An indecent (Greek) proposal

Posted by Tracy Alloway on Jun 28 15:45.

Confused about the French proposal for Greece? Everyone seems to be.

Here’s what we know — or at least, what we think we know given that nothing has been made public.

Greek government bonds (GGBs) that were to be redeemed between 2011 and 2014 will now be partially reinvested into brand spanking new 30-year GGBs. The “partially reinvested” bit comes in this way — the Greek government will immediately pay back 30 per cent of the nominal value of each maturing bond, while the remaining 70 per cent will be invested in a Special Purpose Vehicle (SPV).

The SPV is a tricky one since details are still scarce. From what we understand, the unguaranteed SPV would be based somewhere in the eurozone (possibly Paris) and would take funds from all of the financial institutions participating in the scheme. With every €70 received from the banks, the SPV would buy €50 worth of 30-year GGBs. The leftover €20 would be invested in triple-A zero coupon bonds, issued specially for this purpose, possibly by the EFSF or EIB.

Why do we need the 30-year zero coupons? Importantly, the 30-year government bonds won’t be held on banks’ balance sheets and apparently can’t be traded in the open market, which means it looks like the banks are trying to just hold equity in the SPV, selling the SPV debt in the open market.

Look, we’ve made a little graphic to illustrate:

Got it? Good. Let’s move on.

Coupon clipping

Barclays Capital’s Nick Verdi notes that whether or not the proposal actually helps Greek solvency will depend on whether the coupon charged on the new 30-year GGBs is above or below the coupon of outstanding Greek debt, which at the moment is 5.15 per cent on average. So far all we have are reports from Les Echos and Le Monde suggesting that the coupon rate could be close to the one charged by the EU/IMF programme (5 per cent), plus a sort of variable component linked to Greek GDP performance.

As for the zero coupon bonds, we’re told by Nomura rate strategist Nikan Firoozye that they basically serve as a form of credit enhancement for the SPV, allowing it to issue its own debt more cheaply.

Convolution

Why so outrageously convoluted? You can guess.

It’s all to do with the rating agencies and the big eurozone prerogative of not having to declare a Greek default. The agencies have warned plenty of times that even a voluntary roll-over could be labelled a default if it means that the lender will be left in a worse position, economically, than before the exchange.

This way, however, Greece is basically issuing bonds at distressed market rates — they’re issuing a bond with a face value of €100 and they only get €50 in return, according to Unicredit. Investors are free to invest €50 in the new GGB, because the secondary market is also trading at the same heavily-discounted levels. It’s a perfectly reasonably investment (by rating agency standards anyway), not a distressed one.

The only problem is that by avoiding the dreaded “D” rating, the French proposal doesn’t actually seem to do much for Greece other than stretch out its liabilities for another 30 years.

Here’s Unicredit credit strategist Tim Brunne, writing late Monday night.

Based on our understanding of the available information and additional assumptions, we think that the plan does not represent a true rollover. In order to avoid a “D” from the rating agencies, the redemption of EUR 100mn of Greek government bonds leads to the creation of EUR 100mn of new 30Y Greek bonds with moderate interest payments. However, the Greek government would receive only about EUR 50mn in cash back after redeeming EUR 100mn. The remaining EUR 50mn would not be rolled over. If the Greek government wants to “roll over” EUR 30bn of bonds in the coming years in this way, it must create an additional amount of debt. EUR 30bn of debt then becomes EUR 60bn of long-term debt. That is the price that must be paid by Greece to avoid the default tag of rating agencies. But the debt burden of the country is rising at an even higher pace and the credit risk of public-sector aid is increasing accordingly.

At the same time, participating banks are able to limit their maximum future loss to an estimated 28% of the nominal value of the redeemed debt. Theoretically, the plan has substantial profit opportunities for participating institutions as well. The price these institutions pay for the potential economic upside is that they assume Greek sovereign credit risk again, however with reduced maximum loss. Institutions not “voluntarily” participating in the plan would be repaid in full and would thus be bailed out by the taxpayer, who would provide the major share of the next round of bailout funding.

We’ll say it again (since Brunne wants us to): all of this is theoretical at the moment, as details of the plan haven’t been publicly released. All we have are bits and pieces of reports.

What it does seem to be indicative of, however, is the rather amazing length the eurozone will go to to avoid default (the flipside of which, of course, is continued fiscal transfer within the eurozone).

It’s also another example of Europe using complex financial engineering to attempt to solve its problems, first through the EFSF and now with the unnamed über-complicated SPV.

Update: It looks like the proposal has now been made public.

Related links:
Greek ‘reprofiling’ and Orwellian accounting – FT Alphaville
Sovereigns turn to pre-crisis financial wizardry – FT

This entry was posted by Tracy Alloway on Tuesday, June 28th, 2011 at 15:45 and is filed under Capital markets. Tagged with , , , , , , , , , , , . Edit this entry.

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