Europe’s half-baked deal

By Felix Salmon
October 27, 2011
deal like the one we got last night managed to significantly exceed expectations, making it seem that it's being ratified by market action today.

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Here’s one upside to the fact that Europe finds it almost impossible to agree on anything these days: even a half-baked deal like the one we got last night managed to significantly exceed expectations, making it seem that it’s being ratified by market action today.

There are three main parts to the deal. The first is an agreement, in principle, to leverage the European Financial Stability Facility by a factor of about four. Good idea! Except, the EFSF can’t just borrow $750 billion from its friendly prime broker. So where’s the extra money going to come from? There are a few ideas; foremost among them are “risk insurance” (which would be intended to raise the rest of the money from the private sector), and borrowing the money from Uncle Jintao in Beijing. At the moment it’s all rather inchoate. One place the money’s not coming from is the ECB, which found it hard enough just to keep on buying bonds from Spain and Italy.

The second main part of the deal is the bank recapitalization, where 70 banks — primarily in Greece and Spain — are going to be given €106 billion in order to bring their core capital up to 9%. This is a move in the right direction, but it’s also pretty marginal: the big French banks, for instance, aren’t going to need any more money at all, and in fact almost no bank you’ve actually heard of is covered by this. It’s mainly a way of forcing bailout funds to be injected straight into the banking sector.

Finally, there’s the Greek default, which has now been upgraded from a 21% haircut to a 50% haircut. This is the headline-grabbing announcement, but don’t hold your breath. The deal was negotiated by the IIF, a membership organization which represents banks but can’t commit them to anything. While the IIF’s head, Charles Dallara, walks around feeling important, his member banks are ultimately going to have to make their own decisions on whether they’re going to tender their holdings of Greek debt into a new exchange, and if so how much of their debt they will tender. What are the chances that all IIF members are going to tender all their bonds? Exactly zero.

Which is why, on one level, the ISDA statement that this still isn’t a Greek default, for CDS purposes, makes some sense. I’d probably make the same decision myself. But on the other hand, this does make a farce of the idea that credit default swaps constitute default protection, at least in the sovereign arena. If they don’t protect you against this, what earthly use are they?

And although banks — if this plan goes through — will write down their Greek-debt holdings by 50%, that does not mean Greece itself will see the value of its private-sector liabilities shrink by anything close to 50%. Neil Unmack explains:

Assume, very generously, that private creditors holding 200 billion euros of bonds sign up for the deal. That’s about 90 percent of Greece’s outstanding private debt, excluding those bonds held by the European Central Bank and short-term treasury bills. A 50 percent haircut would reduce Greece’s total debt by 100 billion euros, to around 256 billion euros.

However, in order to sweeten the deal, Greece will also give bondholders 30 billion euros of risk-free collateral to underpin the value of their new bonds. Greece will have to borrow that amount from Europe’s bailout fund. That lifts its total debt to 286 billion euros, or about 130 percent of GDP – higher than in 2009 when the country’s debt crisis first erupted.

In other words, the new Greek bonds won’t be pure Greek debt: there will be a bunch of risk-free pan-European debt in there, too. And Greece will ultimately be on the hook for that new debt.

This deal, then, is the toughest kick that the can has yet been dealt in its bumpy journey down the road. That’s probably a good thing. But the euro crisis is very, very far from being resolved. And even this deal could — indeed, probably will — fall apart at some point. Unless, that is, you think that Europe’s banks are quietly going to accept a 50% haircut when they couldn’t even unify to accept 21%.


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felix – what happens if Bank XYZ says “no, we’re NOT going to accept the 50% haircut – we are long Greek bonds and long Greek CDS against it?”

or, if you don’t like BankXYZ, figuring that the ECB has leverage over them, pretend it’s Evil Hedge Fund XYZ…

what happens to holdouts? even though not everyone voluntarily agrees to the 50% haircut, EVERYON’s CDS are worthless?

I’m asking… not telling… I’m totally confused


Posted by KidDynamite | Report as abusive

“If they don’t protect you against this, what earthly use are they?”

A CDS is in some sense a bet against the institution issuing the insured bond. Why would anybody ever bet against a sovereign? After all, they are the ones who write the rules…

Posted by TFF | Report as abusive

Your logic is politically naive and irresponsible – principally because I respect your views and analysis generally.

The bottom line, here, is that Dallarra was imposed upon by Ecofin Junker to accept it or forefit IIF banks bonds when Greece defaults!

Try to accept this as a faita compli!

Posted by hariknaidu | Report as abusive

” But on the other hand, this does make a farce of the idea that credit default swaps constitute default protection, at least in the sovereign arena.”
No, it doesn’t, the CDS doesn’t pay if the restructuring is not mandatory. RTFC.

Posted by alea | Report as abusive

@alea – what happens to you if you decline to restructure?

what if you’re long greek bonds, and long CDS protection against it? If I’m understanding this correctly (a long shot), then you can keep your position, you do NOT collect on the CDS because it’s not a credit event, but you CAN collect in the future when Greece actually defaults on the old debt that you didn’t restructure?


Posted by KidDynamite | Report as abusive


Posted by alea | Report as abusive

@Alea – so does it then stand to reason that anyone with a CDS position would not accept the restructuring offer?

Posted by KidDynamite | Report as abusive

“One place the money’s not coming from is the ECB, which found it hard enough just to keep on buying bonds from Spain and Italy”

Euuh, Felix, you do know this the ECB represents the largest economy on earth, do you ? This is not the Fed (which is quite broke).

Posted by FBreughel1 | Report as abusive

The CDS position is not significant, the net notional is only $3.7 bln and even if 100% of that is covered by bonds (unlikely) and they don’t participate in the restructuring it doesn’t matter (we are talking €205 bln float for the restructuring). But as far as the CDS is concerned, Greece has not defaulted yet, and no restructuring has occurred yet, it will take months before the restructuring is effective and since it’s not mandatory, it won’t be a credit event.

Posted by alea | Report as abusive

@Alea – I saw that $3.7B number… but the gross number is $75B. Something is hurting my brain thinking about how we can’t just ignore that here when thinking about incentives of the parties involved. ???

and yes, I did read this: 27/713826/how-gross-and-net-cds-notional s-really-work/

Posted by KidDynamite | Report as abusive

Gross positions irrelevant. Read this:
“Net notional positions generally represent the maximum possible net funds transfers between net sellers of protection and net buyers of protection that could be required upon the occurrence of a credit event relating to particular reference entities.” erivserv/tiw_data_explanation.pdf

Posted by alea | Report as abusive

@Alea – let me ask you a simpler question: if the NET CDS exposure is under $4B, then that implies that the current market setup was NOT a lot of parties who bought and hedged (with CDS) Greek debt, right?

and the next step is to conclude (which I think is your point), that this voluntary exchange not triggering a CDS credit event is not a big deal and is being blown out of proportion in a big way.

am I on the right track now?

thanks in advance…

Posted by KidDynamite | Report as abusive

@Alea – thanks for the other reply. I think that one problem us non-CDS experts have here is that we think of AIG 2008 – and the problems arising there – but this Euro situation is very much NOT like that, right? In other words, with AIG, the NET exposures were massive – the banks all bought protection, and AIG sold it to them…

Posted by KidDynamite | Report as abusive

Yes, AIG had a massive NET exposure, non-collateralized (until the downgrade) and was THE only market for certain types of CDS.
The EU situation has nothing to do with that, the NET is very small (vs total bonds outstanding), collateralized and (relatively) liquid.

Posted by alea | Report as abusive

Fbreughel1: Felix’s comments about how difficult the ECB found it to buy Spanish and Italian debt are 100% correct. Also, the Fed is not broke. It actually has plenty of dollars. Try to pay attention.

Posted by johnhhaskell | Report as abusive

The idea of the Fed being broke is kinda laughable. As long as they’re willing to tolerate somewhat higher inflation (which arguably would be a good thing — l ), the Fed can have as many dollars as it damn well pleases.

Posted by Auros | Report as abusive

They should borrow the $750 billion from French banks. This would reduce the transfers involved, not to mention the ultimate counterparty risk.

Posted by dWj | Report as abusive