But you already knew that. The danger is that “events on the ground” are creating a new reality, that the situation gets out of control..
There are two risks, basically:
- Greek politics descending into chaos, leaving Greece without an acting government
- No resolution of the conflict between the ECB (European Central Bank) and the German government
While there is little we can say about the first (politics has a habit of moving in unpredictable ways, but the risk of chaos in Greece certainly seems real to us), there is more to say on the second point.
Core of the conflict is that the German government wants some kind of ‘haircut’ for the bondholders, while the ECB is dead set against that. Both point of view are understandable.
The German government is facing a rather hostile electorate, tired of being Europe’s paymaster and rewarding profligate (the borrowers) and risky (the lenders) behaviour. Since they understand that the borrowers are already squeezed dry, they now turn on the lenders.
The ECB, meanwhile, is sitting on 40B euro of Greek bonds (result of a rather unprecedented program in which it already had to swallow much pride) and another 91B euro in loans to Greek banks of which Greek government bonds are one (but by no means the only one) collateral.
But although a notable and unfortunate side-effect, the ECB is not in this with commercial purposes, of course. The stability of the financial system are of paramount concern. But having to take such a hit could very well reduce its effectiveness or stomach to deal with the fall-out of any significant ‘haircut’ of Greek sovereign debt.
And there is where the problems lie. Greek banks hold some 50B euro in Greek public debt, and have only 29B in equity, which a 50% haircut would wipe out instantly.
Greek banks are already facing a slow exit of private funds, deposito holders fearing an ‘Argentinian’ morning when they discover that their euros in their account are now converted into new drachme with quite a reduced value..
Other European banks would also suffer significant losses (they’re sitting on something like 50B euro). Some 80% of Greek debt is believed to be held at face value, some funny deviation of mark-t0-market accounting. Any significant ‘haircut’, and problems will ensue.
Any solution will have to significantly reduce Greek’s debt (and thereby it’s financing needs) while minimizing the financial contagion effects.
A so called ‘soft’ haircut might achieve this. A ‘soft’ haircut means a significant extension of the maturity of the Greek debt, which would immediately and significantly reduce its financing needs. It’s not cut and dry, and not without risk, but it seems the only remaining option right now.
A significant extension of the maturity would not only give Greece much needed breathing space to get its finances in order and engage in structural reforms that could boost its economic growth rate, it also reduces the net present value (NPV) for the bondholders.
It all depends how this is received by the markets. Best case would be if it happened voluntary, as any forced alteration of the terms of outstanding bonds, even leaving the face value unchanged, could trigger a ‘default’ status by rating agencies.
This will require many holders to sell at distressed prices, and could trigger CDS payments, although the latter are not likely to create havoc (despite the panic which is routinely created on some websites), having a modest net exposure of some $6B.
There are possible mitigating forces, in the form of a possible reduced default risk in the perception of investors, which could significantly sink the risk premium, counterbalancing the loss in NPV of the bonds. Much depend also on whether the bonds can continue to be held at par on bank books, which would considerably reduce any contagion effect.
Oxford Economics is quite optimistic about this way out, citing the Brady plan of Latin American debt at the end of the 1980s, and the Uruguay restructuring in 2003. We sure hope they’re right!