SocGen’s Q&A on the French proposal

Posted by Tracy Allowayon Jun 29 09:50.

Because … as a French bank, they would be well-placed to discuss it, no?

On Tuesday we got a glimpse of the so-called French proposal to save Greece, resembling a mix of super-complicated SPV and Brady bonds. German, Dutch and Austrian banks are now reportedly backing the plan, aimed at delivering private sector involvement while averting a Greek default

Anyway, here’s Société Générale European rates team on Wednesday:

Q1. Does the plan provide a €30bn participation from the private sector?

Hardly. A 49% rollover of the €85.5bn would deliver €42bn. But not all holders will participate (e.g. the ESCB reportedly holds about €25.5bn of the €85.5bn). So at best the private rollover reaches €30bn. We do not have a breakdown per maturity, but assuming that banks own about 30% of the Greek marketable debt, participation by the banks only would bring €13bn – not much! The French government, it seems, is pushing for much broader participation that would include not only insurers but also pension funds and asset management firms.

Q2. Is the plan friendly enough to investors for rating agencies not to declare default?

We would think so, given the appealing structure of the deal for investors. Rating agencies might still argue that Greece is being lent money at a rate that is well below market levels – which may be a case for default. The draft from the Fédération Bancaire Française makes clear however that the deal is conditional to Agencies not declaring default.

Q3. Does the plan address Greece’s solvency problem?

Not at all. The proposal indicates that Greece would pay 5.5% plus the yearly Greek GDP growth capped at 2.5% and floored at 0% – so Greece ends up paying between 5.5% and 8%! The biggest risk here is that Greece plainly rejects Rescue II on such a basis. But there might be room for discussion about the rate charged. In any case, going through the July bump and offering a relatively friendly solution to investors may lead to a relief rally, but in September, December, etc. Greece’s results will have to be assessed again. A failure to reach target would lead to new austerity requests, which at some point will meet a refusal from the Greek parliament. So execution risks will remain high. As we argued before, Vienna-style initiatives – and the smart plan above – do not take us away from the muddle-through strategy. It only buys time and may restore stability for some time, IF and as long as Greece complies with the MTFS.

Q4. What market reaction?

The plan, we reckon, gets the private sector involved – so offers the basis for launching Rescue 2 – but in a rather friendly way. In that sense it may be seen as positive for risk appetite towards banks. We would expect any rally in GGBs and non-core debt to be fairly limited, because of the failure to reduce Greece’s debt load, the large fiscal execution risks in the coming quarters, and the risk that PSI (private sector involvement) may lead to another wave of downgrade of non-core sovereign ratings.

Still, for now, assuming the Greek parliament ratifies MTFS and PSI talks continue to progress:

– We expect follow-through in the positive reaction of bank risk, and this should include a further compression of the basis complex (e.g. Dec FRA/Eonia down some 3bp on Tuesday, but still up 6bp over the past three weeks).

– The maturity of the ZC and new GGB investment still has to be decided, but the bias is for long dates. The exposure, with or without the balance sheet, will create new interest rate risk. This will be partially hedged. This should feed the steepening of the 10-30y slope.

– Assuming contagion towards bank risk does not escalate, the ECB will be free to raise rates in July. July was repriced higher on Tuesday, to now 1.34%. This reflects a lower take-up at the MRO (down from €187bn to €141.5bn, but watch the 3-month LTRO on Wednesday) and hawkish words from Trichet again on Tuesday (‘strong vigilance’). But January 2012 is priced just 20bp above July 2011 – so there is ample room for repricing if US data improves and the sovereign crisis sees a respite. That leaves us with a small 2-10y flattening bias in EUR, and a strong bias for being long 10y vs 2s and 30s.

And finally…

What would professors Jean Tirole, Drew Fudenberg, Eric Maskin and Maureen O’Hara have to say?

The strategic interaction of several decision makers when constructing a framework for the Greece rescue is reminiscent of the search for Nash equilibrium. What is difficult enough in a classroom setting appears to be a tremendous task when applied to a global framework. Aspects of game theory, the economics of incentives, contract theory and market microstructure design need to be taken into consideration. While academics of many disciplines will have plenty of opportunities to analyze the dynamics of the Greece rescue initiative, it is not surprising that many investors prefer to watch how events unfold from the safety of the sidelines. This reduces liquidity in the market and results in a choppy market environment. Gapping 30-year swap spreads, a rapid reshaping of the yield curve and spikes in short-dated volatility have already been plaguing the market in recent days.

Of course, Wikipedia reminds us, Nash equilibrium does not necessarily result in the best pay-off for all the players involved. In the French proposal it looks like banks, including French ones, are (surprise!) getting the better result.

Related links:
An indecent (Greek) proposal – FT Alphaville
The French proposal
– FT Alphaville

This entry was posted by Tracy Alloway on Wednesday, June 29th, 2011 at 9:50 and is filed under Capital markets. Tagged with , , , .

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