Satyajit Das: What's Greek for 'No End in Sight'?

By Satyajit Das  FEB 23, 2012 10:40 AM

With Greece increasingly doomed, the real significance of the recent negotiations is that they provide a template for future European sovereign restructurings.


Greek Prime Minister Lucas Papademos spoke of a choice between “austerity” and “disorder.” He got both, as the Greek Parliament agreed to severe budget cuts required by the European Union and outside rioters protested the plan.
In great dramas, subplots support the main story. The story of “hairshirts” (the Greek economic plan) and “haircuts” (the write-down of Greek debt or private sector involvement) are little more than an intriguing sideshow in the broader European debt crisis.
With Greece increasingly doomed, the real significance of the negotiations is that they provide a template for future European sovereign restructurings. No one buys the oft-stated European leaders’ position that Greece’s position is unique or exceptional. Portugal is first in the line of fire, with the Irish, Spanish, and Italians watching anxiously.
In July 2011, the Institute of International Finance, a lobby group representing major banks and investors, proposed a complex plan entailing investors suffering a loss of around 21% on the value of their Greek bond holdings. On October 27, 2011, banks and investors were “invited” to accept a 50% write-down under threat of larger losses if they did not agree. The write-down was structured as a “voluntary” exchange of maturing Greek bonds for new bonds, to avoid triggering credit default swaps contracts, a form of credit insurance.
Greece has around 350 billion euros in debt, including 70 billion euros in bailout loans and around 80 billion euros in bonds held by the European Central Bank. A 50% haircut of the remaining 200 billion euros equated to reduction of 100 billion euros. As around 85 billion euros is held by Greek banks and pension funds, the reduction of 100 billion euros was less than 30% of outstanding debt, as only private investors are covered and bonds held by official institutions such as the ECB are excluded.
Following protracted negotiations, the Greek government has agreed on a new Greek austerity package. The bond exchange is likely to proceed with bondholders suffering losses of over 70% to 75%. The losses are made up of a writedown of 53.5% and reduction of interest rates on the new bonds to be issued (2% up to 2015; 3% between 2016 and 2021; 4.3% thereafter).
The Troika -- the EU, ECB, and the International Monetary Fund -- needs to reduce the level of Greek debt to a “sustainable” 120% of gross domestic product by 2020. The bond deal and the latest budget cuts are designed to achieve this, paving the way for a second financing package to enable Greece to repay a 14.5 billion euro bond on March 20. Deterioration in Greece’s finances required the bigger write-downs and greater budget cuts.
But even the greater austerity and larger losses to lenders will probably leave Greek debt above the target level, requiring delicate financial engineering to at least cosmetically reach the target. In the end, even with a dollop of wishful thinking and economic gymnastics, the projected debt figure came in at 120.5% in 2020.
The 120% level is largely meaningless, being a political construct designed to avoid drawing unwelcome attention to Italy, whose debt levels are around this level.
There is no certainty that the agreement reached can be implemented. The IIF represents around 50% of banks and investors. The composition of lenders has shifted. Banks have sold off their bond holdings in peripheral European countries. Hedge funds specializing in distressed debt are now prominent among holders of Greek government bonds and may represent 25% to 30% of the total held by the private sector.
Investors with Greek bonds naturally want to minimize losses. Investors who have hedged by reinsuring the Greek bonds prefer default to a voluntary restructuring, allowing them to trigger their insurance and cover losses. Hedge funds that bought into Greek bonds, at prices around 30%, want a result that gives them a profit.
The deeper losses will increase resistance to the deal, especially from hedge funds that may prefer to take their chances in a default.
One option is to unilaterally insert collective action clauses into existing bond contracts, allowing a supermajority of lenders to bind the minority.
A complicating factor is the ECB’s refusal to take losses. With direct holdings of Greek bonds of 40 billion euros, as well as additional loans to banks secured over Greek bonds, the ECB’s capital of 5 billion euros (scheduled to increase to 10 billion euros) is insufficient to absorb losses. As the CAC would force the ECB to share in losses, a special arrangement will exempt them from the effects of any CAC, to the further detriment of already resistant private lenders.
The special treatment of the ECB means that commercial lenders are effectively subordinated to official lenders, a position that has been avoided to date. Given that after any restructuring, the bulk of Greece's debt will be held by official lenders such as the ECB and IMF, it is unlikely that Greece will be able to return to financial markets for a long time, which probably in reality was always the case. But this will discourage commercial investment in risky European debt, such as that of Portugal, Ireland, Spain, and Italy, adding to the contagion pressures.
Any agreement is also likely to face legal challenges from lenders, which would complicate proceedings.
Another complication is the extremely tight timetable that must be followed to ensure the arrangements are implemented in time.
Greece must undertake certain actions to qualify for the funding. Parliaments in eurozone members must approve the package. The European Financial Stability Facility, the current main European bailout facility, must raise around 70 billion euros to finance the bond exchange. There is little margin for error.
If the new agreement cannot be implemented in time, then the Troika could extend the necessary money to meet the March maturity and continue negotiations, although this would be difficult. Alternatively, it could arrange an orderly default. Another outcome is that Greece unilaterally declares a debt moratorium and leaves the euro.
Voluntary or involuntary default, large voluntary losses, and/or CACs all increase the risk that credit insurance contracts may be triggered with increased threat of contagion.
This agreement is unlikely to be the definitive resolution everyone seeks.
Greece has consistently failed to meet economic forecasts. Despite measures by the Greek government, debt continues to increase. According to the EU statistics office, Greece's debt reached 159.1% of GDP in the third quarter of 2011, up from 138.8% a year earlier and 154.7% in the previous quarter.
Greece may get through the March 2012 maturity, but the arbitrary 120% debt-to-GDP ratio, the best case under the plan, is unsustainable, even in the unlikely case that it is met. The Greek economy, which has been in recession for years, shrank by 7% in the later part of 2011. Budget revenues for January 2012 fell 7% from the same time last year, a fall of 1 billion euros. This compares to a budget target for an 8.9% annual increase. Value-added tax receipts decreased by 18.7% in the same period compared to January 2011.
Greece’s financial position will deteriorate and it will miss key milestones – debt levels, budget deficits, asset sales, and structural reforms. A leaked Troika report, prepared for the eurozone leaders, clearly warns of the substantial risks in Greece's successfully implementing the prescribed programs. With elections due in April 2012, government support for the austerity plan cannot be assumed, in the face of a serious recession and increasing social unrest.
A similar pattern is already evident in Portugal, Spain, and Italy with debt, budget, and growth targets, largely unrealistic, being missed. Popular resistance to reforms and austerity is also predictably rising. Italian Prime Minister Mario Monti has made it clear that Italy cannot take more austerity, which has barely started to be implemented.
Even if the Greek rescue is approved, the eurozone still needs to finalize the 500 billion euro rescue system by April 2012’s IMF meetings. The fund is designed to create the much-vaunted firewall to prevent eurozone instability from spreading.
There are suggestions that the size of the bailout fund could be increased. But Germany, Finland, and the Netherlands, the only remaining AAA-rated members of the eurozone, are reluctant to increase their commitments. The credit ratings downgrade of many other member nations, including France and Austria, has increasingly highlighted the risks of increasing their exposure.
The IMF is trying to marshal additional funds from members to support a European bailout. At the World Economic Forum, IMF head Christine Lagarde said that she was attending “with my little bag, to actually collect a bit of money.”

Following direct approaches by Lagarde, China and Japan have mouthed platitudes about “help.” Any support has been made conditional upon the eurozone members increasing their commitments, in the knowledge that it is presently unlikely. Tellingly, China Investment Corp., the country’s sovereign wealth fund, and influential Chinese central bankers have rejected suggestions of purchasing European government debt. As one official stated, “We may be poor, but we aren't stupid.” 
The US has ruled out contributions, though it is shouting encouragement from the sidelines. The US Congress still hasn’t approved the previous round of additional IMF commitments.
Everyone knows the amount of money available is insufficient to deal with the problems.
History suggests that a write-down of debt for distressed borrowers is frequently followed by others.
The entire trajectory of discussions, plans, and negotiations largely ignores Greece. There is no longer any pretence of “assisting” Greece. It is about ensuring that German and French banks minimize their losses. It is probable that no funds will be released to Greece but rather placed in a special account from where it will be used to meet the country’s debt obligations.
What has not been commented on is that Greece has also narrowed its available options with respect to its debt. The restructuring entails a change in governing law of affected bonds from Greek to English law. Under Greek law, the country could legislate to re-denominate its debt in reintroduced drachmas, transferring losses to its creditors. Under English law, it cannot do this.
Germany and the Netherlands have suggested that the EU assume control of Greek finances and elections be suspended in favor of a technocratic government, having the confidence of Berlin, Paris, and Brussels. In the end, the communique required Greece to pass a humiliating law giving priority to debt repayment over other government obligations. The Trioka will establish a permanent presence in Greece to oversee the process. The loss of Greece’s sovereignty has not been well received, at least in Athens.
Subplots connect main plots in thematic terms or provide minor diversions or comic relief. The light relief in this instance come from a group of hedge funds that have threatened to take action in the European Court of Human Rights alleging that Greece has violated bondholders “rights.”
In the end, Greece may live to default another day. Other embattled European nations will be scrutinizing the Athenian subplot extremely closely for clues to their future as they await the battles that lie ahead. A declaration of victory in the European debt wars would be premature.
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.