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** Banks listed in the IIF document (the committee representing them) are under no binding legal obligation to participate in the debt exchanges, and may turn out to own less Greek debt than currently believed. [Note: bank participation in the Latin Brady bond era was high, since at the time, banks held almost all the paper, and in the form of illiquid loans].

The big question: would Germany still live up to the deal if Greece missed deficit targets or assets sales, if bank participation was too low, or if hedge funds (once referred to by the Chairman of the German Social Democratic Party as a “swarm of locusts”) reaped large free rider windfalls? Ultimately, this is a political question. If “yes”, Germany will underwrite Greece no matter what; if “no”, then a broader, coercive Greek restructuring might follow in the not-so-distant future.

What the EU gave: an easing of lending conditions, and an expanded role for the EU lending facility (EFSF)
* Another 109 bn for Greece, allowing the country to continue to pay off maturing debt (to those not participating in the exchanges)
* Rate on new EU loans to Greece, Portugal and Ireland cut to 3.5%, maturities on new & old loans extended from 7.5 to 15-30 years
* 10 year grace period on interest on new EU loans to Greece; the unpaid interest accumulates
* EU loan facility has the ability to buy sovereign debt in the secondary markets, including a plan to purchase 40 bn of Greek debt (most likely including much of the Greek debt purchased by the ECB)
* EU loan facility has the ability to lend to countries (even those not in an IMF program) to recapitalize their banks
* Language (with no specifics) regarding the use of EU structural funds to boost growth in Greece

What the EU gets: more austerity, Maastricht with teeth (?) and private sector involvement in Greek debt rollover
* Legally binding national fiscal framework to be developed by end of 2012; fiscal deficits brought to 3% by 2013 at the latest
* Private sector involvement in Greek debt rollover, committed in principle by 30 financial institutions listed in the document released by the Institute of International Finance; target participation rate of 90%; exchange appears to result in Selective Default credit rating
* Voluntary participation options include exchanging existing debt into 15 or 30 year bond with AAA-guarantees of principal. Bonds exchanged at par will carry low coupons (4.25% effective), while bonds with higher coupons will be exchanged at a 20% discount
Source: Eurozone draft proposal July 21, 2011, IIF press release July 21, 2011

In addition to execution risk in Greece, we are left with 3 other concerns. The current EU-IMF lending facility capacity is Eur 255 bn, but we anticipate that as agreed, national parliaments will expand it to 440 bn. First concern: while that’s to deal with problems in Greece, Portugal and Ireland, if you include Spain, it gets tight (note: the chart excludes costs to recapitalize banks). If Italy or Belgium entered Europe’s Liquidity Hospital, a lot more money might be needed from European parliaments (in one worst-case scenario, Alliance Bernstein estimates that the EU lending facility would have to increase from 440 bn to 1.7 trillion Euros, mostly from Germany). Italy faces a multi-notch downgrade from Moody’s, which is not going to help. As we discussed two weeks ago, Italy has been a model citizen in terms of running low budget deficits for 20 years, but still cannot escape the confines of its very large existing debt stock (120% of GDP).

Limited capacity at the European Liquidity Hospital
Official sector lending capacity vs sovereign funding needs (including deficits) through 2013 - Billions, EUR
[Chart showing Total lending capacity vs Greece, Portugal, Ireland vs Plus Spain vs Plus Italy and Belgium]
Values on Y-axis: 0, 200, 400, 600, 800, 1,000, 1,200, 1,400, 1,600, 1,800
Labels in chart: EFSF, IMF, EFSM, Greece package, Spain, Belgium, Italy
Possible sovereign borrowing needs from official sources
Source: AllianceBernstein, Public Filings.

Second, as shown below, Europe is now a two-speed economy, with the periphery stuck in neutral (industrial production is one proxy for this; there are others, such as unemployment, consumption, export shares, etc). If the idea behind the EU/IMF effort is that austerity will boost growth and lead these countries back to the public markets, there is very little momentum in this direction. If the status quo in the periphery does not change, all the EU package does is allow the current approach more time to fail.

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