Greek Debt Restructuring
22nd April 2011, SPECIAL TOPIC: WILL GREECE RESTRUCTURE ITS DEBT OBLIGATIONS?
Greek Debt Restructuring is all over the media. It is once again disappointing that there is more exaggeration, and very few facts. Lets hence get this topic straight, so that everyone can understand what does it mean to default, how does it happen, who would gain and who would lose, and what would be the extent of these loses. Indeed a detailed analysis of this will outline clearly that restructuring in the classical manner is not possible, as i would create an accounting loss for all the European banks, a loss of such magnitude that it would require approximately EUR 50bn equity injection into these financial institutions. Such move would also expose the truth behind accrual accounting (or held to maturity investments), something that in light of future issues in Portugal and Spain is highly unwelcome. Debt restructuring in Greece will be good for Greece, but Greece is not a Greek problem, it is a problem of Europe not because it sounds nice, but because Europe owns vast majority of its debt..
Greece has a long history of starting something new. The founders of western philosophy, the olympics are just about to show the World how a first country in the "developed" Eurozone can restructure its debt. This topic is so important, that it deserves the mark of "the special one", as:
1. If successful it will change our overall global macro assumptions, delaying by some 5-10 years the inflationary pressures, for while the default will significantly improve Greek Government’s position (this week the yield on 2year bonds hit 23%! and on 10year bonds 15%), in the long run, the Greeks are still overpaid vs the Chinese and other EM countries and living beyond their means (as are all the Western economies - just before I get a lot of negative messages from my Greek friends). Restructuring will merely offer a temporary solution to a long term problem. It might also lead to a series of unknown events, similar to that of 2008, as restructuring will trigger bank losses, which will trigger need for capital, which will trigger further bank bailouts.
2. It will no doubt mark a trend, as "if they can do it, so can we" will be on the table, with Portugal, Ireland and ultimately Spain following, and it is hence important when looking at Greece, if this solution is sustainable when applied to other also semi-bankrupt countries of the EU (most of them basically - well clearly not German, hence their different view to the French on this issue, though Germans have huge exposure to Spain so at one point they will need to think about this too).
3. It offers a very interesting, so far only academic reading and insight into the future, as there is a lot of debate right now on the "frameworks for the restructurings", including M2M method of setting out the used haircut levels, and other legal elements. Indeed this is something that we at Vision Finance need to be on top of (the past and the future trends), as number of our clients are located in the Emerging Markets, truly with a lot of debt, with the only solution being debt restructuring (vide West Africa, even Zimbabwe with 240% debt ratio).
Importantly for you, the reader, it is a topic on which frankly only Vision Finance, and other non conflicted companies and academic world will offer you a fair perspective on, as the conflicts of interest are so immense and financial consequences so severe, that censorship at number of banks will be enforced - and if you do think that I am paranoid (you could do), then just read the Guardian article below:
Frankly speaking should i be part of the bigger organisation I would also have to obey by its rules, so I totally understand my fellow friends in banking. Luckily at Vision Finance do not have this problem - though with full disclosure we will admit that our potential conflict of interest is actually in the direction of the restructuring, as it will mean:
- more business from our EM clients who will plan the same route (and who really need it in some cases.. please see Zimbabwe statistics in our NW handbook)
http://www.financewithvision.com/research page 33
- further long term problems in the Western World, esprcially banks - meaning that our model of being solely EM will be fully justified
- further realization by our key investors, the SWFs, that where possible, its best to stay away from the "bankrupt" countries and ideas that come out of them (not that they are bad ideas, its just that the conflicts of interest are very strong - how many of you saw a CLN / FTD with on Greece lately? and how many of you had a chance to invest into Facebook? alongside GS?).
Nonetheless, we at Vision Finance will try to remain neutral, as frankly even few dollars more to our P&L will not help me to sleep at night, and I value my sleep very much, hence I invite you to read on.
Quick Background:
For European / US / developed world, there are two key ways out of this overall fiscal mess:
a) debt restructuring AND significant austerity measures to bring the country back on track (first easy, second almost impossible)
b) Eurozone wide inflation and debasing of the currency (in our view smarter way as it corrects most problems with the economy, but especially in Europe more difficult to achieve as there are national conflicting interests, and the long opposition of Germany to inflation and there is also an issue of beggar thy neighbour policies).
Previously we discussed our view that b) will be selected in the past, but today we will focus solely on a).
Restructuring is nothing more than the realisation by the investors that debt problems of the borrower are too big, and that it is better to accept less, than have nothing in return (it really reminds me of the old 19thC banking practices when interest was adjusted to the one's ability of pay, ie to almost "enslave" them with debt burden). Today, various legal systems have various levels of required percentage of bondholders accepting the terms, with those done under English law for instance being 75%. This does mean, that 75% of people can effectively "rob" the remaining 25% of their desire to get repaid, by instance by asking Greece to basically sell off their islands to Turkey (you think that this is crazy concept, but how did Alaska, Texas, and even Louisiana end up with USA?***).
Restructuring today is in a way a fully legal way of not paying, or "cheating" the investors out of their cash. More importantly restructuring sends a terrible message to the world... if someone wants to lend you the cash - take it and worry about it later, Indeed at times lenders should hence also accept full responsibility for making silly decisions. If one gives USD50 to the heroin addict, it is unlikely that one will ever get repaid, and the same set of "common sense" rules applies to global finance too. Indeed as we said before half jokingly of course, that Robert Mundell should perhaps consider giving his Nobel Prize back, as he forgot to write in 1999 that if not for Euro; Greece, Portugal, Spain and Italy would never be allowed to borrow so much money at such crazy low rates. It is indeed "insane" that out of EUR270bn total official Greek debt, only EUR8bn is with local pension funds, clearly showing that this is not a Greek problem, it is an European problem (though Greeks control all the cards).
Professor Mundell's recent comment http://www.bullfax.com/?q=node-mundell-says-eu-should-find-informal-ways-aid-greece looking for informal way out further proves our point, as frankly I have never heard of term "Informal" in mainstream economics before. Perhaps this new approach alone entitles him to the Noble Prize.
The details: Greece
The Law
Greece has 90% of debt under Greek Law, which has no current Collective Action Clause laws in place, meaning that the parliament can meet and pass them through, and I assure you that it will be much easier to pass CACs laws than Austerity measures Most of the remaining 10% of debt is under English law, meaning that 75% percent of bondholders need to agree on any changes.
I would imagine that if the Greek legal system would ask for 75% or even 66% (number according to the English law before 2004), nobody should be surprised. Any number in between is also rational, however frankly speaking legally, Greece can even set this level at 1%, and in economic terms, it is as good, if not better, to basically printing their way out of the crisis (what is interesting perspective on things, and I am sure that our friends in Kazakhstan and Ukraine would have a "special" way to deal with such window of opportunity).
For details on how restructurings work legally please see these links ( no point for me to copy other peoples excellent work)
ttp://janethontoir.wordpress.com/2011/04/19/restructuring-greek-debt/
http://scholarship.law.duke.edu/faculty_scholarship/2336/
http://www.scribd.com/doc/52927481/GREEK-DEDT-THE-ENDGAME-SENARIO-by-LEE-BUCHHEIT-and-MITU-GULATI
http://johnbtaylorsblog.blogspot.com/2010/06/is-orderly-restructuring-of-greek-debt.html
Now so the next natural step is to find out who owns this debt (this took me a while):
The first big news that out of EUR 270bn or so Greek debt (officially, as I am certain the number is much higher if one includes all the off balance sheet transactions), only EUR 8 billion is with the Greek Pension Funds. It is crazy, but true, and actually great for Greece, as any default hits mostly the overseas investors (and you can always take away from pensioners with one hand and give them back with the other hand).
Other big holders (source New York Times and BIS):
http://graphics.thomsonreuters.com/11/04/PT_BNKEXP0311_SB.swf
http://www.nytimes.com/2010/02/25/business/global/25swaps.html?_r=1&ref=business
The French Banks .... some EUR 50bn
The Swiss Banks ... some EUR 43bn
The Germans... some EUR 30bn
UK Banks... some EUR 28bn http://www.guardian.co.uk/business/2010/apr/28/debt-turmoil-bank-crisis-fears
US Banks... some EUR 12bn http://www.reuters.com/article/2010/02/09/greece-debt-banks-idUSN0911899120100209
This adds up to about EUR 170bn. The remaining EUR 100bn are probably with the Italians (Unicredit) , the Japanese Banks and of course the Sovereign Wealth Funds (whom I really feel sorry for, as they simply got taken for the ride by all the investment banks and I bet you that IF the restructuring does take place, and all the above take a huge hit in Equity, SWFs will be first to be asked for extra bank funding). Now these calculations exclude the CDS contracts, but I would imagine that this is basically just a distribution arm to more small and medium size funds, private banking clients, and local players who would have never thought that a default of an Eurozone country is possible.
Next important topic is the price talk, or what discount on the bonds
This is the area that interested me most in this topic, as there is a growing number of outstanding academic research suggesting various new ways of calculating default mechanisms, what has importance for the future, for instance
http://works.bepress.com/cgi/viewcontent.cgi?article=1002&context=deyjoy - very good one
http://www.europolitique.info/pdf/gratuit_fr/282201-fr.pdf
number of IMF led suggestions too
On Greece especially S&P estimates haircut of 50- 70%, http://www.creditwritedowns.com/2011/04/greek-haircut-for-debt-restructuring.html
and though I have strong doubts with respect to all the conflicts of interest all the rating agencies have, there is no reason to dispute this figure (if anything it should be conservative and the low haircut side). Also if one looks as the yields levels, 23% in 2y, 15% in 10y, a similar level emerges - 40% - 70% haricut, bringing down the debt to approx manageable 60% of GDP as identified originally by Maastricht Criteria.
Results of the Research
While it is apparent that Greece is only the first one in the process of potential restructurings, and that a solution needs to be found for many countries at the same time, there is in our opinion low chance for the standard restructuring of the Greek Debt as it is reported in the press, even if it makes sense (in our view it does).
Already the exposure of the Banks is so significant, that the required post Greek default equity injections to cover these losses would be almost impossible to raise, and experience of recent roadshow of Spanish Savings Banks verifies this, requiring governments, especially that of France and Switzerland to bail out further their local banks (this was always obvious, but now is more evident).
The major issue is that vast majority of these exposures, are booked using accrual accounting technique (or purchase price), and while some reserve has by now no doubt been put in place at these banks (probably approx. 10%), to make any restructuring meaningful, the debt would almost need to be halved, meaning that further 40% is missing (or in the case of France alone some EUR20bn). These are big numbers, especially if you compare them to the current market valuations of these banks and the profits that they generate, and Greece is a tiny problem. Furthermore extrapolate this to Portugal and Spain and the return of 2008 is on the cards. Indeed Spain is German problem.
Conclusions
FROM CREDITORS perspective:
The best way forward is hence to continue to
1. Continue to Print Euros
2. Design a new Restructuring Method, where the debt nationals are not cut, but the interest is reduced to say 50 years at 1% level, ensuring that the Banks do not have to write off any notional amounts. If one wants to be very cynical about this, you can even increase the debt of Greece to say EUR300bn, via one off restructuring charge of say EUR30bn. extend it to 100 years repayment plan, and even hence even realize the profit of EUR30bn for the bond holders who are of course on Accrual Accounting. The Mark to Market valuation of the 100years debt yielding 1% annually will be what it will be. (is this Informal enough for Professor Mundell?).
3. Potentially, as this is also all about politics, accept a medium solution, say 20% haircut, so that the hit is small, coverable by the banks - especially in France. But this will not be a restructuring at all, but merely a cover-up time buying exercise as the issue of Greece will return - but perhaps by this time Mr Sarkozy will be already retired sailing with Carla around the world and giving speeches on what should be done (its easier to do this when you are not the one doing it).
Taking a guess which decision will happen would require a microphone in the Ministry of Finance of France and Germany, but in our view we can at least rule out the standard 50% restructuring that is being discussed in the press. Nobody can afford it.
From GREEK perspective:
Take any money EU / IMF gives you. You can always restructure later anyway. It will make no difference if you default on EUR270bn of debt, or EUR400bn of debt, and frankly speaking if the print press goes into full gear, inflation speeds up, you might not even default at all.
Restructuring also has potential "butter-fly" effect, as if suddently Global Banks will need to raise EUR100bn of Equity to cover their losses, once again we could enter into the era of unknown, and just as I think that it was essential for US to bailout everyone back in 2008 as simply the world order could have collapsed, you alone might also trigger events on similar scale. Better not to risk, especially if you have other options (which because of the above will no doubt be given to you).
Implications for Emerging Markets and Vision Finance
Wait and see. Prepare for the wave of Restructurings, if this one is passed. If Greece can restructure, so can most of my clients. Indeed we already hired a very bright specialist for the Debt Restructuring Team, and hopefully this article will offer him a big picture lesson on this topic (it takes Vision to kill two birds with one stone).
Wishing you Happy Easter from sunny Dubai, interestingly a place that recently also announced its own little debt restructuring deal offering insight on how this process works
http://www.arabianbusiness.com/nakheel-s-11bn-restructuring-seen-favouring-lenders-393932.html
though if you remember how rocky the world was few years ago when Dubai news came out, well compare USD11bn is to that of USD393bn of Greece, and to that of USD1.1 trillion in Spain, and then maybe you will see that the only smart way out is to print, print and print.
***If you want to step away from finance and understand the true logic US Foreign Policy, as no doubt taught at Georgetown to future US Diplomats, please read below to learn the history of what one does for money (rather than just default).
http://en.wikipedia.org/wiki/United_States_territorial_acquisitions
(Iraq and few others are still not added).
