By Satyajit Das, the author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming September 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
The proposal to extend the maturity of Greek bonds emanating from the Élysée Palace reflects French strengths first identified by Napoleon III: “We do not make reforms in France; we make revolution.” Structured to meet a German requirement that private creditors contribute to the Greek bailout, the proposal falls short of what is actually required.
Under the sketchy proposal, for every Euro 100 of maturing bonds, the banks will subscribe to new 30 year securities, but only equal to Euro 70 (70%). Of the Euro 70, the banks, in turn, will only give Greece Euro 50 (50%) and invest the other Euro 20 (20%) in 30 year high quality zero coupon bonds (via a special purpose vehicle) to secure repayment of the new bonds. The new 30 year Greek debt will carry an interest rate of 5.5% per annum with a bonus element linked to Greek growth of up to an additional 2.5% per annum.
Of the Euro 340 billion in outstanding Greek bonds, banks hold 27%, institutional and retail investors hold 43% and the International Monetary Fund (“IMF”) and the European Central Bank (“ECB”) hold 30%. It is not clear whether non-bank investors are willing to participate in the arrangements. The ECB has previously resisted any debt restructuring, including maturity extension.
The French plan assumes holders of bonds would agree to roll over 50% of their holdings to provide Greece net funding of Euro 30 billion. But under the French banking federation’s own figures, this would if impossible unless all the Euro 60.5 billion (excluding central bank holdings) maturing by mid-2014 is rolled over. This is inconsistent with the proposal’s assumption of investor acceptance of 80%.
As not all Greek debt trades at the same price in the secondary market, if all bonds maturing are not rolled over, then banks could arbitrage the offer exchanging bonds trading at a deep discount, holding on to those trading at better prices.
The plan assumes that the “voluntary” exchange will not be treated as a “selective or restrictive” default by rating agencies or trigger credit insurance contracts on Greece. Fitch Ratings and S&P have indicated that the French plan will “very likely” be deemed a default, albetit for an unspecified “temporary” period, as it constitutes a distressed debt restructuring.
The Euro 20 invested in high quality collateral will need to earn around 4.26% per annum to accrete in value to Euro 70 to cover the principal of the new 30 year bonds. German 30 year bunds currently yield around 3.75% per annum, less than the required rate. Other AAA rated bonds, such as the European Financial Stability Fund (“EFSF”) bonds, might be used to provide the extra return. Given that the EFSF is backed by guarantees from countries with questionable long-term credit quality, the security afforded by such a guarantee is unproven.
Greece must find Euro 50 for every Euro 100 debt exchanged under the proposal. Given it has no access to commercial funding, this would have to come from the EU, IMF, EFSF or ECB.
Greece’s cost would be between 7.7% and 11.20% per annum, as it only receives Euro 50 of the Euro 70 face value of the new bonds. Assuming the remaining funding is at 6%, then Greece’s blended rate for every Euro 100 of finance would 6.85-8.60% per annum, compared to the 7-8% per annum considered sustainable by markets.
Most importantly, the overall level of debt, considered unsustainable, of Greece would remain unchanged.
The exchange scheme seems designed primarily to allow banks to avoid recognising losses on holdings of Greek bond. Even if the principal of the 30 year bonds is “risk free”, the interest on the bonds remains dependent on Greece’s ability to pay. Valued at a rate of 12 % per annum for 30 year Greek risk (a not unreasonable estimate), this would mean that the new bonds are only worth around 64% of face value, equivalent to a mark-to-market loss of around 36%. It is not clear if the authorities will require this loss to be recognised.
One alternative under consideration, an exchange of maturing bonds for new 5 year (French proposal) or 7 year (German) bonds is even worse as it defers the problem for an even shorter period of time.
A more logical solution would be that suggested reluctantly by the Institute of International Finance. Under this proposal, Greece would repurchase some its outstanding debt at current market prices, well below the face value of the bonds. This would reduce Greece’s debt level. It would also result in the bank’s sustaining losses.
According to the Bank for International Settlements, French banks have exposures to Greece, including of around Euros 50-60 billion. German banks have exposures of around Euro 30-35 billion. These banks might result require new capital to absorb the writedowns. If necessary, then the French and German governments would need to provide this capital. In effect, rather than lending to Greece, it would have to use the funds to recapitalise its own institutions. This would, in the final analysis, be more sensible than continuing with the farce that Greece is solvent and the bank’s holding of Greek debt are worth the face value of the securities. It would be the first logical step in addressing the problem of over indebted European nations.
History records that in August 2001, the IMF oversaw a debt exchange for Argentina in an unsuccessful, last ditch effort to avoid default. Indecisive and confused action by European authorities seems doomed to ensure that this restructuring, if it eventuates, will be followed by others and an eventual messy, disorderly and expensive default.
The French proposal perpetuates the lack of acknowledgment that Greece has a “solvency” rather than a “liquidity” problem. Like the EFSF whose structure has been criticised as nothing more than a collateralised debt obligation (“CDO”), it uses financial engineering techniques to defer or disguise losses in an unending game of “extend and pretend”.