Greek GDP “warrants”: seriously mispriced, one way or the other?!

27 July 2012 gabriel.sterne@exotix.co.uk
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Greek GDP “warrants”: seriously mispriced, one way or the other?!
Executive Summary
• Rarely have we encountered so much scepticism on a financial instrument as Greece’s GDP-linked securities (aka warrants), currently priced at around 32 cents, less than a third of the value of one year’s payment. Some of the comments we have encountered run along the lines of “worthless!” and “they will fall to 5 cents on a Greek exit.” Yet we still think they are a candidate for one of the most undervalued asset globally, at least on reasonable assumptions of expected returns. We recognise this is a controversial call, so we spend considerable effort in justifying it.
• We are relatively positive on long run recovery prospects:
o Euro exit or not, we think Greece is likely to be on the road to recovery by the 2020s. Current levels of output are being crushed way below capacity owing to the credit “choke” and absence of incentives to invest until the bottom has been reached and accepted by investors as such. When these factors eventually fade, we expect a firm rebound.
o Summary Chart 1 illustrates that in an historic context (including prior to euro entry), the lower nominal GDP triggers (applied to the level of euro-denominated Greek GDP) are undemanding, extremely so by the mid-2020s.
o Summary Chart 2 places these triggers in the context of the international experience of 137 recoveries from banking crises since 1980. The triggers fall below the tenth percentile of the distribution of GDP recoveries by the 9th year since crisis onset (2017 for Greece) and below the fifth percentile by the 13th (2021). So Greece can recover less quickly than in the case of 95% of crisis recoveries since 1980, and still trigger the warrants by 2021. We develop a statistical model of crisis recoveries which predicts, even given the costs of the crisis, Greece will comfortably hit the nominal warrant triggers by the early 2020s.
• We think the discount factor applied to such distant payments should be around 10%, way below current GGB yields, which average 25%. In contrast to GGBs, there is little chance of default on the warrants because there is simply no need to default because no payments are required until recovery; and because there is no cross-default (warrants are detachable).
• We present a simple method of calibrating valuations given discount factors and expected probabilities of hitting triggers. We think the expected present value of returns is in the region of three times current prices.
• How can our views be so far from market prices? We highlight a number of explanations: (i) sharply differing views on the discount factor; (ii) more optimistic views on the impact of drachmatisation. (iii) there are also various risk premia, illiquidity premia, novelty premia that apply to the instrument, (iv) Greece’s call option (from 2020) limits upside; and (v) it is possible to believe in the long run positive story yet still think the shot run outlook for the warrants is weak, since there may be structural excess supply in the market, and the short-run news flows (and perhaps euro exit) could drag down the price further.
• We maintain our BUY recommendation, though we do not impose a price target. The key calls we make are massive long term undervaluation versus severe short-term downside risk. We do not think a single price target by a single date could possibly capture these issues, and indeed could be misleading to investors.