Today’s Debt Swap Talks Will Get Greece No Closer To A Resolution

New York Times cartoon atlas greece

[credit provider=”New York TImes Syndicate” url=””]

We’ve seen an about-face in European market sentiment so far today, mostly on renewed concerns about Greece amid talks between creditors and the Greek government on how to devalue holdings of Greek debt.All this despite “positive” rumours from those negotiations that private bondholders, led by Institute of International Finance head Charles Dallara, are actually close to a deal to take voluntary haircuts on holdings of Greek bonds.

So why the angst?

There are three good reasons:

  1. There will probably be legal challenges to the deal negotiated,
  2. A “voluntary” agreement that does not trigger a credit event will probably have worse consequences than one that does, 
  3. Even with the debt swap, Greece is not much closer to being solvent.

Greece’s creditors will have to voluntarily agree to exchange their sovereign debt holdings for bonds with different terms if the country wants to avoid provoking a credit event, which would likely result in the payout of sovereign credit default swap contracts (essentially, insurance investors buy on holdings of Greek bonds). If the rumours are true, then it would seem that the two parties are indeed close to such a deal. Because CDS contracts are difficult to track, no one really knows what the impact of such an event would be.

But just because the negotiations are going well does not mean that all of Greece’s private bondholders are raring to participate in the plan. Not all investors will willingly stomach a haircut of 50% or more on their bond holdings, and the Greek government has threatened to impose retroactive “collective action clauses” (CACs) which would essentially force bondholders to take the deal whether they like it or not given a specific level of creditor participation.

The ISDA–responsible for determining what constitutes a credit event–has repeatedly been ambiguous about whether or not this would actually cause credit default swaps to be paid out. Various hedge funds have already threatened that they will contest this decision in the Greek courts, something that could hold up the actual debt swap indefinitely.

However, as Citi’s Willem Buiter pointed out months ago, avoiding a credit event is actually not such a good thing. In a nutshell, the Greek CDS industry is not actually that far-reaching, and a high-handed approach to avoiding a credit event not only discredits the CDS industry (what good are CDS as insurance contracts if you’re never going to get your money back?) but discredits faith that EU leaders will play by market rules. If they lose that faith now, they’ll face even steeper difficulty going forward because investors won’t trust that they’ll honour guarantees.

But really, the angst is probably being led by the knowledge that no matter what these negotiations bring, Greek debt is no closer to actually being sustainable. Just check out this chart that Nomura published before the October summit: 

greece debt dynamics changes to psi nomura

[credit provider=”Nomura Global Economics”]

While at the time, Nomura argued that a bigger PSI deal was really a good idea, even the most ambitious plan (something we did not see) would not have kept the ratio of Greek debt to GDP above approximately 120% until around 2020. In December, the EU raised estimates of Greek debt levels to 157.7% and 166.1% of GDP in 2011 and 2012, respectively, confirming this poor outlook.

The bottom line is that Greek debt is just plain unsustainable, and probably will continue be without significantly more ambitious debt restructuring. Greece is still screwed, and current negotiations do little to nothing to change this.