Diary of a Financier

The Greek Outcome: 6 cents or One Half-Dozen

In Economics on Wed 11 Jan 2012 at 06:56

I’ve been sitting here with everyone else wondering what’s taking so long with the private creditor negotiations in Greek sovereign bonds. After marinating in it a bit, I’m not sure everyone understands the Catch-22 there.

Having feigned austerity (as if there were anything they could do), Greece now has to convince the IMF/ECB/EU to deploy the next $130B bailout tranche in March:

In March Greece faces a redemption cliff: if by then the €130 billion promised to it by the Troika as per the July 21 second bailout, is not delivered, it is game over–first for Greece which will default, then for the ECB, which will be forced to write down holdings of Greek bonds, in effect wiping out its equity and credibility, and lastly, for the Euro, which will see a core member leaving (in)voluntarily.

March 2012 is the new drop dead zone. A few recent headlines ran across my ticker screen and prompted me to bring the following Catch-22 to the fore. The tickers read:

Senior EU officials expect a debt restructuring deal between Greece and its private creditors to be announced next week.

The haircut is expected to be the 50% hoped for at the Oct. 27 summit.

Sources say the EU is prepared to drop the fiction that the haircut is voluntary, possibly bringing CDS payouts into play.

That may be another vicious rumor, but to the question, ‘what’s taking so long with these private creditor negotiations?’ here’s the thing: no matter the outcome of negotiations, it’s all the same for the large creditors at the table…

Class Action style, all of sovereign Greece’s creditors are being represented at the bargaining table by Greece’s largest creditors–institutions like banks, hedge funds and pensions. Creditors “savvy” enough to arrive at that table were savvy enough to hedge their Greek exposure with CDS. (We know an extraordinary notional sum of CDS exists, we just don’t know how much, especially including OTC. Somebodies are long that protection.)

The ISDA sold its soul in October 2011, when it ruled that a negotiated restructuring to Greek sovereign bonds would not constitute a “credit event” (i.e. not triggering CDS payouts). Such a negotiated restructuring connotated private acceptance of a specific haircut (originally 25%) and a maturity extension on the remaining bond values (the 75% balance has its maturity extended 10 years). The respective parties are currently haggling over these propositions in daily negotiations.

Put yourself in the shoes of a hedge fund manager or a bank, negotiating that haircut at that table. You own a slug of Greek bonds, hedged via CDS. That is, you were hedged in your exposure, but since the ISDA negated CDS payouts on Greek restructuring, everything is out of whack: your bonds trade sub 40-cents-on-the-dollar, while your CDS express intrinsic value of 70-cents. You have gaping losses where you once thought yourself virtually riskless. Now you’re scrapping for remains. Your options:

  1. You can concede to a huge haircut (70%): since your CDS won’t payout to cover losses on the bonds, you’re left with a pittance, the remaining balance (30%) with a depreciated present value (longer duration/maturity).
  2. You can argue for a small haircut (50%): your CDS still won’t trigger a payout, and the insufficient debt/GDP reduction for Greece leaves a high-probability likelihood that addition haircuts will impair your remaining balance (50% down to <30%).
  3. You can walk-out on negotiations and leave Greece to choose for itself between a hard-default or a return to the drachma: Greece will either choose defection from the EMU, or she’ll be forced out by core members (Franco-German), because the Troika will not pay for another bailout at this point.

Since Spring 2011, I said currency dissolution is the smart route for Europe. (It’s a nutty game of prisoners’ dilemma in arriving at the first dissenter.) Greece’s politicians would serve their countrymen well to revert unto the drachma. Devalue the currency and pay debt back in full–albeit toilet paper FX. That way, domestic Greek pensioners at least have income to depend on. They won’t be able afford international travel or most discretionary imports, but they’ll have income to finance living expenses. Via any other option–hard-default or bond restructuring–Greek pensioners will take a haircut to their own incomes. They’re synecdoche for the broader populace, few of whom would be able to afford living expenses–not even the essentials, not domestic nor foreign–were Greece to agree to any sufficient option but the drachma’s return.

The same goes for the institutional investors like banks, hedge funds and other shadow banks. They’re either going to get a big haircut (whether today or tomorrow) or accept full repayment in a devalued currency. It will all amount to the same real value, but only one option saves the Greek populace from depression: the drachma.

Both sides want the same thing; they actually need the same thing. That’s what’s taking so long though. Any negotiated outcome leaves institutational investors with an explicit haircut and worthless CDS. Deferring decision as long as possible allows investors to clip coupons until Greece falls off that redemption cliff in March. At that point Greece will be unable to honor both full principal and interest payments, particularly since the Troika won’t dispatch March’s $130B bailout tranche. Although defection back to the drachma is optimal, Greece needs this negotiation to telegraph feasance to its super-senior creditor, the Troika. Mere window-dressing.

If there’s anything I’ve learned from this Eurocrisis (and all those preceding), it’s that the smart money only looks smart in the end. The dumb money–the herd–has the clout, and their willing suspension of disbelief/ignorance lasts longer than any pragmatist can imagine. Human nature and the market’s infrastructure skew the system in favor of suchn irrational optimism, enabling temporary levitation like helium to a balloon. Eventually, gravity [always] reestablishes itself.

In Greece’s case, the IMF has inviolable covenants attached to its loans by charter–unlike the EU or ECB, which were not equipped to manage bailouts. Whereupon discovering Greece to have breached those covenants (austerity targets) at the upcoming March checkpoint, the entire Troika will shun her for breaching both explicit and implicit promises.


N.B.- As to whether or not a return to the Drachma would be a credit event for Greece, there’s some debate. Yet, not only has the ISDA shown its willingness to favor sovereigns in the interest of averting catastrophe, but also the 1999 formation of the EMU (particularly the adoption of the single currency) was not a default on preexisting debt. That historical parallel is as good a guide as any, although I’ve solicited the opinions of a few swaps/bond traders, who confirm that notion.

  1. […] economics. However, it is folly, and I’m shocked nobody has abandon these roots. Like I keep saying, it’s a “6 cents or one-half dozen” scenario. Whether Germans/creditors receive […]

  2. […] scale will come to the same conclusion I have: …[C]urrency dissolution is the smart route for Europe. (It’s a nutty game of prisoners’ […]

  3. […] necessary to stem contagion. Finally, they’ve recognized my “6 cents/Half-dozen” notion that net-net, bailouts will cost as much as the losses from a breakup… except a breakup […]

  4. […] institutions alone demands monetization were Eurocrats to save the ERM system.  Yet, recall my mention of the “6 cents or one-half-dozen” outcome, wherein consolidation and dissolution […]


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