Thursday, 27 October 2011

Preliminary thoughts on the EU statement on Greece

Finally the European political leaders seem to have reached an agreement on how to deal with the debt of Greece and the one brewing in Italy, Spain and France.

Although the statement issued by Europe is at places vague, the main points that can be discerned with regards to Greece are as follows:
  • The haircut would be 50% and it would voluntary. The fact that they still insist on a voluntary agreement is significant and important. The CDS may or may not trigger, but this is the least of our concerns. This is purely an ISDA decision that would predominantly affect the CDS market. The main point is that any voluntary exchange would place Greece under Selective Default and not under default thus avoiding the nasty side effects of bankrupting the Greek banks and pushing the country into a limbo state needing drip-feeding for months. 
  • The statement excludes ECB holding. 
  • The programme would contribute 30bln towards the PSI. The statement refers to “a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors”. We take this to mean a reduction on the face value of the bonds, but we reserve full judgement until we have more information or clarification from the EU. 
  • It further stipulates that the objective is to reduce the debt to GDP by 2020 to 120%. There is a clear reference to “a Greek” monitoring and implementation. This is to allay fears of loss of sovereignty. Given however, the hitherto inability and inadequacy of the Greek government to enforce and implement much of what has been agreed this may be altered on the ground. There would be yet again a new Memorandum of Understanding.
With regards to the 50% haircut and whether it is on the Notional amount or the NPV we have:
NPV haircut.
The statement refers to the “notional held by private investors” and this may mean the amount rather than the face value. For this reason we examine the NPV case.
A haircut of 50% on the Net Present Value could be achieved if for example you reduce the average coupon on the PSI proposed options by 2% and lower the guarantee to 50% from 100%. In this case the 30bln that the statement refers to as a contribution to the PSI is roughly what is needed for the stock of Greek bonds. In other words, if all 177bln of outstanding Greek stock (excluding the ECB) is exchanged into a 30Y bond with only 50% AAA guarantee, Greece would need to purchase close to 29billion worth of a zero coupon (depending on where they mark the 30Y rate).
Accounting wise though the reduction in the debt to GDP from the matching of the Asset (zero coupon) and the liability (30Y bond) would only be around 56billion. Thus day one after the exchange Greece would owe around 136% and given time to 2020 this could fall to 120%. The problem however, is that Greece would also need to start servicing this debt, day one. At an average of 2.5% coupon this would mean 5billion on interest only a year. Greece unfortunately still runs a primary deficit of around 2.5billion and it would be very difficult to meet this without further external assistance or grace period.
Notional reduction
A 50% reduction on the face value of all outstanding stock would reduce the debt by 88.5 (50% of the 222 of stock-45 of ECB)billion would reduce the debt to GDP to around 124%, day one. As we have no details of how the new bonds would look like or what form the principal guarantee (if any) it is hard to evaluate it.
Combination (Face reduction, 15% cash, NPV loss)
A combination approach is the other possibility. Namely, a reduction in the face value of the bonds with a simultaneous NPV write down on the new bonds and possibly a cash payment of 15%. This was leaked a couple of days ago as an alternative. Again, the 15% cash payment or 26billion on the 177 billion (222-45) of outstanding Greek stock in Private hands ties nicely with the 30bllion that the statement says has been earmarked for the PSI. In this case a 50% face reduction (minus 88.5billion on debt) taken with the cash payment (plus 26billion) would take the debt to GDP to around 135%.
There is no mention in the statement under which jurisdiction the new Greek debt would be offered. We expect that since bondholders would suffer a substantial haircut now, they would demand future protection under English law. If that is the case, then under the scenarios examined above 100% of the outstanding Greek debt whether in the form of bonds or bilateral loans would be under English law. This would significantly reduce the ability of Greece to exercise any control over it and it would make harder any future default or restructuring for Greece.
Conclusion-Greek banks
The solution given to the Greek debt crisis does not seem to be comprehensive as it lacks important details on the sustainability of the Greek debt after the voluntary exchange. Greece would still need to have large primary surpluses day one in order to service the new debt. Also there ambiguity on the state of the Greek banks after the exchange. A 50% cut would leave them needing recapitalization. Is this going to happen through common equity and hence nationalization or through preferred? The common equity approach would overnight not only change the ownership but it would effectively place them under EU control (through the control of Greek finances). Thus the dynamics and the incentives are altered.