Friday 13 January 2012

Greece on the CAC Warpath.

 According to newspaper reports Greece is one step away from introducing CAC in the bonds under Greek law. In this note we try to investigate some of the possible ramification of this action for both Greece and Europe. If you believe that introducing and activating the CAC’s is a way to punish the bad guys read on. 
Let me start by saying that the legal opinion of many is that introducing a law imposing retroactively CAC’s may be worded in such a way so as not to be an event of default. For the sake of the argument let us accept that premise. i.e. it can be done without causing too much trouble to begin with. On the question of the activation however the majority of the legal observers, agree that this would be an event of default. So what! Say some. Let it be a credit event and triggering of the CDS. Here is a hypothetical sequence of events: 
  1.  Greece activates the law and calls for the majority, of whatever the percentage, to decide whether to impose the PSI to the rest of the bondholders.
    • Question: Is the ECB part of it or has it been excluded?
      • Answer: ECB is included. In this case the ECB, depending on politics, may decide to vote NO or YES. If it is a YES, then it votes itself into bankruptcy and the raising of equity from shareholders (NCB; namely taxpayers). Unless of course it can wave a magic wand and cover the loss from some kind of other assets or provision it has on its balance sheet. If the ECB votes NO then the PSI free riders rejoice. Either way, it is not a happy position for the ECB to be in. PSI may be abandoned but the damage is now done. Greece has defaulted.
      • Answer: ECB is excluded. Excluding the ECB from this would for sure be challenged by other bondholders. 
        1. The main argument for the exclusion would be that the ECB is mandated to safeguard the financial stability of Europe and under this guise it purchased the Bonds. Thus it should be excluded from any restructuring. Thus bonds under the SMP would be excluded while bonds owned by NCB may be included!
        2. The counter-argument is that this is discriminatory and that the bondholder’s decision making process is irrelevant. Investors buy debt for a variety of reasons and to bias the repayment or restructuring according to this opens a Pandora’s box.  
        3. It would further make all other bondholders subordinated to the official sector. This would cause havoc into the bond markets. More trouble than good. 
        4. An unintended consequence of the exclusion of the ECB from the CAC’s is that now it would be easier to block the PSI. Why is that? Because now a bond-holder with only 15% of an issue might jump to 25% or more if the ECB holding is taken out of the voting. In other words, it can play either way. It is simply unpredictable and immensely messy. Lawyer’s paradise.
2. Greece activates the CAC’s that did not exist in the Bond’s birth. In other words it changed unilaterally the legal term of a bond. This would trigger the CDS and everybody would be happy. The CDS fulfilled the role it was constructed for. Should Greece care about this triggering? Not really unless it has sold massively protection, which it has not. The CDS is a privately negotiated contract and whether it triggers or not in itself does not directly affect Greece. What affects Greece is the almost certain fact that Greece would be officially termed as defaulted in its obligations.
a.       If the Greek debt is under default then we also have that all Greek banks are under default. What would be the response of the small depositors if they hear that Greek banks are bust? Your guess is as good as mine.
b.      But if the Greek bonds are defaulted so is the ECB (if not excluded) which would be needed to support the Greek banks. If it sounds complicated and crazy it is because it is complicated and crazy.
c.       Moreover, European banks would now have to replace the Greek collateral with the ECB with other creditworthy bonds.
d.      All of the above are conditional on how long Greece would be under the default status. If it can be done in two weeks so that Greece only assumes the zombie status for 14 days and the Greek public is accommodative then there a chance of success.
e.      If the default status is prolonged due to disagreements between bondholders or politicians then other factors kick in, like finding the credit lines for necessary supplies of vital commodities. Also the questions of exit from the EZ might resurface.
f.        How about the funds from the Bank of Greece’s ELA? They are the liability of the state which has now defaulted.
g.       What about Target2. Is it going to function normally now that one member has gone bust?
h.      As I mentioned in a previous note, why bother with the nuclear option for just few billion. Might as well legislate that all bonds become zero coupon for the next 20 years (say). That would give ample time for Greece to recover.

Last but not least there is the fiduciary duty of the majority of the bondholders not to act totally against the interests of the minority bondholders. This is a very shuttle and interesting point. CAC’s serve the purpose of facilitating the speedy resolution and restructuring of debt against some incalcitrant  and often malevolent bondholders. They are not meant to be used as a punishment or for opportunistic reasons. There have been cases in the past were courts ruled against (See Buchheit, L and Gulati, M (2002), “Sovereign Bonds and the Collective Will”, Georgetown University Law) the CAC majority for basically abusing their dominant position.

What would happen to Italy?
Italy along with Greece does not have CAC in the bonds. Allowing Greece to introduce them in this cowboy fashion would certainly alter the perceptions and risk profile of the Italian bonds. No matter what they say, what happens in Greece sets a precedence that no investor is allowed to ignore in the future.

I listed some of the questions that need to be asked if one is to proceed with the activation of CAC’s in Greece. There is no doubt that readers may have more and please do post them. The one thing that is certain is that Greece would represent the largest sovereign bankruptcy in history. Many legal careers would be made on the corpse of Greece and many would retire writing books about the whole shenanigans.  Qui Bono? This is the real question to ask. Who benefits from such a mess? Evaluating the pros and cons it is not Greece. Like in the gold rush, those that advised on prospecting and those that sold the digging were the only real winners.

Spot the Bad Guy
So who are the bad guys in this thriller? The investors that are free riding on the back of the ECB? The ECB which forces a change in the law when it goes against its interest? The Greeks  who now can keep on restructuring both malevolent and innocent investors? The politicians? The lawyers and advisors who benefit from a prolonged and complicated default? The IMF that may use this as an excuse to exit a project that has no real control of? Take your pick.

In my humble opinion the risks are much greater for Greece than the benefits. And the same goes for Europe. There are far better ways to deal with the debt of Greece without creating havoc, entering uncharted legal territories or endangering the financial system and the markets. All it needs is a bit of cold calculating logic and good unbiased advice.