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There’s been some excitement in the air about the fact that the Greek government and representatives of the banking sector are reportedly nearing an agreement on the terms of a deal to restructure the countries debt as part of a controlled default.But don’t be fooled: this deal is doomed.
In fact, the consequences of the deal actually going through would probably be far worse than a dreaded credit event—something EU leaders are desperately trying to avoid.
Back in July, Greece’s creditors were told they would take losses of about 21% on their holdings of Greek bonds as part of an orderly Greek default. At the time, Greece asked for a minimum of 90% participation in the bond swap and it looked probable that they would get something close to but still beneath that.
Fast forward to October, and the terms of the deal were drastically changed. Now Greece and representatives of the banking sector determined that banks would take haircuts of about 50%. Negotiations about the terms of that deal are the talks that are drawing to a close right now.
The problem is that Greece’s creditors have to participate “voluntarily” in order for this restructuring not to provoke a credit event, which would induce a payout of credit default swaps—insurance contracts that hedge against the possibility of a Greek default. This contingency could have far-reaching effects, because the CDS industry is relatively opaque.
Regardless of what representatives of Greece’s creditors—led by Institute of International Finance managing director Charles Dallara—might agree to, however, banks and hedge funds that actually hold Greek bonds and have hedged against the possibility of a Greek default are not going to accept massive losses without receiving the insurance they feel due.
So EU officials have a choice: either accept the inevitability of a credit event and potentially face losses in the public sector (the European Central Bank holds about €40 billion in Greek bonds) or skirt the rules with a high-handed manoeuvre that would coerce all creditors to swap their debt holdings “voluntarily.”
That latter choice—likely the fallout of the “agreement” creditors and the Greek government—would probably be far worse than the implementation of a deal. Not only would it completely undermine the credibility of EU leaders, it would destroy the massive European CDS industry because it would become nearly impossible for financial institutions to fully hedge against the possibility of any sovereign default.
There are two best case scenarios right now: the ECB joins in the Greek debt restructuring, inspiring confidence that the public sector will accept part of the burden for its participation in the Greek crisis and reducing the losses creditors take, or EU leaders accept the inevitability of a disorderly Greek default and let it happen.
While the latter possibility is a little frightening, the Greek CDS industry is relatively small—$74 billion net and $4 billion gross according to Citi’s Willem Buiter. Further, it would likely make Greek debt more sustainable by forcing creditors to take bigger haircuts. Under the current deal, there’s little hope that Greece will return to sustainability anytime soon.
But perhaps most importantly, this would preserve investor confidence in EU leaders’ willingness to play by the rules. If EU leaders pull some high-handed flourish right now to force losses on Greece’s creditors, who’s to say they won’t do the same thing in the future with Portugal, Italy, Spain, Ireland, or even the European bailout fund?
Bottom line: don’t be excited about these “agreement” headlines. This deal is not what EU leaders would have you believe.