The problems with a Greek “light dusting”

By Felix Salmon
May 4, 2011
Christopher Whittall, "a consensus has grown among market participants that authorities will look to avoid triggering CDS when restructuring Greek bonds".

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According to Christopher Whittall, “a consensus has grown among market participants that authorities will look to avoid triggering CDS when restructuring Greek bonds”. Recall the inimitable language of Lee Buchheit, in his latest paper on how Greece might restructure:

The EU’s post-Deauville assurance that there will never be a restructuring of an existing Eurozone sovereign debt instrument (at least until 2013) presents something of an obstacle to any pre-2013 restructuring of Eurozone sovereign debt instruments. The face-saving solution may be linguistic. A voluntary liability management transaction undertaken by the debtor country before 2013, the argument goes, is not a “restructuring” as that term was used in the post-Deauville assurance. Restructuring, it may be claimed, connotes a degree of coercion on the affected creditors. But if the creditors themselves elect voluntarily to participate in a liability management transaction to improve the creditworthiness of their debtor, who in the official sector can or should gainsay that decision?

This is pretty much the same idea underlying the cunning plan to restructure without triggering CDS:

“To have a restructuring credit event, there has to be something that binds all bondholders. There is no restructuring from a CDS point of view if not all holders are bound,” said Simon Firth, a partner at Linklaters in London. “A consensual amendment to the terms of the bonds that didn’t bind all the holders, because not everyone participated, wouldn’t constitute a restructuring.”

Is that one of the options that Buchheit talks about in his paper? (Which was written, I ought to mention, with his frequent co-author Mitu Gulati.) Here’s his “light dusting” scenario:

One possibility would be to approach the private sector (principally northern European commercial bank) holders of Greek bonds with a mild restructuring proposal that limits, or even neutralizes altogether, any net present value loss they would suffer as a result of participating in the transaction. A simple Uruguay-style13 reprofiling of the debt stock with no haircut to principal would fit this bill. To ensure widespread creditor acceptance, some might urge that any new instrument issued to effect the restructuring benefit from credit enhancement (a partial guarantee from the official sector, for example, or collateral security à la Brady bonds) so as to neutralize the negative NPV consequences of the stretch-out of maturities.

Whittall has another idea of one carrot which might be involved in the deal:

The ECB could also incentivise the exchange by only offering secured financing on Greek bonds that had had haircuts. “It would be a massive incentive for banks that hold the bonds to do the exchange,” said the senior European credit trader.

So here’s the idea of how Greece could restructure its debt as early as this year, if it were so inclined, while being able to formally say that it was not really doing so, and while avoiding a trigger of its CDS. It would offer an entirely voluntary bond swap, under which existing debt would be replaced by new bonds with longer maturities, lower coupons, and possibly even a lower face value. The ECB, as one of the architects of the deal, would certainly tender all of its debt into the deal — as would the governments of France and Greece.

And European banks would be tempted to accept as well, for a few different reasons: the new bonds could be repo’d at the ECB, or they might be backed by some partial European guarantee, or some combination of the two. And of course there would be a huge amount of arm-twisting behind the scenes, with central banks applying “moral suasion” to the commercial banks they regulate, urging them to tender their bonds into the deal.

Whittall, and Bond Girl, worry about the effect that such a deal would have on the CDS market. After all, CDS are meant to behave in very similar ways to the bonds that they reference — but in this case, if they were not triggered, they would behave much more like the untendered bonds than like the majority of tendered bonds. So bondholders who tender into the exchange and who had protected themselves with hedges in the CDS market would find that protection no use at all.

The effect with respect to holders of Greek debt in particular would be de minimis: the amount of Greek CDS outstanding is tiny. But if CDS were no longer considered a decent hedge of the underlying bonds, that would trigger an unwind of what’s known as the “basis trade”, where hedge funds buy the underlying and then hedge in the CDS market. In turn, that would mean some unknown amount of spread widening.

That prospect doesn’t worry me: bond prices tend to find their level, regardless of technical considerations in the CDS market. And if CDS volumes shrink because the market doesn’t consider them a good hedge any more, that’s fine too. No one was ever harmed by a reduction in the amount of derivatives contracts outstanding.

But the friendly-restructuring scenario has a much bigger problem. A light dusting isn’t going to be enough to get Greece back onto a sustainable fiscal footing — and the markets aren’t going to believe that one friendly deal will be the end of the matter. As such, bondholders will have every incentive to stay in the old debt and not tender into the deal.

Unrestructured debt will have shorter maturities than the bonds it’s swapped into, and if the original debt hasn’t matured by the time the inevitable second restructuring comes along, then the holders of unrestructured debt, if they take a single haircut, will end up with a better deal than anybody who accepted two haircuts in a row. And since the first restructuring was entirely voluntary, there’s no way that Greece could offer the people who took it a significantly better deal in round two than it’s going to offer the holdouts.

Given that logic, it’s going to be very hard for Greece to come up with a deal which a lot of private-sector bondholders are going to buy into. Which means that the “light dusting” would apply only to the official sector, and not to the London Club of private creditors. And there’s no way that the governments of France and Germany would ever stand for that.


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