The Wall Street Journal noted the following potential drawbacks with the European plan outlined on CNBC today:
First, the scheme relies on the private sector to lend to the EFSF in times of trouble. But that’s precisely when the private sector is least likely to be lending. And, to be honest, European banks aren’t exactly super-healthy right now.
Second, it won’t come as cheap as ECB financing, or as cheap as the EFSF’s own triple-A bond market funding. That means higher funding costs for the leveraged EFSF, which it would likely have to pass on to the rescued countries.
Third, banks would be wary about large commitments to a leveraged EFSF. The EFSF is an off-balance-sheet vehicle. Its creditors have no recourse beyond the guarantees that the euro-zone countries pledge to it. When the size of the EFSF’s bond and loan portfolios exceeds those guarantees, the creditors have to start wondering who will repay if things go terribly wrong. (The ECB would have this problem, too, if it financed a leveraged EFSF. But losses on the ECB’s own balance sheet are ultimately the responsibility of the euro-zone nations. Thus the euro-zone nations might be more likely to stick a private EFSF creditor with a loss.)
Fourth, the amount of leveraging is dependent on banks’ willingness to provide financing, the collateral “haircuts” that might be demanded, the price the banks would charge for acting as intermediaries, etc. Whatever the volume of a privately leveraged EFSF is, it’s surely smaller than an ECB-leveraged EFSF.