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White magic in Greek rescue: Greece will fund Germany after all

by Kostis Papadimitriou Tue Jul 26th, 2011 at 03:47:50 AM EST

Well, the title is accurate although a bit misleading, but I hope it is attention-grabbing. I need that because, although I find the Private Sector Involvement part of the deal fascinating, most people I talked to get confused and then bored. Actually it seems it is designed to confuse outsiders.

Let's take the most straightforward of these instruments (instrument 1), which by the way is similar to a Brady bond structure by most aspects.

For every 100 euros of Greek debt that matures, the banks will lend again (roll over) 100 euros for 30 years at the equivalent of 4.5% fixed rate. So far so good. Then Greece will buy AAA zero coupon 30 yr bonds for 100 euros, i.e. bonds that will pay 100 euros after 30 years but no interest at all in the mean time. You need around c. 35 euros to buy that (if you put 35 euros in an account that reinvests a c. 3.5% interest in its life then you get 100 euros after 30 years). This means that Greece will need an extra 30-35 euros of funding to buy that collateral. It will get this extra funding from the EFSF at c. 3.5%. So the nominal debt has now increased to 135 euros. However, Greece also has an asset worth 35 euros (the collateral). But in standard national accounting we only look at the debt of sovereigns, not their assets.

A good AAA issuer in euros is Germany, or some supranational European institution (EIB). But if Greece by a German AAA zero coupon bond, then it has actually borrowed money to Germany! So the EFSF will lend money to Greece to re-lend them to Germany (or another AAA issuer). Rather peculiar if you call things by their name.

The other interesting part is that the whole deal is actually 1/3 a normal loan and 2/3 a mortgage loan (or is it, 1/4 and 3/4s?) for Greece. After 30 years Greece will only have to repay 35 euros for each 135 euros of the deal because the 100 euros owed to the banks will be covered by the proceeds of the zero coupon bonds.

For the banks, the arrangement is a normal loan but with dual risk. It has a AAA rating for the principal and Greek risk for the interest (however, the principal is just 1/3 of the current present value while the interest is 2/3s).

For the EFSF, it is a normal loan with a c. 3.5% interest.

For the AAA issuer is a zero coupon bond, i.e. a bond where the interest is reinvested through its life and is paid together with the principal at maturity.

So the white magic of high finance is that you involve four counter-parties (Greek, the banks, EFSF and the AAA issuer), you stir AND shake them to get a nice cocktail. You could end up with the same result involving only two counter-parties.

Regarding the largest part of the deal with the official sector, the latest Greek rescue is rather straightforward and more or less fair for all parts, I believe. Greece is finally funded with a fair rate, i.e. the equivalent of AAA. This is the least Greece, and other periphery countries, should get for having handed monetary and foreign exchange policy (the latter is even most important) to a supranational authority on which they have negligible influence.


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So many of you recommended this diary and not one comment for days?

Science without religion is lame, religion without science is blind...Albert Einstein
by vbo on Sat Jul 30th, 2011 at 10:15:07 AM EST


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