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Friday, July 01, 2011

How attractive is the 'French Model'?

Apologies for the delay in getting our verdict on this plan out....

Following the negotiations over the last few days, between banks and the EU/IMF/ECB, a proposal has been put forward on how to involve the private sector in a second Greek bailout. The idea is to have investors share more of the burden, reducing the potential cost to taxpayers of a second Greek bailout.

Unsurprisingly, the ‘French Model’, as Sarkozy has gleefully termed it, still seems to involve some significant public sector guarantees. Apologies in advance for some technical jargon which may creep into this post - it's a complex issue but is vital to the future policy choices in the eurozone crisis. (FYI We’ll ignore the speculation about who might take part in this plan and how much it could save since any estimates would be mostly guesswork at this stage).

So, first off the plan calls for banks (read – private investors) to rollover or reinvest 70% of their holdings of Greek debt, which expire between July 2011 and June 2014, into new 30 year Greek government bonds. This debt will yield 5.5% (but could increase by up to 2.5% based on GDP growth) and will not be able to be traded until January 2022.

The Greek government will then take 30% of this money and loan it to a special fund (meaning that Greece only gets 70% of the rolled over 70% in cash, essentially accessing only 50% of the total amount originally maturing). This special fund will then use the money to purchase 30 year bonds from the EFSF (or some other triple-A creditor) equal to the same value as rolled over private sector debt (from we can tell). The fund will hold these bonds as collateral against the private sector involvement, essentially guaranteeing all the funds which the private sector has committed to the second Greek bailout. If Greece were to default, the special fund would sell these bonds and use the proceeds to cover the losses of those private sector creditors who rolled over their holdings of Greek debt.

But here’s the kicker. Since the bonds which the EFSF put up as collateral are only paid for at 30% of their value, the EFSF is essentially guaranteeing 70% of private sector involvement. If Greece were to default, even after this plan (which we’ve argued numerous times still looks likely), then the bonds would be sold off and the proceeds used to cover the banks losses. The hope seems to be that the bond will increase in value and so some profit will be used to reduce the public sector guarantee. Ultimately, how much the public sector guarantee is invoked depends on the level of losses which investors face from a Greek default (currently estimated at between 50%-60%). In the end though, governments will still be left to pay off the 30 year debt they issued as collateral and are unlikely to have ever received the full amount in cash to cover it, meaning they will essentially be indirectly paying for private sector losses.

Interestingly, we’re yet to hear from the credit rating agencies on this plan. Since the yields on the new 30 year Greek bonds would be much below market rates and the banks are still not fully recouping their original investments, the whole process could still be deemed a default, although much less likely than previous options. Oddly, earlier in the week ECB Governing board member Juergen Stark insisted that any 'Brady bond' style initiative (which is how many are viewing the French plan) would be illegal under the no-bailout clause of the EU Treaty (clearly the irony is lost on him).

In any case, it’s a complex and convoluted plan which looks to be as voluntary as possible and requires minimal private sector involvement. But, importantly, it looks reliant on significant taxpayer-backed guarantees. And we're therefore back where we started - taxpayers being left with the ultimate risk.

See below for the French Banking Federation's graphic of the plan:


Alan said...

Although it is still more generous to the private investors than they deserve, there is still some risk to them.

As I understand it, the collateral that is purchased (for a price of .30 on the euro) is a 30 year zero-coupon AAA euro bond. This implies a yield of 7.78% - way above the current 30-year AAA euro rate.

If (or, rather, when) Greece defaults, the private investors will lose their 30-year bonds, yielding between 5.5% and 8.0% (depending on GDP), and they will instead be replaced with the collateral - zero yields for the same maturity. That is a significant haircut for the private investors.

Open Europe blog team said...

Thanks for the comments Alan.

You are definitely right that there is some risk to private bondholders, although it is massively reduced. Also it is not clear whether, in the case of a default, the 30yr AAA bonds will be transferred to the private sector bondholders or if they will be sold off and revenues given out to bondholders according to their losses. If they do get cash then they will be able to reinvest it and gain returns, meaning they will not even be fully forgoing the potential 8% yield. The risk is ultimately determined by the timing of a default as well as the recovery rate and mechanisms attached to transferring the collateral, all nearly impossible to estimate at this point in time, but it seems like there will in any case be a substantial transfer of risk to the issuer of the collateral. In any case, given the S&P announcement today this may all be academic as it looks like a new plan will be needed.

Rollo said...

The aim, especially now Lagarde has been made head of the IMF, is to save French banks by transfering their Greek liabilities onto the tax payer, regardless of the crushing of the Greeks. The 'french model' is a phony way of avoiding talk of a default, so that the ECB can still chip in with tax payer's money.

miguel said...

I agree that a workable solution needs to be found to get medium-term respite and that the "Frech model" will not refund 100%.I feel that this situation with Greece and other risky countries(PIGS/PIIGS)has been fueled up with speculation to obtain higher remuneration -greed- from loans given without professional/expert prior analysis. That "all" those involved in this big crisis :UE, Brussels Commission, Eurozone, ECB,Finance Ministers of the Eurozone and UE,IMF,and last but not least Greece itself, are to be heavily blamed and sanctionned.
I therefore think that the notations agencies, which are to be severely blamed too, for not having seen this situation coming long before it happened, should now be realistic and not shield anymore private investors by alleging that their participation would be considered default. Because these same private investors have put at great risk funds which far less informed individual people who have confided their "money" to them inadvertently, allowed them "indirectly" to invest in such high risk loans.We are in a repeat situation of the Lehmann case,and without being any kind of financial expert,I think that continuous protection of private investors and speculators of all kinds needs to be severely repressed. Seemingly measures have been partially taken(?),for sure a lot of talk has been going on. Now, here is a situation which would allow to sanction these private investors, including even the ECB who bought up masses of Greek bonds to "hold" the situation. "Hold" from what? To propose naming a European Minister of Finance with no authority and no political power: is that a well matured solution, or another half baked measure!?
All this to avoid "panic"? - a run to the banks (1929-30) (i.e. Lehmann...) . Well, some sort of great "panic" has been installed because the Greek situation is the detonator of a lot of conceptual and political mistakes in the Eurozone, which created an incomplete monetary union, and not an economic union with political power (11 years have gone by!),which most probably would not have been possible due to absence of political will?. If the "final solution" is to oblige the other Eurozone (UE) countries to take over "temporarily" (best scenario, because it implies that Greece's recovery was succesfull), like if this was an economic union where such solidarity was incribed in the marble, if the Greek austerity plan turns out to be a fiasco, who pays for all this ?:the tax contributors in each country!And one of the majorreasons being that UEcountries' governements are not keen to have electors and tax payers find out the high amounts that are exposed to great risk at banks and or other private financeers,not only in Greece,but in"PIGS/PIIGS" countries and others.
Accordingly,all supranational organizations,UE(Eurozone,governements and finance ministers, and notation agencies, better find realistic solutions which do not fall on the head of taxpayers.