Nouriel Roubini's Global EconoMonitor

Greece Financing Offer: I Am Not Going to Say I Told You So, But…

For over a year, RGE has argued that a solution to the Greek debt insolvency crisis should include an orderly and market-oriented but coercive debt exchange, with a par bond for hold-to-maturity investors (banks, insurance companies, pension funds) and a discount bond for mark-to-market investors (hedge funds, etc.).

And indeed, the EZ has now proposed, and the private sector (as represented by the Institute of International Finance (IIF) that includes most of the large global banks) has accepted, an orderly debt exchange of the entire public debt of Greece coming to maturity between 2012 and 2020: The agreement includes two par bond options and two discount bond options. The maturity extension is 30 years for three of the options and 15 years for the fourth discount bond option. Private-sector involvement is estimated at €50 billion in 2011-14, to reach €106 billion through 2019. So, as we recommended, the maturity extension will include all of the debt maturing in the next decade, as opposed to—as suggested by some—the debt maturing only in 2012-14; thus, the amount of debt relief for Greece is now much more significant than a partial debt re-profiling of only some maturities.

We had recommended that credit enhancements should not be given in this debt exchange as they would be too expensive and unwarranted, but we did not rule out their use.

Unfortunately, credit enhancements have been added—as in the original Brady Plan: Three of the four new bonds have a full principal collateral guarantee (collateralized by 30-year zero coupon AAA bonds), while the fourth bond has a partial collateral. The principal is partially collateralized through funds held in an escrow account.

Overall, the IIF debt exchange proposal is quite generous to banks, and does not provide enough enhanced debt sustainability to Greece, which goes from paying a 4.5% coupon to paying roughly a 4.5% coupon (a bit of deferred interest, made up by a higher coupon later). In addition, Greece is asked to provide a principal guarantee.

Still, the cost for Greece to fund the purchase of this 30-year zero coupon bond will be much higher than that of the Latin American economies that followed the Brady plan: As bond yields on long-dated AAA bonds are much higher today than they were in the early 1990s, the value today of a 30-year zero coupon bond is much higher than two decades ago.

The IIF expects a large participation rate—about 90%—in this debt exchange; this rate is likely and would be similar to that in previous orderly sovereign debt restructurings (Pakistan, Ukraine, Uruguay). The holdout risk would have been very low even without the credit sweeteners, as there were other coercive ways to bind in potential holdouts; but the credit sweetener ensures a very high participation rate for all investors still holding Greek debt, both hold-to-maturity ones and mark-to-market ones.

As we have pointed out in numerous notes, the “credit event” issue and the downgrade of Greece to Selective Default (SD) by rating agencies will be a red herring issue as, in any successful debt exchange, the country will be in SD for only a few days or weeks.

Will this credit event—as defined by the rating agencies—trigger the CDS? The answer, as we have argued before, is most likely not.

Moreover, the fact that private creditors—specifically the IIF, which represents all the major global banks—are fully on board for this debt exchange increases the probability that the ISDA will not consider this exchange offer a credit event; thus, it is very likely the CDS will not be triggered even if this exchange offer is effectively a credit event. It is voluntary but successful only under the implicit threat of default.

Of course, the ECB had to let go its request that a credit event should be avoided at any cost. And ECB President Jean-Claude Trichet, in the post-summit press conference, did not rule out the possibility that the new exchanged debt will be acceptable as collateral for the ECB in spite of the likelihood that rating agencies will downgrade the debt to SD. The fig leaf for the ECB is twofold: Firstly, as we pointed out, the debt will be in SD only for a very short period of time. Secondly, the most important fig leaf for the ECB is that the new exchanged debt will have a principal guarantee: Even leaving aside the fact that the ECB repos operations are vastly over-collateralized in the first place, the additional principal guarantee via the 30-year zero coupon AAA bonds fully reassures the ECB of the safety of such collateral.

So, all in all, this is an OK solution for Greece along the lines of what we had strongly recommended; the main caveat is that the private creditors accepted PSI in exchange for a very sweet credit enhancement that significantly increases (relative to risk-free rates) the implied interest rate on the new bonds, even if the overall yields will be lower than the current high and unsustainable market rates; thus, the credit sweetener significantly reduces the NPV debt reduction that Greece will obtain to only 21%, a level that, over time, may not be sufficient to restore debt sustainability that—based on RGE’s calculations—requires a 30-to-50% NPV reduction of the debt burden.

David Nowakowski, Fixed Income and Credit Strategist at RGE, contributed to this note.

8 Responses to “Greece Financing Offer: I Am Not Going to Say I Told You So, But…”

gamma_citizenJuly 28th, 2011 at 10:26 pm

So, it comes down to a fake solution to delay default and to give private creditors extra time to recognize their losses. Again.

Dr_VJuly 31st, 2011 at 8:45 am

The European Commission, the IMF and ECB set up a tripartite to effect policy and foresight into the Greek Debt matter, true, but video conferencing doesn't carry much weight. When you loan that much money, you need a team onsite to manage it. The EU should have stepped in and cleared out the Greek Ministry of Finance, seized any and all documents, froze of of it's (Greece) assets, and put EU Finance specialists in place for the next "X" number of yrs, full stop. Greece has demonstrated they cannot handle money, that is a fact. The "default" has effectively occured, now it's about the management of the insolvency. The EU needs to do their job and get in there. Think of it as a "financial occupation" until Greece can demonstrate their are financially fit again. This plan should also be in the pipe for Portugal, Ireland, Spain among others. When you act, act consequently and decisively. You don't go begging for cash and then have the audacity to set your own terms, surely. Greek society crumbled once before, now is not the time to act stoic in the face of danger. Humble yourselves and do the right thing for your own sakes.

fanofedwardAugust 5th, 2011 at 8:12 pm

How about Euro exit for Greece? Fudging the debt burden by delaying maturities, reducing interest rates, posting extra collateral etc doesn´t solve the fundamental problem. The fundamental problem is that you need Greece to grow again. Dracma reintroduction (and devaluation) will automatically adjust price levels vs Europe so that investment flows back in. Which price level is the right level?? I don´t know and neither does anyone else but I can tell you that the market will soon enlighten us (if Greece ditches the Euro) by conveniently devaluing the Dracma until prices reach equilibrium.

fanofedwardAugust 5th, 2011 at 8:19 pm

and politicians will retort:
1. No one will lend to Greece again
2. Greece´s credibility will be eternally damaged
3. Europeans will desert Greek beaches never to return
Nothing of the sort, Greece and Berlin will learn the lesson and start working on political union before embarking on monetary union. There will be a Euro number 2 in 10 yrs time and everybody will be wiser and older.

Dr_VAugust 6th, 2011 at 11:18 am

The strangest thing is, the the IMF and ECB set up a tripartite committee, and then decides to communicate with Greece by way of video conferencing, while all hell breaks loose. When you lend that kind of money out, you put people onsite to manage it. The entire Ministry of Finance should have been fired. An EU Emergency Bailout Team should have been recruited, and put in place until 2020, or until Greece could demonstrate some sort of fiscal common sense, like I said 2020. Giving them cash and turning them loose doesn't work. They need to be put under pressure, think of it as an "EU Financial Occupation", to ensure they do what needs to be done, including working a full day. Complete control over the country and manatory compliance is the only solution. There is no Plan B. If they show no signs of accepting the plan, let them go down. That's exactly the signal that needs to be sent before others line up for a handout, (Portugal, Spain, Italy). How can a country full of people who refuse to work survive?