Tuesday, 6 December 2011

Abandon PSI+. Buyback Instead

This post is also mentioned in Greek (citypress Yannis Paleologos)
On the 26th of October the European leaders pushed the head of the IIF to accept a 50% haircut on the nominal of the Greek bonds. This apparently was done in order to punish the banks that invested carelessly into Greek debt and to reduce the Greek debt burden. The noble aim was to reduce the Greek Debt/GDP to around 120% by 2020.
They also reiterated their resolve in keeping the whole PSI exercise on a voluntary basis. In this note we argue that the size of the haircut may have struck a death blow in the PSI and that now it would be better if Greece was to make a public offer to buy these bonds back at an average of 35% (say) rather than mess with the PSI conundrums.

Problems in implementing PSI

The current PSI version (also known as PSI+) calls for the voluntary surrender of all Greek bonds maturing up to 2030 (around 205billion) and the exchange of these bonds with new ones with half the notional. The structure of the new bonds is not known and is the subject, apparently, of intense negotiations between the different parties. There are many reports on the possible structures but since nothing is finalised we would not speculate. The issues that need to be resolved are:
·            Legal jurisdiction of new bonds (investors demand English law).
·            The coupons of the new bonds.
·            The maturity of the new bonds.
·            Partial or Full Guarantees on principle like Brady bonds.
·            Partial Upfront cash payment.
·            Ability to amortise the losses over time.
There are however, many other issues including technical reasons with bondholders that may cause the complete failure of the PSI+ or at least very low participation. Lets look at some of them:
1.    If you own the bonds outright and on a cash basis then your decision to participate would depend on where you have marked the bonds and on how much pressure the government can exert upon you to do the exchange “voluntarily”.
a.    If you still own them at a 100 or at 79 (old PSI writedown) and you are a European Bank then the pressure may be exerted to participate. In this case you would suffer the further losses to 50 and perhaps more if the new Greek Bonds have lower Net Present Value. Most Greek banks and Greek Pension Funds are in this situation. In fact the directors of the Greek Pension funds may have a further hurdle to jump, that of felony charges in case they reduce the assets voluntarily!
b.    If on the other hand you have them mark to market at current prices, the incentives are different. You have already taken the bulk of the losses and you have them marked at 25-40. The loss is a sunk cost. There is no upside in participating in the PSI. The reason is simple, if you chose to stay out your upside is to get repaid at 100 (especially if you own near maturities 2012-13). If you are wrong and Greece defaults then most probably you will get a recovery value of around 30-40. But this is roughly where you have the bonds anyway. So the odds are you are better off staying out of the PSI+ if you can handle the political pressure. The same logic goes for Hedge Funds and other buyers who bought the bonds after the big drop and so they have very little incentive participate.
2.    Assume that you own the Greek bonds on an Asset Swap Basis. Most northern European investors and funds acquired the Greek bonds on an Asset Swap Basis[1]. Thus they have the Greek Bonds at 100. If they were forced to participate then they would suffer losses both on the Bond side (50%) and on the swap side. Since most of these Assets swaps were done when credit spread levels were around 100-200bp, unwinding the swap would cause further losses! These would be on top the losses from the new PSI+ bonds (NPV losses). Thus, it may be better for them to sit it out as the option is almost digital. i.e Participate and suffer perhaps more than 80% losses or stay out and get repaid 100%.
3.    There are many investors who do not wish to touch Greek risk again either because their institutional rules do not allow to hold bonds that are not investment grade or because they are not allowed to hold bonds with maturities of more than 20years (say) or that are not straightforward boring bonds or simply because they are sick and tired of all the games being played. Participating in the PSI+ perpetuates the risk and it is not clear that the new PSI+ bonds would have high credit ratings.
4.    If you are a non-EU holder of Greek risk or you are private investor (not institutional but retail or other) then there is no reason whatsoever why you should chose to participate. Probably, these holders are not more than 10% of the total.
5.    The big elephant in the room is the free rider ECB. The central bank owns close to 45-50 billion of Greek bonds and has repeatedly said that it would not participate in the PSI+. If one can afford to stay out then it would join the ECB as a joined Free Rider.
6.    Many bonds are structured bonds, which have liability swaps with the Greek state. Retiring these bonds would also mean closing the swap with the Greek state. This may produce gain or losses for the state. We simply do not know how much.

All of the above plus many other technical reasons point to a single answer to the Greek PSI+. Since the only bondholders that are going to participate are those that are under the political influence of the EU government then the solution is very simple:

Abandon the messy PSI+. Buy instead!
Force the holders under EU influence to “voluntarily” sell these Greek bonds at 35%. Most of the bondholders under the political guillotine have already marked them close to that value (50% or less), so they would avoid further losses and risk management of the new PSI+ bonds. Ask for the ECB to sell its holdings at purchase price (around 75%) or less. The savings in money, anxiety and endless negotiations are considerable. Lets run through the numbers.
Assume 70% participation in the buyback offer.
·            After taking into account the ECB holdings the saving is going to be close to 90billion and it would reduce the Debt to GDP to around 127% instantly. This is similar saving with the torturous PSI+.
·            It is a much better strategy than the prolonged negotiations perpetuating the pain for both bondholders and the Greeks alike.
·            It also removes the risk of Greece defaulting or of threatening with law changes by retiring the purchased bonds.
·            Furthermore, you do not have to worry about the new legal jurisdiction of the new PSI+ bonds. Some of the bonds, specifically the international ones have clauses that can cause the immediate default of Greece (see ITC note on 5th Dec on Greece Could Default)
·            Buying them back and destroying them or simply changing the moratorium clause by getting the 66 2/3 majority would solve many unnecessary complications.
·            It would free ECB from the burden of holding Greek risk
·            It would punish the irresponsible banks by voluntarily forcing them to sell at 35%.
Of course you may ask where is Greece going to find all the money to buy back these bonds. Greece would need 73billion to retire 157billion and it would leave 48billion free riders. This is in fact the very conservative scenario (70% participation). The money can come from a new deal that is going to replace the PSI+. The time has come for bold initiatives to resolve the debt crisis and the PSI, PSI+ were bad solutions that ought to be abandoned and aborted forever.

[1] In an Asset Swap, the buyer acquires the bond at a 100 and simultaneously enters a swap whereby it pays the exact coupon of the bond in return of receiving Euribor plus a spread. The spread level depends on the credit of the bond and on how far from 100 was the bond trading when the trade was entered.