Tuesday, January 24, 2012

Crunch Time For Europe?

By Jan Strupczewski and Dina Kyriakidou of Reuters report, Greece clings to hope of debt deal despite setback:

Greece was clinging on Tuesday to hope of a last-minute bond swap deal to avoid a messy default after euro zone officials sent talks back to square one by rejecting a final offer from the country's private bondholders.

Athens is desperate for a deal within days to ensure funds from a 130 billion euro rescue plan drawn up by European partners and the International Monetary Fund arrive before 14.5 billion euros bond redemptions fall due in March.

After weeks of haggling with creditors in Athens, euro zone finance ministers in Brussels on Monday dealt a sharp setback to those hopes by rejecting creditors' demand for a 4 percent coupon, or interest rate, on new, longer-dated bonds in exchange for existing debt.

Private sector creditors now have the upper hand in deciding whether Athens will be forced into a hard default that could sow chaos across the global financial system and push other weak euro zone members closer to a default.

Charles Dallara, the head of the Institute of International Finance negotiating on behalf of creditors, is due to speak in Zurich later on Tuesday after leaving Athens over the weekend.

Greece's top official at the Brussels meeting remained stoic, saying the country had the euro zone's support to complete the debt swap talks in the "coming days."

"In reality, we are now entering the final stretch," , Finance Minister Evangelos Venizelos said in a statement.

"I believe everyone has now realized that Greece must be supported in its effort, which is of vital importance not only for us but for the euro zone as a whole and the global economy."

Asked if there was still hope of a deal, IMF chief Christine Lagarde said she remained positive.

"I'm determined to be positive," she told Deutschlandradio Kultur. "Political leaders have the instruments and possible measures in order to manage this situation and bring the euro zone back on to a sustainable path."

Conservative leader Antonis Samaras, head of one of three parties backing Greece's technocrat prime minister, told Reuters he expected the talks to be wrapped up by March 5 at the latest and said the country must head to polls as soon as the EU/IMF bailout is finalized.

He set April 8 as the deadline for elections.

"PLAN A MODE"

With weeks of talks yielding little progress and growing concern that Greece's fast-deteriorating economic prospects mean it will need more aid from partners either way, European policymakers appeared to be more willing to consider the previously taboo option of an involuntary debt swap.

A "voluntary" swap where both sides agree to the terms of the deal is required to prevent insurance against a Greek debt default from being paid out.

"There has been a slight change in mood, but no change in the policy lines pursued," a senior euro zone source told Reuters when asked about the mood among policymakers on Greece.

A second euro zone source confirmed the perception of a shift but cautioned: "We are still in Plan A mode."

A source close to the talks said creditors would go towards an involuntary debt swap if there was no agreement by the end of the week -- raising the risk of a messy default.

The bond swap is meant to cut 100 billion euros from Greece's debt burden of over 350 billion, in a bid to ultimately slash its debt from around 160 percent of GDP to a more manageable 120 percent of GDP by 2020.

Sources close to the talks told Reuters on Monday that the impasse in Brussels largely centred on questions of whether the deal would return Greece's debt mountain to levels that European governments believe are sustainable.

Greece and its private creditors had been converging on an agreement that would see private creditors accepting a real loss of 65 to 70 percent, sources close to the talks said after several rounds of talks last week.

At the time, Athens and its creditors were discussing new bonds would likely feature 30-year maturity and a progressive interest rate averaging out at 4 percent, sources said.

Greece is stumbling through its worst post-World War II economic crisis, with unemployment at record highs and frequest protests against austerity measures demanded by its international lenders as a condition for bailout loans.

The country is now in its fifth year of recession.

Greece is stumbling and European political dithering has not helped. We are witnessing political masturbation at its worst.

And what is this rubbish that the private sector creditors "have the upper hand"? I will repeat, it's high time Europeans banded together to resolve this debt crisis once and for all and they should start by teaching hedge funds a lesson.

Let me be blunt: Fuck the hedge funds and anyone else holding out, just impose the debt deal on all bondholders and get on with it already. And Greeks need to get serious on cutting their over-bloated public sector, go after big tax evaders, cut corruption and bureaucratic red tape, and focus on growing the private sector.

And what about CDS triggers? Agustino Fontevecchia at Forbes reports, Greek Debt Deal Will Force Bondholders To Take 'Voluntary' 70% Haircut:

Greece is back in the news again, as the government of Lucas Papademos negotiates the terms of the Greek debt restructuring, dubbed PSI, with the Institute for International Finance (IIF). Private bondholders are expected to take a 65% to 70% haircut, forced by retroactive collective actions clauses (CACs) that will probably spark credit default swaps, according to research by UBS.

UPDATE: Reports have surfaced that suggest Eurozone Finance Ministers rejected the latest PSI deal, asking private bondholders to take a coupon rate below 4%.

As mentioned below, troika (ECB, IMF, and European Commission) had already asked private creditors to take the lower rate, which would push the haircut up to 70%.

The IIF’s two top negotiators, Charles Dallara and Jean Lemierre, have sent markets mixed messages as of late. Dallara told reporters he is “confident that our offer, that was delivered to the prime minister, is the maximum offer consistent with a voluntary PSI deal,” according to Dennis Gartman.

Reports suggest that latest offer will come with both a 70% haircut and a reduction of the coupon rate to an average 3.5%, from the previously accepted 4%, according to the FT. This should help cut Greek debt by €100 billion ($129 billion). In a prepared statement, Dallara said “the elements of an unprecedented voluntary PSI are coming into place.”

Restructuring Greece’s massive debt load, to lower its debt-to-GDP ratio from the nearly 180% it’s at now, is one of the pre-requisites the IMF put on the troubled peripheral nation to be able to tap about €130 billion ($167 billion) in additional bailout money that should keep the country going until 2014. The passing of a structural reform package is the second; a troika delegation is expected in Athens this week to work a plan to cut about €7 billion ($9 billion) from the 2012 budget.

Failing to restructure Greece’s debt in time could lead to a so-called “disorderly default.” Greece faces a €14.5 billion ($19 billion) bond redemption on March 20. “In all likelihood, the Greek government will not have the cash to repay the bond, which means this is in effect the deadline for restructuring the country’s debt,” wrote UBS’ Stephane Deo, global investment research economist.

The whole situation also begs the question about the meaning of “voluntary” in the context of bond and credit default swap (CDS) markets. IIF has been negotiating with top European policymakers and the Greek government in order to avoid a credit event, i.e. a default, in order to avoid triggering CDS contracts. While net open positions in Greek CDS total €3.3 billion ($4.2 billion), making them relatively negligent, they would set a precedent that could be hard to escape in the case of a much bigger problem, such as an Italian or Spanish restructuring. Major banks like JPMorgan have come out to say their exposure to Europe is limited, while Morgan Stanley and Goldman Sachs came under fire by investors last year on their reported exposure.

UBS’ Deo expects the Greek restructuring to rely on CACs in order to force participation. “Because more than 90% of Greek debt is under Greek jurisdiction, these CACs would retroactively apply to existing bonds, and hence drive the participation rate up to 100%,” he wrote.

Rules governing the CDS market are hazy at best. The International Swaps and Derivatives Association (ISDA), the body responsible for determining whether CDS have been triggered, has been on a media campaign to try to justify how these restructuring can be made to seem like they do not constitute an actual default.

Many have been outraged by their position. Dennis Gartman, for example, noted the current deal “is a default in all but name only.” UBS’ Deo, on the other hand, explained “not triggering the CDSs would wipe out the credibility of this market, which would be very detrimental in our view.”

ISDA has relied on the technical nature of CDS contracts and, in particular, the blurry line that exists when it comes to determining defaults in the sovereign bond market. While Deo expects CACs to trigger this particular form of protection, ISDA has been able to pull a rabbit out of a hat every time complications surfaced that suggested a credit event would occur. In response to possible CACs, ISDA explained:

If bonds contain a Collective Action Clause (CAC) with a 75% threshold for making a change to bond terms, then if 75% or more of the holders vote in favour, that change is binding on all the holders, even those that voted against. That is, the change does not have to be agreed upon by all the holders to trigger a Credit Event, just the relevant majority of them. In that sense, the change is “mandatory” for those who voted against it. We understand that Greece’s domestic law debt, which accounts for over 90% of all of its outstanding debt, does not contain CAC clauses.

The dust should begin to settle as this week passes and final details on the actual restructuring deal (PSI) are released. Deo believes that policymakers will have to rely on CAC and that those won’t trigger CDS; I wouldn’t underestimate ISDA Credit Derivatives Determinations Committee’s capacity to act as a magician and pull the proverbial rabbit out of the top hat.

We'll see if any debt deal is settled but according to Andreas Koutras, it's crunch time for Europe and it needs to relieve the ECB before the PSI:

This is crunch time for Europe, Greece and the ECB. The PSI has reached an impasse not because the coupons demanded by bondholders are too high but because bondholders can afford to Free Ride along the ECB.

By insisting on a voluntary PSI with the largest bondholder the ECB, exempted, a huge free riding problem has been created. This more than anything else (coupon, English law etc) is the major obstacle for a successful PSI. Europe must come up with the money to take the Greek holdings out of the ECB’s SMP program NOW. It would do it anyway at some point in time.

Let us see why:

  • ECB stays out, the PSI proceeds in a voluntary manner. Greece would have to find the money to repay fully this 45-55billion. This probably means the EU (Germany) providing new loans to cover these redemptions in the next 3years (market believes that the ECB holdings concentrate in the near maturities).
  • ECB participates in the PSI and takes the losses. Then, barring magic tricks, the National Central Banks (ECB shareholders: Germany 19%, France 14%, Italy 12.5%) would have to cover the losses.
  • Greece default through the use of CAC’s or otherwise. The ECB would have to write down the value of the Greek bonds again. Therefore shareholders pay again.
We thus see that in all plausible scenarios, the EU (Germany) would have to come up sooner or later with the money to cover either the losses or the redemptions at Par. It is better to do it now and change the odds in the PSI offer and give Greece and Europe a fighting chance. By removing the ECB early, holdouts would have very little to stand on. In addition, insisting on a special status for the ECB, Europe risks contagion to other countries whose bonds the ECB owns.

The ECB is NOT a creditor (preferred or otherwise) towards Greece (through the SMP) but a bondholder who bought the bonds in the secondary market. Whatever the reasons of the ECB, they cannot play a part in the decision process. If we allow distinguishing holders of bonds with regards to their investment or buying motives then we should grade the debt according to who owns. The ECB is a supranational entity but does not enjoy unlimited immunity[1].

The relief can come either by giving the money to Greece to buy (at cost) and destroy the bonds immediately or by exchanging the ECB holdings (at cost) with EFSF paper and then passing the bill again to Greece if Europe does not want to shoulder the pain.

Selling the bonds back at purchase price can be justified by the size of the holding (20% of total outstanding) and also by the particular needs of the buyer. The bond market is an OTC market.

Allowing during a default or through CAC’s a special status for the ECB would be detrimental to the other peripheral countries. It would mean effective subordination of every other bondholder since it would create a two tier system. The European Government market would immediately re-price to reflect the increased risk.

Europe must act fast to remove that risk factor from the market. Doing so, would show leadership and the determination to deal with the European Peripheral debt crisis.

Historical Context

Back in 2010 as the Greek debt tragedy was unfolding the ECB took the controversial decision to support the Greek government bond market with outright purchases of Greek bonds. The ECB had to act swiftly on the face of EU inaction and squabbling. It justified this though their mandate on Financial Stability. Despite the fact that article 123 (TFEU) explicitly prohibits Credit facilities or outright purchases of government debt the ECB was allowed to violate the spirit of the law. The exact wording was “purchase directly from them by the European Central Bank”. Since the purchases were in the secondary market and not in the primary (at issuance) the ECB had only to comply with the “without prejudice” it its other mandate i.e. Price Stability and Monetary policy. This gave rise to the so called Securities Markets Program (SMP) sterilization. Thus on a regular basis the ECB withdrew the same amount of liquidity from the system as it was supplied by their direct purchases.

Despite the heavy intervention by the ECB to the tune of 45-55billion (in nominal) the Greek bonds continued their accelerated descend. As a result the ECB silently suspended the purchases of Greek bonds and was thus left with around 45-55billion of Greek debt. Bonds acquired by the ECB were also marked at purchase price and amortized to Par at maturity.

Problem was however, that the ECB, as explained above, does not mark the SMP holdings to market but at purchase price. Attempting to mark the Greek bonds at the current levels would generate losses that would not be covered by the equity (10.8billion). Unless the ECB waves a magic wand and comes up with some revaluations or other accounting gimmicks it would need to go back to its shareholders to raise the requisite capital. And this apart from the humiliation of having a Central Bank going bankrupt also requires taxpayers’ money. As the largest shareholder is the Bundesbank this means German money.

JC Trichet very quickly identified this problem and tried in March 2011 to sell the SMP holdings to the newly created EFSF. Unfortunately, his recommendation was not adopted by Europe’s politicians and this was also a source of friction between the ECB and the EU. The EU politicians refused to take responsibility of the losses that the Greek bonds generated.

In July 2011 the council of Europe decided to restructure the Greek debt in a very unconventional way. In order to avoid default and the ECB taking heavy losses it demanded the PSI restructuring to be voluntary. It also assigned 100billion for bank recapitalization to soften the blow of the Greek debt write-downs. This decision unfortunately turned the benign intention of the ECB into a huge headache. Europe should deal with this first before any PSI restructuring.
As for hedge funds, Andreas disagrees with me:
As for the hedge funds, I don't agree. Firstly it is not the hedge funds that stop the PSI from becoming reality. Hedge funds represent only few % of the total. And in any case they did not cause the misery in Greece. It was politicians and now European policy makers that screwed up big time. Hedge funds are part of the market (good or bad) and they will fall or rise by market rules. As for the CAC's it will not affect the hedge funds as they hold mostly bonds under English law and not under Greek. The whole thing is just a big poker game to push participation up....

... hedge funds in Greece were a late comers.
The CDS game could not be played as it was too expensive for them and the bid-offer to wide for playing. On top the volatility was too great. Few funds could afford the swings. We all new from the start that Greece had the upper hand in any restructuring due to the Greek law. Europe fucked it up big time by not calling a default back in 2010. Now they are cornered. A default would cause more damage to Europe and Greece now.

I was one of the few who called for a quick default and restructuring early on. Now the stakes are too big and we already have 73billion of super senior and untouchable debt.
True, hedge funds didn't cause the misery in Greece and they represent a small percentage of the debt holders, but it's also true some stand to make a lot more money if Greece defaults, which is why they're prepared to sue Greece if they don't get their way.

But I agree with Andreas that it is time for Europe to get its house in order and make some hard political decisions. The longer they continue putting off these decisions, the worse it will be eurozone and the global economy.

Below, euronews reports that fears that Greece could default on its massive debts are mounting after eurozone finance ministers in Brussels rejected an offer from the country's private creditors late on Monday night. Despite that, the Greek finance minister Evangelos Venizelos said he was confident an agreement would be reached. "We have the green light of the eurogroup to close the deal with the private sector in the next few days," Venizelos said.

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