How the official sector restructures, Greece edition

November 27, 2012

So the Greece deal is done, and it has ended up looking much like Lee Buchheit said it would look, especially as regards the way that the official sector is dealing with the enormous amount of Greek debt it holds:

What do I think will happen in the end? There will be some form of rearrangement of the official sector debt. If you asked me to predict, I would say it will not be a principal haircut. There is an alternative. The alternative is to stretch out those liabilities for a very long period of time at a very nominal interest rate.

Now check out the official Eurogroup statement, which, crucially, includes this:

An extension of the maturities of the bilateral and EFSF loans by 15 years and a deferral of interest payments of Greece on EFSF loans by 10 years.

This happened faster than most people thought it would: even Buchheit thought that the deal would have to wait until after the 2013 elections in Germany. But the point is that this kind of deal was inevitable, and sets a very important precedent.

This deal isn’t just the latest chassé in the long dance between Greece and its creditors; it’s a blueprint for every other European country with unsustainable official-sector debts as well. Including Greece itself, which will surely require another deal like this down the road. And it encapsulates the big difference between the way the private sector likes to deal with big debts, in contrast to the way the official sector does it.

The private sector likes a big one-and-done deal, where you start with a massive debt stock, and then you swap it for something smaller. The key number is the “NPV haircut”: the value of a bond is the net present value of its future cashflows, and so a big cut in coupons, or a terming out of interest payments, can be just as drastic, from a bondholder’s point of view, as a cut in principal. There’s nothing sacred about principal: what matters is the mark-to-market value of the bond.

The official sector, by contrast, holds principal highly sacred. That allows the Germans and others to say that they aren’t forgiving any debt; it also means that no national parliament needs to ratify a bill writing off any Greek debt. On the other hand, the official sector is happy to term out maturities until, as Buchheit puts it, the 12th of never, and also cut coupon payments at the same time.

I don’t know if anybody’s done the math to work out what the effective NPV haircut is here, especially if you also add in things like the way that Greek interest payments are going to get recirculated back to Greece in a weird kind of rebate program. In a way, it doesn’t matter, because the lesson here is that when push comes to shove, the official sector will always agree to let Greece (or any other troubled Eurozone country) term out its obligations instead of risking a default.

This is the big difference between the private sector and the official sector. The private sector, if it’s owed $1 billion on April 15, expects $1 billion on April 15, whether the debtor can really afford it or not. Failure to make that payment is a default, and if default is a real possibility, then there’s certainly no way the private sector will lend the country new money to make the payment.

The official sector, in contrast, if it sees a big $1 billion payment due on April 15, will simply term it out for a few years. That doesn’t impair the value of the asset on any official-sector balance sheet: it was $1 billion before, and it’s still $1 billion. And so it doesn’t really help with respect to anybody calculating Greece’s debt-to-GDP ratio, since the nominal amount of debt outstanding never actually does down. But in reality, Greece’s ability to manage those debts is much greater than it would be if the debts were mostly private. Because the official sector, deep down, in its heart of hearts, doesn’t actually expect to ever be repaid.

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