Will the Greek Swap Provoke Aftershocks?

As Greece moves closer to sealing the biggest sovereign restructuring in history, some economists are concerned that the Greek swap will provoke aftershocks on borrowing:

Greece’s day of reckoning with bondholders dawns with economists from Barclays Capital to Deutsche Bank AG concerned that the world’s largest debt restructuring will provoke aftershocks.

Eight months of negotiations reach a head with today’s deadline for private creditors to accept a bond swap aimed at writing off 106 billion euros ($140 billion) of Greek debt. The government vows to bind holdouts to the deal should participation fall short of its target.

Possible repercussions include a surge in borrowing costs for other indebted nations as investors refuse to lend to countries that may follow suit in imposing losses on bondholders. The accord may also trigger derivatives designed to insure against default, and may not be enough to prevent Greece from reneging on its debts in the coming years.

“We have to be on alert for all kinds of potential risks surrounding this,” said Julian Callow, head of international and European economics at Barclays Capital in London. “We are in such unknown territory here by the sovereign debt standards of advanced economies that we have to pay attention.”

Italian and Spanish bonds rose yesterday on speculation enough investors will sign up to the swap. Italy’s 10-year yield declined 13 basis points to 4.94 percent, while Spain’s 10-year borrowing cost dropped 6 basis points to 5.09 percent.

‘Another Milestone’

Greece needs to complete the swap to qualify for a 130 billion-euro bailout by helping drive its debt closer toward a target of 120.5 percent of gross domestic product by 2020, from 160 percent last year. Greece needs the cash to meet a March 20 bond redemption of 14.5 billion euros and dodge a default that would jeopardize the euro’s existence.

The debt swap is “just another milestone on the long road to stabilize the euro,” said Thomas Mayer, chief economist at Deutsche Bank in London. “What we’re doing here is root canal work on the architecture of European Monetary Union.”

The goal of the exchange is to reduce the 206 billion euros of privately held Greek debt by 53.5 percent. Investors with 58 percent of the Greek securities eligible for the program had indicated participation by 5:00 p.m. in London yesterday.

Greece’s largest banks, most of the country’s pension funds, and more than 30 European banks and insurers including BNP Paribas SA, Commerzbank AG and Assicurazioni Generali SpA have pledged to accept the offer. That brings the total so far to at least 120 billion euros, based on data compiled by Bloomberg from company reports and government statements.

Participation Goal

The government has set a 75 percent participation rate as the threshold for proceeding with the transaction, in which bondholders will receive new Greek government bonds and notes from the European Financial Stability Facility. Goldman Sachs Group Inc. analysts wrote on Feb. 28 that a voluntary participation rate meeting that target might allow Greece to proceed without making losses involuntary by enforcing so-called collective action clauses.

Default swaps on Greece (CDNNGRCE), insurance contracts against non- payment, now cover about $3.2 billion of debt, down from about $6 billion last year, according to the Depository Trust & Clearing Corp. That compares with a swaps settlement of $5.2 billion on Lehman Brothers Holdings Inc. in 2008.

Swap Ruling

Compelling holdouts to take part will likely trigger payouts on those contracts, analysts said. A final decision would be up to the determination committee of the International Swaps and Derivatives Association, a panel of traders and investors who rule on whether swap holders can collect by handing over the defaulted debt in return for payment.

“I do fully expect to be part of the collective action clause,” Patrick Armstrong, managing partner at Armstrong Investment Managers in London, said yesterday in a Bloomberg Television interview.

“There’s a potential risk for the banking sector writ large across Europe and further abroad” from the clauses, as underwriters of the insurance have to pay out and seek funds to do so, said Erik Britton, a director of London-based Fathom Financial Consulting.

Activating the clauses also sets precedent, allowing countries such as Portugal to mimic the initiative and providing another reason to steer clear of European debt, said David Kotok, who helps manage about $2 billion as chairman and chief investment officer of Cumberland Advisers Inc. in Sarasota, Florida.

‘Game Changer’

“The actual use of a CAC would be a game changer beyond Greece’s borders,” he said. “It says ‘we can retroactively rewrite a contractual agreement.’ It’s one thing to threaten or cajole, but it’s another thing to do it,” Kotok said.

European finance ministers will hold a conference call at about 2 p.m. Brussels time tomorrow, German Finance Ministry spokeswoman Marianne Kothe said yesterday.

Failure to seal a deal could imperil the pact Europe’s policy makers wrapped up just days ago to provide a second bailout of Greece, said Jim O’Neill, chairman of Goldman Sachs Asset Management. Investor resistance would throw “a short-term spanner in the works” of the crisis-fighting effort, said O’Neill. “If it doesn’t go through, European policy makers have to yet again do some nifty footwork,” he said.

Even a Greek success in persuading lenders to forego what they are owed leaves challenges for the euro area. Joachim Fels, chief economist at Morgan Stanley in London, said he worries about complacency among governments which may tempt them to relax on economic reforms and fail to increase Europe’s defenses against contagion.

‘Deep Recession’

“Europe’s southern countries are still in a deep recession and struggling to meet their fiscal targets,” Fels said in a March 4 note to clients. “ If something goes wrong in the next several months, I think that banks will be more vulnerable due to their larger sovereign bond positions,” and “the firewall will still not be big enough.”

At Citigroup Inc., chief euro-area economist Juergen Michels warns Greece will struggle to reduce its debt enough to meet its bailout terms and still faces a 50 percent chance of leaving the euro. Spain’s decision to revise its budget deficit target higher is another sign the crisis isn’t over, he said.

“There is more disappointment out there,” said Michels. “At the moment it looks relatively calm, but we doubt that we have seen that all the problems have gone away.”

The calm before the storm? Andreas Koutras has been busy covering the latest developments. Yesterday he wrote a comment, What if PSI fails?, concluding:

...the threat of disorderly default does not seem to hold much weight. It is for this reason that investors are sceptical about tendering their bonds. Tendering 100 to get back 20 versus a default and recovery of about 20 is not a real threat. It is an incentive to hold out.

And today, he followed up with a comment, What if PSI succeeds?:

For whatever reason, percentage, CAC or altruistic suicide the PSI succeeds. What is the sequence of events that might follow?

1. It is a German power game and Schauble would feel vindicated. He might even think that the success would propel him to the Chancellorship. The mighty Germany finally ruled over the bad markets. However, judging from the German record on bank bankruptcies or bailouts, one should be very skeptical about taking financial advice from them.

2. New bondholders might want to hedge their 30Y interest rate risk by paying fixed on a 30Y swap. However, this assumes that Greece would not default before that again. A very unlikely event given the Greek debt dynamics and economy. Thus many would try to offload their new Greek bonds as they do not have a mandate for 30Y Greek credit risk and hedging it would be very expensive. Greek banks would find it very hard to hedge as this requires 30Y swaplines. Thus they will keep it in their books and amortise their losses for of the old Greek bonds. Overall, however, we might see some hedging driving the long end higher.

3. Now many holders of the old Greek bonds had them as an asset swap. In other words they were paying the fixed coupon and receiving floating. Now that the bonds would disappear they face the choice of either keeping the swap (if they are allowed) or closing it with a loss. If they do close them then we should see a steepening of the curve, first from receiving the 5-10y sector and then paying the 30y to hedge the new Greek bonds.

4. Markets would rejoice the success for a couple of days even with if the CDS is triggered. They are sick and tired of the Greek issues. They can now turn their attention to the US election, Iran, Oil price, Portugal for the next PSI and the next restructuring of Greece.

5. In fact, a successful PSI might give the time for Northern European Banks to reduce their exposure to the rest of the peripheral market in an orderly way.

6. Greece and many Greeks might feel relieved that their trials are over. They might even think that the bad days are over. They reduced the debt load by 100billion. Did they not? Well, 30billion would be taken back to pay the 15%, 5.6billion is the accrued interest and another 23-30 billion (more later, after Blackrock) would be needed to recapitalise Greek banks. Then another 11billion would be needed by the end of the year to pay the immunity of the ECB and further 5-8billion would be needed to pay interest in the original loans and the deficit. Overall the Debt/GDP ratio would fall according to Troika from 164% to 163% at the end of 2012. Isn’t that absolutely fab.

7. On the bright side, the cashflow of Greece would improve as now they would only pay 2% (for the first 3Y) on 100billion and around 3.5% on the official loans.

8. Greece should be upgraded by the rating agencies by few notches. This would reflect the better cashflow profile and the support of the EU.

9. A fundamental rule of debt restructuring is that it should be done once and for all the debt. Otherwise you become a serial defaulter like Argentina. The PSI unfortunately fails in this respect. All that this means is that now a new restructuring is on the horizon. That of the official sector. Having demanded an 80% for the private bondholders they now can get a 50% for themselves or even less to bring the Greek debt down to manageable levels.

10. Greece would be free to hold elections now that the job of PM Papademos is done. He would breathe a sigh of relief that in a couple of months he would not have to deal with Greek politicians any more.

11. Greece now would not be able to redenominate their liabilities to Drachma even if they want to. The majority of the Greek debt would be under English law. This is a double edge sword. Either Greeks would do the correct and painful reforms or they would suffer even more. If they do not do them the exit door in few months from now is wide open.

Everybody is hoping for a successful PSI with or without CACs. The market might get a quick fix before it comes down again and faces reality. Nothing really has been resolved. Greece now can be dealt with behind closed doors in Brussels.

Here is where I part ways with Andreas. Even though the Greek experiment isn't over -- not by a long shot-- I feel like a huge monkey has been lifted off the shoulders of financial markets, buying the power elite time to figure out a way to resolve this debt crisis once and for all.

And Schaeuble might feel vindicated but he's feeling the heat. Speaking at the European University Institute in Florence, Schaeuble said Greece's problems were of its own making and dismissed suggestions that Germany was being punitive towards a country that perhaps should not have joined the euro:

"We have shown a lot of solidarity with Greece,» Schaeuble said in response to some hostile questions from his audience about Germany's approach to Greece's debt crisis. «Everyone knows the real problems of Greek society are in Greece and not to be found abroad."

Faced by students in pig masks and holding banners saying «No Austerity» and «We are all PIIGS», a reference to peripheral euro zone countries Portugal, Italy, Ireland, Greece and Spain, Schaeuble said it was «ridiculous» to say he wanted to punish Greece.

In Germany he often had to justify the billions of euros that his country was contributing to keeping Greece afloat, he said.

Mr. Schaeuble is right and wrong. The fact is that Germany played a significant part in this euro crisis, a point underscored by Soros when he took Germany to task at Davos. Until Schaeuble et al. figure out a way to address this 'debt crisis' (more like an unemployment crisis) in a more comprehensive way, they are just delaying the inevitable, adding fuel to the fire while populations suffer miserably.

Below, Geoffrey Yu, a currency analyst at UBS AG, discusses participation in the Greek debt swap, the outlook for the euro and European Central Bank monetary policy. He speaks with Caroline Hyde and Linda Yueh on Bloomberg Television's "First Look."

Also, Hans Humes, president of Greylock Capital Management, talks about prospects for investor participation in Greece's debt swap and Greylock's interest in Irish debt. Humes speaks on Bloomberg Television’s “InBusiness With Margaret Brennan.”

Lastly, Patrick Armstrong, managing partner at Armstrong Investment Managers, talks about the debt swap and why he won't participate in the deal between Greece and private investors. He speaks with Mark Barton on Bloomberg Television's "On the Move."