Greece rescue - Behind the scenes

Debt rescheduling, monetary policies questioning and EFSF bond purchases in the secondary market. These are the key steps of a plan that should not significantly affect banks’ net income but rather spread economic losses over time.

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As we wrote in our paper Financial markets and self-fulfilling prophecies, if we are dealing with a solvency crisis, self-fulfilling prophecy or not, there is nothing to do since the problem is structural. Thus, strong structural solutions are needed and we had listed four:

Financial markets and self-fulfilling prophecies

This phenomenon is equivalent to the change from a brutal economic and financial equilibrium to another, not because the fundamentals of the macroeconomic environment would justify it, but because there was a change for good or bad reasons of market (...)

- Policies aiming to improve potential growth and competitiveness (long-term issues that can only be pushed by a summit)
- Implementation of a true fiscal federalism with national debts pooling and establishment of a Eurobonds issuing program (which is, politically speaking, difficult for Germany). Moreover this is not the path that has been chosen at the meeting of the Euro Group
- Debt restructuring or partial defaults (to minimize systemic risks while copying successful examples we have seen amongst emerging countries since 1998: Russia, Argentina, Uruguay, Ecuador). It is in a way – even though very implicit and hidden – embedded in rescue plan.
- Temporary exit - with the risk that it becomes permanent - from the Euro Zone for some countries: devaluation of the new national currency and redenomination of the debt, inflationist tax to reduce debt (which is beneficial from an electoral perspective but economically suicidal on the long run). Naturally, this scenario is fading away since Greece can continue to meet its due payments until 2014


First key step

The mechanism relies in postponing the liquidity constraint and the wall of debt. It is similar to the one we now are used to. Let’s recall the previous amounts: €110 billion granted to Greece in May 2010, €85 billion to Ireland in November 2010 and €78 billion to Portugal in May 2011. Today, It’s about granting €109 billion to Greece, using the classic formula (2/3 by the European Financial Stability Facility and 1/3 by the IMF) with one singularity: a massive purchase of time comparable to the use of heavy weapons. This includes 15 to 30 years maturity, a discounted rate at 3.5% against 4.2% for current IMF’s bilateral loans. Buying time is not necessarily bad, what matters is the use of time. In our case, as the Anglo-Saxons would say, “Time Will Tell”

Second key step

Challenging monetary policies in favor of moral hazard and thus removing investors’ accountability. It would therefore put an end to the improper funding of mismanagement and poor management. This implies empowering the investors, all investors, rather than constantly call for the taxpayer. It also means that we must question the existence of a lender of last resort and even of a buyer of last resort, in order to make it clear to many investors that they need to stop investing with eyes closed just because the ratings of the investment vehicle are so-called high quality investment grade or because of positive market consensus.

However, the introduction of a banking tax, once considered by France , to help Greece, seems ruled out. During the summit of the Euro Group of July 21st, the Euro zone has sought to reduce the volume of the Greek debt (now 350 billion euros) by involving private creditors. This involvement, as we will see later, should not significantly affect banks’ net incomes but will be rather expressed by economic losses spread over time and will eventually become virtually painless for analysts and shareholders. Ultimately, investors are not paying for their lack of accountability and the taxpayer will be the true buyer of last resort. This point will be detailed afterwards.

Third key step

The purchases by the EFSF in the secondary market by the EFSF. Clearless and unquantifiable, this alternative has little chance of success for two reasons. First, Greek securities holders who do not mark to market their positions have no interest in externalizing capital losses and, second, those who actually do mark to market their positions have interest in waiting for a rise in bond prices inferred by EFSF’s purchases. it looks like a vicious circle.


These so-called voluntary contributions were estimated at nearly € 50 billion and come in addition to the €109 billion of traditional loans granted by the "troika" EU-EFSF-IMF within the rescue plan. We can classify all the options studied in two large ranges of techniques

- The first technique, comparable to a Greek debt reduction up to €12.6 billion is a plain and simple purchase of Greek debt by private investors such as banks, insurers and other institutional investors. These investors’ contributions could involve buying securities issued by the EFSF. For example, with a current average price of Greek securities around 55%, it would allow Greece to cut its debt by 45%. This solution is rather interesting for private investors because it will mechanically generate a short squeeze and, thus, a rise in mark-to-market price of Greek securities in their portfolio. However, one can wonder if the ambitious target of €12.6 billion can be reached. I do not believe in it and I think that the investors will focus almost exclusively on the second technique

- The second technique is a swap of current outstanding Greek bonds with new bonds providing very long maturities for an estimated amount of €37 billion. This technique can take several forms: a public exchange offer including discount and longer maturity; swap or public exchange offer without discount but longer maturity; voluntary roll over… Simple actuarial calculations lead to the following conclusions: assuming a Greek debt maturing in 2019 and priced between 50 % and 60 % of parity value by the market, a swap with a new bond maturing in 2026 (15 years) would induce a real economic loss of 20% ; The loss for a swap with a security maturing in 2031 (20 years) would be around 32%; and 45% for a security maturing in 2041 (30 years).

These proposed solutions will lead to a credit event unprecedented in the monetary history of the Euro zone and probably unprecedented with respect to the regulation of derivatives :The non-requirement for sellers of options on Greek default (the famous CDS or credit default swaps) to meet their insurance obligations

Triggering a credit event according to the ISDA

- Rejection and moratorium on the debt (the most radical solution chosen by Russia in 1998)

- Restructuring / rescheduling (Argentina 2001 and, even though it is still concealed, Greece 2011

- Bankruptcy (for companies and banks since a State does not go bankrupt but defaults) like Enron 2001, Worldcom 2002 , Northen Rock 2007 , Lehman 2008

- Default with failure to pay on time (could and - as it will without a doubt be said tomorrow – might have concerned the United States in August, 2011 for example, but we think that the budgetary arm-wrestling between republicans and democrats will turn into a compromise avoiding the real technical and institutional default)

It was ultimately decided that the actuarial loss would be 21% flat for everyone and for all Greek securities in the portfolio subject to discount rate assumptions and lengthening of the maturity. Private investors’ accounting losses were computed using a discount rate of 9%. After all, why not doing that if you consider that the level is inline with the market value of a Greek issuance (knowing that support plans of EFSF-IMF-EU subsidize the rates applied to Greek debt around 3.5% and being aware that the secondary market show rates between 15% and 20% over the yield curve of Greek government bonds). Thus, use 9% to estimate actuarial losses around 21%, why not. The choice of the level of rates is not neutral since the loss would have been naturally greater with a higher rate and, conversely, lower with a lower rate (but the latter choice would have lacked credibility).

In fact, schematically, the loss of 21% is based on the following: extension of Greek papers due 2019 and priced around 50% in the market today with new paper maturing on average in 2026 (15 years) whose current value is 29% in 2011 and 100% in 2026, if all goes well, using a discount rate of 9%. Overall, the involvement of "private world" should not significantly affect the net incomes of banks but rather spread economic losses over time


All in all, our lovely European Central Bank that is giving us tough talks on austerity and raising its key rates to reaffirm its anti-inflationary credibility will have showed an unusual pragmatism in this business.

Two members of the ECB had been very dogmatic few hours before the announcement of the Greek plan. Stark claimed that a selective default would be problematic and Bini Smaghi said that restructuring would be dramatic. Now, as we have just seen, we are heading towards a default (and let us stop playing with words and waffle about temporary, selective and technical default). Similarly, we are witnessing a restructuring that is cleverly managed and turned into a financial transaction as complex as possible to hide the default and the triggering of credit derivatives.

Worse, until now, the ECB had threatened, in case of a default of Greece, not to accept public Greek debt securities anymore as a collateral of European banks - and Greek in particular - cash lending program ; This would have forced governments to bail out by their own means the Greek banking system and elsewhere as appropriate. Now it seems that the ECB has significantly softened its position through a concession which is granted: EFSF purchases Greek debt today and will potentially purchase other peripheral debt tomorrow in the secondary market as well. The ECB has always been in favor of this idea because it assures the institution of not being forced to do so and to take risks of public debt monetization (which is contrary to the bank’s "religion")

Buying time is not necessarily bad, what matters is the use of time. In our case, as the Anglo-Saxons would say, “Time Will Tell”
Mory Doré

As the central bank will therefore stop monetize government debt, will continue, against all odds, to rise key rates (even if we doubt this situation cannot last), will require very restrictive fiscal policies and not only in PIIGS, it was then essential to make concessions and that she chipped her sacrosanct credibility. This means that ECB will continue to accept defaulted sovereign debt as collateral in order not to disrupt the refinancing of some weak banks of the eurozone during ordinary and extraordinary bidding sessions.

With more hindsight, markets will end up sanctioning this loss of credibility and the move will significantly weaken the euro against dollar. Even if it is true that the fiscal position of the United States is probably the worst that can exist on the planet, the big crisis of dollar denominated assets is pushed away in time (nobody knows till when, maybe the second half of this decade). The US dollar will continue, rightly or wrongly, to benefit from its internal international reserve currency status as no competitor can still substitute to absorb huge amounts of foreign exchange reserves invested in dollar. Above all, despite the visceral opposition of Germany, we are witnessing the pooling of Greek, Irish and Portuguese impoverishment within the entire area, which will lead to a weakening of the currency.

We must then anticipate a general rise of long-term yields, even in countries that are considered the most virtuous of the area, as non-residents will become more demanding regarding the return on investment of euro zone assets, mainly due to the weakening of the euro.


As a citizen, I can only be disapointed by the rescue plan given the lack of democracy and explanation that has surrounded the European meetings. As a taxpayer (and you will see why), I can only be furious over the bills awaiting me. As a banker, I can only be relieved to learn that I will not have to impact the Greek default within my balance sheets. Finally as an investor, I benefit from moral hazard and I can only congratulate myself on the perpetual presence of buyers and lenders of last resort (ECB, States, IMF, EFSF ....)

Let us explain. The sovereign debt crisis in the euro area have finally shown that countries in trouble are assisted on very long periods at more and more discounted interest rates by emergency funds and therefore, implicitly, by the most robust European sovereigns. In addition we have seen that private creditors were unlikely to redeem early, even from the most toxic investment, and that they would rather swap their assets with new sovereign securities or shares of European fund. This means that peripheral European debt will be ultimately held by public creditors and semi-public (states, European Fund, IMF, ECB) since the debt held by the private sector will be most likely repaid through the support mechanisms and pooling we have been experiencing since May 2010.

This leads to the following edifying conclusion (not even mentioned ??by governments and tv news but that one need to highlight in a true democracy): We hear authorities proud to say that private investors are involved even though we have seen that the public sector will ultimately bear the cost of upcoming restructuring and defaults (make no mistake, Greek default - because it is indeed a default - is unfortunately the beginning of a series). John Maynard Keynes was very ironic about the fact that In the long run we are all dead. But this does not exempt to the extent of being worried. Without any demagogy and even while considering that the market economy is the worst system except all the others, it is still not acceptable that we spend our time to nationalize the losses and privatize profits


The Debt issued by the EFSF, following each support plan to a member of the eurozone, do have a fiscal impact on states providing their guarantee, in proportion to their involvement as guarantor. Today, the EFSF commits to cover € 440 billion which is the capital allocated by the states to the ECB: 27.13% or € 119.4 billion € for Germany, and 20.38% or € 89.6 billion for (this amount is the total additional public debt that France will have accumulated if all the guarantees have to be activated, which is not unlikely). The gross public debt of Germany would then increase by 27% of EFSF issuances and that of France by 20.38%. As part of the Greek rescue plan, considering that the EFSF supports two thirds of the €109 billion, thus € 71 billion, and the impact on the public debt of France is € 15 billion as mentioned by François Fillon (french prime minister)

Euro zone bailout plans: origin and utilization

Back on bailout plans granted to countries in the Euro zone encountering severe fiscal deficits since May 2010. How are tens of billions Euros raised, what are they for, and mainly, are those amounts enough to re-establish the public finances and stabilize those countries (...)

We know today that the four rescue plan, 2 for Greece + 1 for Portugal + 1 for Ireland correspond to future and existing EFSF’s issuances (2 / 3 clasic rule) up of € 254 billion out of a total of backed guarantees of about 440 billion € (in fact, this amount is lower as the guarantees provided by the rescued states are now worthless: € 12.3 billion for Greece, € 11 billion for Portugal and € 7 billion for Ireland). The effective capacity of EFSF, designed to exist until june 30, 2006 is actually 410 billion €.

The balance of assistance available today is therefore around 156 billion €, which in addition to the (2/3 EFSF, 1/3 IMF) rule limits the amount of any future plans to €236 billion. This not reassuring at all ! I will not be surprised if they announce a twofold or even threefold increase of the EFSF capacity, knowing that debt will be issued on the market and will be guaranteed by the states of the zone .... All this will impact the sustainability of the debt of some so-called virtuous countries

Unlike the EFSF which must issue debt on the markets, the IMF support relies on the Special Drawing Rights and therefore EFSF can not be the anteroom of a future European Monetary Fund (EMF). So Nicolas Sarkozy seems to be wrong in saying that the meeting of july 21st, 2011 initiates the creation of a genuine "European Monetary Fund" while at the same time we learnt that the system set up for Greece will not be duplicated for other countries. If this is true, there can be no talk about European monetary fund (or else it would be a kind of European monetary fund only for Greece, which is ridiculous), or he will exist one day a true European Monetary Fund, in which case the proposed scheme for Greece should be generalized

And as we were saying, the EFSF issues and borrow from the markets whereas a EMF should have access to monetary resources. Like the IMF. As mentioned in some recent articles (including bailouts in the Eurozone), We need to keep in mind that each member of the IMF has the so-called special drawing rights (SDRs) allocated according to its economic weight. These rights were created in 1969 to play the role of additional reserves. Thus Germany has 13 billion SDRs, France 10.7 billion and 50.4 billion SDR for the entire zone (thus a parity value today of around € 1.15 per DTS). There is a rule that sets the quota to 10 times the funding limit, this means that the entire euro zone has the ability to theoretically raise up to € 580 billion. To help countries in the euro zone, we can say that this rule has been widely used.

For example, the financing by the IMF of 30 billion euros (10 billion in 2010) for the Greek plan of May 2010 as a stand-by arrangement is equivalent to 3200% of the share of Greece in the Fund (32 times instead of 10). In other words, the IMF funds Greece using quotas of other countries in the area. Similar situation in Portugal as in the may 2011 rescue plan, the Extended Fund Facility Fund is 2300% (23 times instead of 10) of the share of countries in the IMF

Mory Doré , August 2011

Article also available in : English EN | français FR

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