Thursday, 19 January 2012

The unfolding debt deal

The Financial Times are today reporting that last week’s impasse between Greece and private holders of its debt is being resolved with a sliding interest rate that favours the long-term investor. Interest will begin at 3 percent and rise to 4.5 percent, averaging about 4.25 percent over the lifetime of the bonds, according to the newspaper. 

The talks had stalled after German negotiators apparently introduced a sharply lower rate than the one that was on the table during the final stages of talks. According to one banker quoted by the FT, the deal would represent a writedown of a whopping 68 percent of the debt. 

If these details are confirmed, it would mean that the reworked offer has one chief priority – to favour banks and long-term investors over speculators – the two main groups of bondholders. 

It would do this in two ways; firstly, by discouraging immediate resale of the new bonds. A three percent initial interest rate lowers the so-called net present value – a calculation of a bond’s market value if it is sold before reaching maturity; secondly, by keeping the bond remuneration at a minimum (closer to 30 percent of the value of the original bonds Greece is effectively defaulting on. That is the discount German Chancellor Angela Merkel famously imposed on the Institute of International Finance last July, revised to 50 percent settled in October’s European summit). This penalizes hedge funds that have been buying up Greek bonds since the bond buyback scheme was announced last year. They were able to pick them up at the roughly 25-30 percent of face value, on the reasonable safe gamble that the European Financial Stability Facility would offer a better rate than the markets. The vast majority of the bonds, after all, are held by banks (an estimated 40 billion euros’ worth are held by Greek banks, and roughly twice that amount in banks across Europe, while the European Central Bank holds roughly a further 45 billion) and the EFSF was set up to provide liquidity to the banking system as well as governments. In other words, hedge funds were buying a free ride on a European Marshall Plan. The concomitant bank refinancing one would expect ought to be quite generous, given the severe haircut on the bonds. About 40 billion euros of a second, 130 billion euro bailout promised to Greece are said to be earmarked for banks. In the event, the amount could be higher. 

There may be two reasons for this change of heart on the part of the Germans, the eurozone’s only remaining large, triple-A rated economy now carrying a disproportionately high influence in negotiations. One is that the cost of money available to the European Financial Stability Facility has gone up since Standard and Poor’s earlier this month downgraded six eurozone economies, including France. That may have made German policymakers less charitably disposed towards parts of the financial world, including risk assessors and hedge funds.  The other is Germany’s known distaste for speculators and derivatives – bets against success – that can apply to countries as well as companies.

The counter-bets are particularly irksome to the Europeans right now. Not all bondholders are in favour of a settlement. A small group, owning about five billion euros’ worth of bonds, are also invested in credit default swaps, which insure them against up to 100% of losses.  There are also an alleged 35 billion euros’ worth of CDSs in the hands of non-bondholders who have simply bet against a consensual settlement. CDSs cannot be triggered if their owners voluntarily accept a discount on bonds.

The known unknowns

Remaining to be seen is what proportion of the old bonds will be paid out in cash upon maturity, and what proportion will be rolled over into the new bonds with variable interest. Given the German mood one would expect a smaller rather than a larger up-front payout.

Even more important will be whether the ECB’s sizeable stake will be included in the writedown. Were that to happen, the effect on Greece’s long-term hopes of solvency would increase. In addition, Greece would then more easily implement a collective action clause, making participation in the scheme compulsory for all its bondholders.

Also key, of course, will be the calculated effect on Greece's bottom line. The plan is to reduce Greece's debt to 120 percent of GDP by 2020, down from more than 150 percent today. There are , like Athens University economist Yannis Varoufakis, who claim that Greece will not be deemed solvent even after a successful writedown.


  1. Excuse me, but how can there be known unknowns? Wasn`t the tendency to predict future trends by guessing how they would be the direct cause of the collapse of Enron and behind all subsequent banking failures?

    1. Hi Penny, the subtitle was merely a reference to Donald Rumsfeld's infamous remark about the intelligence on Al Qa'ida and Iraq. But yes, securitising revenue streams into bits of paper on the basis of their expected performance is a gamble, and like you I am not of a gambling (or gamboling) nature.

  2. BREAKING NEWS: On February 31, 2012, after seemingly endless negotiations with creditors, all international holders of sovereign Greek debt will announce unanimously that they will forgive Greece 100% of her sovereign debt. Their official rationale will be: "If we keep spending all our energies on 3% of the Eurozone's GDP (without really accomplishing anything), we will neglect the other 97% of the GDP and the cost of that will be much higher than forgiving Greece all her sovereign debt now".

    This means that the central government of Greece will no longer have any foreign debt. The domestic debt of the central government remains unaffected by this. Consequently, Greek banks, pension funds, insurance companies, etc. can remain hopeful that their loans to the central government will be paid.

    Some time during March 2012, Greece will discover that things haven't really changed that much. Even though the government now has to pay much less interest than before, it still requires new financing in order to pay all the bills. They cannot raise this new financing in international markets because part of the 100% haircut deal was that Greece would no longer request financing in international markets until the country had regained creditworthiness.

    At the same time, the banking sector begins having severe liquidity problems. Part of the 100% haircut deal was that the ECB insisted on freezing its lending to the Greek banking sector. They would not cancel their outstanding loans but neither would they extend new loans.

    The banking sector loses well over 1 BN EUR per month in liquidity because import payments exceed foreign revenues from exports and services by that amount. Also, capital flight continues draining the banking system of another 1 BN EUR per month (or more!).

    With new capital inflow from abroad to finance these deficits having come to a halt, the government has no choice but to take dramatic actions: imports taxes and capital controls are implemented and the government issues a new bond whose purchase is mandatory for all domestic savers. This bond serves to finance the continued budget deficit and to provide liquidity to the banking system.


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