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Understanding the EFSF, Part 1: How it Compares to TARP

By , Currency Analyst
10 October 2011 20:30 GMT

Talks between French and German leaders have led to a wave of parliamentary action across the Euro-zone’s members to expand the European Financial Stability Facility (EFSF). The EFSF has been compared to the United States’ Troubled Asset Relief Program, as one of the last remaining hopes to keeping the Euro-zone, and thus the Euro, intact. The following is a brief overview on the EFSF in its current form and how it functions, as to better understand why markets react negatively or positively on EFSF related news.

On July 21, a brief wave of optimism spread across financial markets as European leaders unveiled an expanded European Financial Stability Facility (EFSF), designed to save Greece from defaulting on its debt obligations. Originally created by Euro-zone member states in 2010, the EFSF is a rescue package with the “objective of preserving financial stability of Europe’s monetary union by providing temporary financial assistance to EAMS in difficulty.”

The EFSF is regarded by the media as the European version of the Troubled Asset Relief Program (TARP), enacted by the American lawmakers in November 2008. Although the TARP was widely unpopular amongst the American public, its supporters, mostly government officials, praised it for saving the United States from a depression. Looking at the similarities between the EFSF and TARP, we can evaluate whether the new bailout package for Europe can have the same ‘success’ as the TARP had in the United States, and if there are significant correlations, what the effect might be on the Euro.

Both programs were created as economic conditions worsened and urgent government action was required as a last resort to restore confidence and stability in financial markets. In the midst of one of the worst financial crises in history, TARP was established, which “authorized the Secretary of the Treasury to purchase and guarantee troubled assets from any financial institution.” Within TARP, different measures were formed to “stabilize and recapitalize the financial system, restart the credit markets, restore confidence and lower borrowing costs for businesses and families.”

Unlike the TARP, the EFSF is actually an incorporated company. Also unlike the TARP, financial assistance is provided to Euro-zone members through the “issue of bonds or other debt instruments on the market to raise the funds needed to provide loans,” even though no such Eurobonds exist to date. The focus is on aiding countries that risk a sovereign default, such as Greece, which would have led, and still would lead, to a wider contagion risk.

On the other hand, under TARP, financial assistance was provided directly to banks facing difficulties. The EFSF is not designed to bail out banks directly but instead provide debt ridden countries with funds, indirectly securing banks’ exposure to . However, since much of the European countries debt is held by banks, they are essentially being bailed out indirectly.

The source of the funds for the two facilities differs as well. Although the U.S. Treasury used the TARP authority to make investments, loans and asset guarantees, the bulk of the $350 billion package was courtesy of the American taxpayers. In return, the Treasury received equity and debt securities from the companies that were assisted. However, “as of March 31, 2011, Treasury has recovered more than 100 percent of the funds invested in the bank programs through repayments, dividends, and warrants,” driving down the overall cost to under $50 billion.

Meanwhile, investors in the EFSF bonds primarily include institutional investors such as banks, pension funds, central banks, sovereign wealth funds, asset managers, insurance companies and private banks. “The issues would be backed by guarantees given by the Euro-area Member States of up to €440 billion.” Additionally, the EFSF is not a collateralized debt obligation which means “there is no seniority and all investors have exactly the same rights,” unlike the TARP, which covered collateralized debt obligations.

As the European debt crisis intensified over the past month, the original EFSF was deemed insufficient and flexible enough to offer the bailout support debt ridden countries would need to avert a default. New powers were added to the facility including “the ability of lending to governments for bank recapitalization and precautionary credit lines before they are shut out of markets” that make the EFSF more like TARP. “The new deal also lowers the interest rates on current EFSF loans to Greece, Portugal and Ireland by between 100 and 200 basis points, and extends maturities on those loans out to 15 year.”

How Will it Affect the Euro?

Recently, market conditions have developed from headline to headline - that is to say that market participants are trading on fear. One such method of having this fear being alleviated has been continued talks about Euro-zone officials as to how to contain a potential debt crisis.

EUR/USD 10-minute Chart: October 3 to 5, 2011

Understanding_the_EFSF_Part_1_How_it_Compares_to_TARP_body_101011_eurusd10.jpg, Understanding the EFSF, Part 1: How it Compares to TARP

Charts created using Strategy Trader– Prepared by Christopher Vecchio

Presented above is a chart of the EUR/USD from October 3 to October 5, 2011. Late on October 4, after depreciating nearly all trading day, the EUR/USD found significant support upon a rumor that Euro-zone offficials were working on a plan to boost the EFSF's ability to secure 'sick' assets and shore up European debt markets.

EUR/USD 5-minute Chart: October 9 to 10, 2011

Understanding_the_EFSF_Part_1_How_it_Compares_to_TARP_body_101011_eurusd5.jpg, Understanding the EFSF, Part 1: How it Compares to TARP

Charts created using Strategy Trader– Prepared by Christopher Vecchio

Similarly, after a weekend of meetings between French President Nicolas Sarkozy and German Chancellor Angela Merkel, in which plans to save the Euro-zone (via the EFSF) were discussed, the EUR/USD rallied nearly 300-pips. The rally was a near-straight line higher for the Euro across the board on Monday, as shown by the chart above.

Based on the reactions we've observed, there is a simple conclusion to make: talks of an expanded EFSF and further efforts by Euro-zone officials is enough ammunition to drive the U.S. Dollar lower and the Euro, as well as other risk-correlated assets, higher. Going forward, on further positive developments out of Europe in regards to the EFSF, the EUR/USD stands to gain more. Should no further developments occur, and these talks amount to little more than just words, the EUR/USD would be poised to move lower.

--- Written by Christopher Vecchio, Currency Analyst

To contact Christopher Vecchio, e-mail cvecchio@dailyfx.com.

Follow me on Twitter at @CVecchioFX

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10 October 2011 20:30 GMT