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Peter Tchir: It's All Greek to Me


Fixed income guru Peter Tchir discusses what the Grexit could mean for markets.


Editor's Note: This report was sent to readers of Peter Tchir's Fixed Income Report on January 6, 2015.

The new year started with a bang, or more accurately, with renewed talk about a Grexit and what it would mean for the markets.

I see 4 distinct scenarios as being plausible, though not equally likely:

1. Muddle along with tweaks to the current program.
2. Significant concessions made to Greece, with Greece continuing to use the Euro.
3. Greece leaving the Euro with a well-orchestrated plan to smooth the transition, and steps taken to prevent any "contagion" spreading to Portugal, Spain and Italy.
4. A messy exit dragging Portugal, Spain, and Italy into the mess.

So to figure out how each of these scenarios could come about and how likely any scenario is, I think we need to start with the debt since it is after all, a debt problem.

€80 Billion of Greek Bonds

I start with the bonds outstanding.

The total is €80 billion. I cut out about €3 billion that is yen denominated, or issued by Greek railways or other entities, and an inflation linked bond for simplicity.

That leaves me €77 billion to look at.

I think we can treat the €13 billion of T-bills as a separate class of debt, because they have special protections under European banking law and Greece managed to pay them in full the first time around, so let's treat that debt as sacrosanct.

The remaining €64 billion of debt can be broken down into 3 distinct categories:

  • €27 Billion of ECB debt. These are the residual bonds held by national central banks that were purchased via Trichet's SMP (yes, Europe did try buying sovereign bonds and it was pretty much a disaster). These bonds have been getting paid in full as they mature and pose a special dilemma for any debt restructuring.
  • €30 billion of PSI debt. This is the debt that is held by investors, and we will walk through why it isn't a major problem for the Greece, and also why there is little to be done with it.
  • €7 billion of what were we thinking debt. This is the debt that was issued in April and July of 2014. Greece issued €2 billion of 3.375% bonds due in 2017 at just under par back in July that are now at 79 cents on the dollar. These bonds could be subject to some restructuring, but the amount is small enough and the first maturity is 2017, so there is no urgency to deal with these bonds (there is less than €300 million in coupon payments due on these bonds in 2015, so another reason they can be somewhat ignored as a key player in any debt renegotiations).

Ignore the PSI Bonds

The PSI bonds can largely be ignored as well. They have "step up" language on the coupons, but the current coupon is 2% meaning that the entire coupon owed in 2015 on these bonds is only €600 million -- a small number in the grand scheme of things.

The first maturity is in 2023 so again these bonds aren't a "pressure" point.

Finally, unlike the new issues that were done, these bonds started 2014 in the mid-50's on average, got as high as the 70's, and are back to the mid to low 50's, so there are no big "unrealized" losses to be booked up default (unlike the new bonds which could be held by banks in accrual accounting books).

So I don't see the PSI bonds as being important at this stage of the Greek debt problem.

Those Pesky ECB Bonds

These were the bonds that didn't get "CAC'd" (collective action clause). They all have an issue date of February 15, 2012, because that is when these special bonds were created for the central bank to hold.

While "only" €27 billion in total, they require €8 billion of payments from Greece this year (€6.7 matures this year, and €1.4 billion is owed in interest on these bonds).

So the amount owed to the ECB in 2015 is meaningful, far more meaningful than what is owed on bonds held by the private sector at this stage).

At the same time, the ECB is not in position to take a loss. The ECB's balance sheet is not so large that they are unlikely to be generating enough income to offset that sort of loss. That was the issue in the first place -- the ECB effectively subordinated all other bonds holders, and continues to do so.

A large portion of the ongoing "bailout" is actually to lend Greece money so it can pay back the ECB.

These bonds are an issue precisely because have reasonably large current flows due, and because the holder is not in position to take a loss. A dangerous position for both the borrower and the lender.

Where's the Rest of the Debt?

There is another €220 billion of debt in the form of loans. This is where it get interesting.

There are officially 8 different loans, which have a combined redemptions this year of almost €9 billion, plus interest payments.

So the first thing to note is that the ECB's bond position, while small, creates almost the same 2015 obligation as the loans do, which is why I consider that debt so important.

The first loan that has a final maturity is the 10 billion XDR loans. XDR is the IMF's special drawing currency. There is currently 20 billion of XDR loans outstanding - which would likely fall around 50% to the U.S. if there were any losses on those. I have to admit, that watching Congress deal with some serious losses via the IMF lending to Greece should make for some exciting television.

The first big loan is €53 billion that comes due in 2017. This loan was done back in 2011 and shows the European Commission as the lender as this was done prior to the EFSF being established.

So whatever games can be played between now and 2017, it is clear the rubber meets the road then.

The other large loan, is very long dated, but is currently at €107 billion. The lender for this is the EU Stabilization fund, which gets its money from the EFSF.

The EFSF has issued €194 billion of bonds to fund its obligations, which are primarily due to be repaid by Greece. 

The EFSF operates under a guarantee structure where the member states guarantee any losses suffered by the EFSF -- which is why it is Aa1/AA rated.

Germany has the most to lose.

So for argument's sake, let's use a nice round number and say that "Europe" is on the hook for about €200 billion of Greek debt. It has obligations via the IMF, from direct EU lending, and via the EFSF, with the bulk of the exposure coming from the EFSF (or possibly its replacement, the ESM which also has €50 billion of debt outstanding and some "paid in capital").

If each country bears its share of the burden, then Germany is on the hook for €58 billion of the loans to Greece. France is in for €43 billion. 

More "interesting" is that Spain and Italy are in for a combined €64 billion.

Under a worst case scenario where Greece walked away from the debt entirely, Germany would have to pay €58 billion to the lenders via guarantee programs. If Spain and Italy decided to walk away rather than pay their full share, then Germany and France would probably have to split that. France at that point might also walk away, taking Germany to paying for all the loss.

Germany can talk tough, but right now, the various entities are lending to Greece, largely so that the EU (Germany in particular) can pay itself back on old loans.

The Rational Approach

The rational approach seems simple:

  • Understand that Germany and the EU lose if Greece defaults, so ensuring Greece doesn't default is in the EU's best interest due to loans that have already been made.

  • The ECB is NOT set up to be a money making operation, so renegotiate the debt they hold down to their cost basis (they did not buy these bonds at par). Increase their maturities and reduce their coupons. For that matter, neither is Germany, which has been making a healthy return on their EFSF guarantee fees.

  • Accept that mistakes have been made on all sides (including the misnomer that Greece ever really got a charitable bailout), stop searching for blame or to punish, and move forward.

  • Take advantage of the convoluted array of vehicles and rely heavily on non-accrual accounting gimmickry to ease the terms on Greece without taking accounting losses that could cause problems for the various entities (I did say it was gimmickry).

This could work with Greece remaining within or outside of the Euro. If the decision is that it is best for all parties for Greece to get a new currency, then these loans all have to be redenominated into that currency - probably at a very "favorable" initial exchange rate. 

Greece could not change currencies and maintain payments on the existing euro denominated debt.  It would be unsustainable, and quickly result back in the default scenario causing Germany to lose, so the logical conclusion would be to once again rely heavily on accrual accounting and bleed the loss in slowly over time by converting at rates that are favorable to Greece.

Two adults in the room, and that is what should happen.  Unfortunately there are 20 some odd adults in the room, and maybe some adolescents, many of whom have secretly despised the other for years, if not decades, or even centuries.

Ring Fencing

Ring Fencing is less of an issue if the "Rational Approach" is used where Greece gets new and favorable and sustainable terms, in or out of the Euro. 

If Greece remains in the Euro the need for ring fencing or support is reduced. But here is what the ECB needs to do:

  • Launch sovereign QE, it will show the willingness to support the remaining countries if nothing else, and is apparently already on the radar screen, so launching now shows "commitment" or something that the markets should like.

  • Announce that at the very least, that even if ECB held bonds are structurally senior, any bonds bought below par will receive cost rather than par at maturity.  Going full pari passu would be better, though would also be largely unbelievable because the ECB is not in a position to take losses of that magnitude and never will be.

  • Some real form of spending or stimulus in Greece (if they remain in the Euro, but also Portugal) would again have a strong signaling effect.

The EU failed to understand how quickly investors move from one "disaster" to the next in the early stages of the crisis. They need to "signal" through actions that they now understand and will aggressively support remaining members.

The Slippery Slope and Catalonia

Giving Greece better terms starts the slippery slope of having other countries demand more support. So give it to them. Europe is a mess.  Germany can borrow out to 7 years at less than 10 bps (or at least they could earlier this morning). There is no growth, and while sovereign QE may not help growth, giving each country better terms, good deals, and the incentive to try and grow, could help.

The alternative slippery slope is the Catalonians watching the EU (read Germany) sticking it to the Greeks once again and deciding they have had enough of this. At the other end the Finns thinking they have had about as much fun with a single currency as they can stomach, and the U.K. deciding Brussels just isn't worth the headache.

Hidden Debt

European countries are masters at using the "guarantee" approach to burying debt. EFSF and ESM don't seem to count as any countries debt, yet clearly they are at some level. 

They were also big on having banks issue debt, guaranteed by the government, that they could then buy (this was particularly popular in Italy).

They were also masters of "off market" swaps to create large up front premiums.

So I have just looked at the obvious debt, but I would be concerned about what other debt or other credit obligations are out there, and how they would work their way through the system.

Yet another "rational" reason to negotiate nicely with Greece, and probably one reason that it would be better to do it with Greece remaining in the Euro than with a new currency.

4 a.m. Summit Agreements

How many summits failed to find a resolution? How often would it take multiple summits before Europe would decide anything, and even then only at the wee hours of the morning?

I have laid out a case or even a path that Europe could take that would give Greece the support it needs, without dragging down the rest of Europe, and could be done with Greece remaining in the currency union or not.

The results of the actions I suggest are in some cases already being contemplated (it must be getting close to the 1 year anniversary of sovereign QE hints out of the ECB). 

The debt restructuring I talk about isn't being contemplated, but the result is less painful than the other potential inevitable outcome of a default by Greece triggering restructuring that cannot be contained.

If Greece finally understands that borrowing a little means the borrower has a problem, but borrowing a lot means the lender has a problem, then they will finally demand, and should get terms that are sustainable and can be a template for other countries.

Greece should be cozying up to China (and the IMF) to put in place fallback plans in case they leave the Euro in a hurry, at least to make their negotiating stance more believable.

So as much as the rational side of me sees an outcome that should not be bad, that could be spun as positive, that can work best if Greece remains in the currency union, but could alleviate most of the damage of a Grexit, I can't help but be concerned that the EU and even the ECB has consistently failed to act until pushed to the edge.

It also doesn't help that the ECB, has its own agenda because of those residual SMP bonds.

So I think that the better part of valor is to remain very cautious on risk here based on headline risk coming out of Europe likely to get worse before better.

Now back to trying to figure out if Oil down almost 10% year to date (on the 3rd trading day) and over 50% in the past 6 months is really good, or a very dangerous sign.

Editor's Note: This report was sent to readers of Peter Tchir's Fixed Income Report on January 6, 2015.

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