Felix Salmon

Greece’s bond buyback has succeeded, after a fashion. There weren’t enough bids by the original deadline of Friday, but then the offer was extended and two things happened. First, Greece’s banks bowed to the inevitable and tendered all of their bonds, rather than just most of them. And second, the Greek government made its most explicit default threat yet:

Stelios Papadopoulos, the head of the Public Debt Management Agency, stated “We have decided to extend the Invitation to offer Designated Securities for exchange to 11 December 2012. Holders that have not tendered so far can still take advantage of the liquidity opportunity offered by the Invitation. Investors should bear in mind that even if Greece accepts all bonds tendered in the Invitation, it will continue to engage with its official sector creditors in considering further steps to put its debt on a sustainable path. Future measures may not involve an opportunity to exit investments in Designated Securities at the levels offered for this buy back.”

In English: you can hold on to your bonds and hope to get paid out in full, if you want — rather than accepting 33 cents on the dollar right now. But be aware: Greece has to do what its official-sector paymasters tell it to do. And if it takes “further steps to put its debt on a sustainable path”, who knows how much money you might end up with when it’s all over. Are you sure you don’t want to just take those 33 cents?

Joseph Cotterill makes a good point: with the Greek banks now having been taken out of their bonds, the low-lying fruit for any future restructuring offer is now gone, which means that in any future restructuring, Greece is going to be dealing with hard-nosed hedge funds rather than complaisant domestic banks. That said, Greece might conceivably now have a nuclear option in its back pocket: the comments to Cotterill’s post are full of speculation that Greece might be able to find a way not to cancel the bonds its buying back. In which case it could use its new supermajority vote to cram down a very bad deal indeed on any holdouts.

All of which is to say that this buyback deal is increasingly feeling a lot like a second default, just months after the first one. It’s good for the optics of Greece’s debt-to-GDP ratio, and it doesn’t seem to be triggering any CDS. But it’s a useful lesson for any other European countries (Ireland and Portugal are the obvious next candidates) who are thinking about restructuring their private debts. You don’t necessarily need to do the whole deal at once: especially if you are clever in your use of collective action clauses, you can start with a small and insufficient haircut, and then follow it up with a second restructuring a bit further down the road. If your creditors are largely domestic banks, that could work out much better than socking them with one-off monster losses.

When S&P downgraded Greece to Default on Wednesday, I thought it was a bit silly. After all, here’s a chart of the benchmark 2042 bond, since issue: although it’s trading at just about 30 cents on the dollar, that represents an all-time high, and the price has trebled since the end of May. When an issuer’s bonds were trading at 10.65 in May and are 30.63 today, that’s not the kind of price action you expect from a defaulting entity.

When one of the big two ratings agencies says that an issuer is in default, that’s an important determination. But S&P doesn’t seem to be keen to own it: the stated reasons read a bit like “we’re only following rules, there’s nothing else we can do”. The logic goes like this: Greece is buying back its debt at a substantial discount to face value — and when investors “receive less value than the promise of the original securities”, that counts as a default, as far as S&P is concerned.

Now the analysts at S&P are human, so they’re allowed to make a reasonable determination as to what that means in practice. Specifically, what was “the promise of the original securities”, and are the investors who tender into the exchange getting less than that? One way to make that determination is to simply look at the face value of the bonds, but that’s silly. A long-dated zero-coupon bond, for instance, will always trade at a big discount to its face value, but that doesn’t mean it’s distressed, or delivering any less than was promised. And the 2042 bond I’m charting above, for instance, has a very low 2% coupon, so of course it’s going to trade well below par.

So instead, it’s worth looking at the yield on the bonds — in this case, it’s about 11.5%. That’s high, but I don’t think it necessarily enters into “distressed” territory. In any case, we know exactly what the promise of the original securities was: when they were fresh off the securities-creation machine, they were worth about 24% of face value, and now they’re worth about 30%. So investors are getting substantially more than the promise of the original securities, if you use the market as your measuring stick.

Judging by S&P’s own criteria, then, I’m not a huge fan of the decision to brand Greece as being in default. Certainly the credit default swaps aren’t going to be triggered, and on its face this deal doesn’t feel like a default: the tender offer is a voluntary one, it improves the value of the bonds rather than destroying value, and at the margin it means that the bonds are more likely, rather than less likely, to pay out in full and on time.

But then I saw this:

Banking sources told Kathimerini that Greece’s four main banks – National, Eurobank, Alpha and Piraeus – submitted all their bonds, with a nominal value of 11.5 billion euros, to the buyback process…

Sources said local banks are hopeful that investors’ take-up of the offer from the Greek government, which had set a price range of between 30.2 and 40.1 percent of the principal amount, was big enough to allow lenders to eventually hold on to some of the bonds they submitted.

Greek banks were hoping to keep 20 to 30 percent of their bond holdings to minimize their losses.

As far as Greece’s banks are concerned, then, this is not a voluntary deal after all. They don’t want to tender all their bonds, but they are tendering all of their bonds, and they’re hoping to be able to keep at least some of them. Why would they do something they don’t want to do? Because the alternative is that they risk Greece failing to get enough tenders, which would cause the offer to fail, which in turn would be disastrous for the economy. Technically, the banks have a choice here, but in practice they don’t. And when you’re being coerced to give up your bonds at 30 cents on the dollar, that feels like a default.

From the point of view of the Greek banks, then, I can see why this might be considered a default. On the other hand, from the point of view of any independent investor, including all the hedge funds who have made very good money on these instruments in recent months, the exchange isn’t a default at all. Independent investors really do have the voluntary choice of whether or not to tender into the exchange, and in fact they love the fact that the exchange is happening: it’s providing a healthy bid for their paper.

So, is Greece defaulting on its bonds again? My feeling is that the answer is no. You can make the argument that this is a coercive distressed exchange, and that coercive distressed exchanges are one way of defaulting. But default is a fraught word, and I don’t think it should be used lightly. In this case, when the exchange is genuinely voluntary for all but the Greek banks, it seems weird to call it a default. Especially when the bonds are trading at their all-time highs.

Charles Forelle has a very wonky post today under the headline “Greek Deal Could Weaken Private Bondholders”, which sounds a bit scary. Basically, there was a Clever Idea which got inserted into the documentation governing Greece’s new bonds, but now it seems clever only in retrospect.

The Clever Idea in this case was that when Greece made interest payments on its bonds and on its EFSF obligations, it wouldn’t pay those creditors directly. Instead, it would pay an intermediary, which takes the money and divvies it up between the private-sector bondholders and the EFSF. The effect was meant to be that Greece couldn’t default on its bondholders without also defaulting on the EFSF.

But as we saw in January, Clever Ideas almost never actually help on a substantive level. My favorite example here is the Rolling Reinstatable Guarantee, which was dreamed up in 1999 as a way of ensuring that bond issues by Thailand, Argentina and Colombia would get paid just so long as those countries were current on their obligations to the World Bank. And yet, when Argentina defaulted, the bonds with the RRG defaulted along with all of the other bonds — even as Argentina remained current on its World Bank obligations.

In this case, the problem isn’t that Greece defaulted on its bonds without defaulting to the EFSF. If anything, it’s the exact opposite. The EFSF has basically restructured Greece’s debt, in a manner which would certainly constitute an event of default were it to take place in the private sector. As a result, all those expected EFSF payments have basically evaporated, and Greece needs to pay only its private-sector bondholders.

At the margin, this is a good thing, not a bad thing, for bondholders. It means that Greece only needs to pay them; it doesn’t need to make payments to the EFSF at the same time. So any protection they lose from their Clever Idea is more than offset by the real world cashflow relief that the EFSF has just granted Greece.

On top of that, the stock of Greek bonds is being cut, too, with a €9.6 billion buyback operation which is designed to cut Greece’s outstanding private-sector debt significantly. Once again, that means that Greece needs to find less money to pay off its remaining bondholders — and that’s good news for those who don’t sell their bonds into the buyback operation.

All of which is to say that if you’re looking at debt issues, the important things — who’s going to fund the deficit, how much debt a country has, how much the debt service will cost — will always outweigh any Clever Ideas. In this case, the “co-financing agreement” is now pretty much worthless — but the fact is that it was pretty much worthless all along. If Greece really wanted to find a way of defaulting on its bondholders while remaining current on its EFSF obligations, it could always come up with with such a way. Now, happily, it doesn’t need to worry about such things. Because its EFSF obligations are to all intents and purposes zero, at least for the foreseeable future.

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.

Martin Wolf appeared on CNBC today, which is never a good idea. Between all the swishing noises and flashing graphics, it was pretty hard to understand what he was saying — and in any case, the questions from Andrew Ross Sorkin were generally of the form “tell me what’s going to happen in the future”, rather than “analyze what we know about the present”. At one point Sorkin literally asked Wolf to “handicap the outcome” of the Greek election. Wolf is a fascinating and erudite man, and I’ve never had a conversation with him where I didn’t learn a lot. But maybe if I asked him that kind of question, it could be possible for me to walk away none the wiser about anything.

Ryan McCarthy picked up on one point that Wolf made: he said — or seemed to say — that a eurozone deposit guarantee scheme would not protect deposits against the risk of devaluation. Sorkin really should have pushed him on this, since it seems to me at least that the whole point of a eurozone deposit guarantee scheme would be to keep depositors whole in euro terms, even if their country leaves the euro and devalues. Even without such a scheme, there’s a strong case to be made that if and when Greece leaves the euro, the EU should essentially write a large check to Greek depositors, making up for any losses due to the drachmaization of their deposits. Because if the EU doesn’t do that, capital flight from the European periphery will go from bad to catastrophic.

But CNBC is a place for heat rather than light, so instead of an interesting conversation between two smart journalists, we got shown the graphic above, twice. It purports to show a real-time quote for the Greek 2-year bond, which currently seems to be yielding 349.152%. (I love the idea that they know this number to three decimal places.) According to the chart, the yield on this instrument has been rising steadily until now: there’s no indication that there was even a dip after the bond restructuring in –

Hang on a sec. Check out that x-axis! You can’t be expected to grok this in the amount of time that the chart appears on CNBC — just a couple of seconds. But the chart stops in March, when the restructuring took place and the Greek 2-year bond ceased to exist. No wonder the yield is “unch”!

CNBC has more than its fair share of meaningless graphics, but this one is especially stupid: it’s a chart of an instrument which ceased to exist three months ago, showing what the yield on that instrument did in the run-up to its default.

Of course, CNBC’s viewers can’t be expected to understand that. The one thing they will understand is the yield, which is shown at 350%. CNBC is sending a clear message, here, that Greek debt is about to default, and it’s using a made-up measure to do so. There’s no such thing as the Greek 2-year bond yield, but Bloomberg has done its best to come up with an approximation of what such a thing might be trading at — and their best estimation puts the Greek two-year benchmark at 8.98%. Which means that CNBC is only off by a factor of, oh, 340 percentage points. Well done that channel! In any case, here’s the clip.

There’s a good reason why the likes of Paul Krugman, Joe Weisenthal (twice), Cullen Roche, Ezra Klein, and everybody else are raving about George Soros’s analysis of what went wrong in the Eurozone: it’s really good. The big theme is that the European-unity project is a bubble, which could burst at any minute. But it’s the granular analysis in this 4,400-word speech which really makes it worth reading.

Essentially, Soros characterizes the European project as being a bit like a runner, moving at a steady clip in the direction of greater unity. Running is a weird thing: it’s basically the art of falling over continuously in a particular direction. So long as you keep on moving forwards, you can maintain a dynamic equilibrium. But stopping is really hard, because whenever you try to do that, you’re out of balance:

The process of integration was spearheaded by a small group of far sighted statesmen who practiced what Karl Popper called piecemeal social engineering. They recognized that perfection is unattainable; so they set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they achieved it, its inadequacy would become apparent and require a further step. The process fed on its own success, very much like a financial bubble.

The problem here is that the statesmen didn’t understand that they were running: they thought they were walking. They thought that while forward momentum was a good thing and maybe even necessary, ever-greater union was in and of itself a good thing, which would bring the continent closer together and make it stronger. With hindsight, by contrast, we can see that it was a way of turbo-charging the European bubble, and setting it up for a catastrophic pop if and when the process of integration didn’t continue far beyond what was politically feasible circa Maastricht.

The bubble was a consequence of the convergence trade, which in turn, says Soros, was a function of BIS risk weightings:

When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge which in turn caused competitiveness to diverge. Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries enjoyed housing and consumption booms on the back of cheap credit, making them less competitive. Then came the crash.

The problem here is that the convergence trade could probably have been better described as a divergence trade: it created a two-tier Europe, with a strong creditor-filled center funding a weak debtor-filled periphery. And as a result the political union — which had always been the necessary other shoe to drop — became impossible, rather than inevitable.

At this point, says Soros, optimistically, Europe still has three months to pull together a comprehensive package to save the union — a package which is just as economically necessary for Germany as it is for Spain. But politically, getting this done is going to be incredibly hard: “the disintegration of the European Union,” says Soros, is “just as self-reinforcing as its creation”.

The economic necessity for Germany, here, is a product of Target 2, the mechanism by which the Bundesbank’s balance sheet now holds €660 billion in peripheral-country claims. Germany needs to throw money, more or less continuously, at the European periphery at this point, because if it doesn’t, its central bank will suddenly find itself insolvent to the tune of roughly €1 trillion. That wouldn’t be the end of the world: if Germany got its Deutschmark back, then the Bundesbank could simply print €1 trillion worth of Deutschmarks to fill that hole. But a world where the Bundesbank is willing to print €1 trillion worth of Deutschmarks is simply not the world we’re living in, and the Germans will do pretty much anything to avoid that outcome.

Which leaves us with the only alternative:

Germany is likely to do what is necessary to preserve the euro – but nothing more. That would result in a eurozone dominated by Germany in which the divergence between the creditor and debtor countries would continue to widen and the periphery would turn into permanently depressed areas in need of constant transfer of payments. That would turn the European Union into something very different from what it was when it was a “fantastic object” that fired peoples imagination. It would be a German empire with the periphery as the hinterland.

This is, in a nutshell, the bet I have with Joe Weisenthal. He, like Soros, says that Europe — including Greece — will become a German empire, where the Germans reluctantly dole out a stream of transfer payments to a resentful periphery. I’m taking the other side of that bet, because I think it’s politically impossible, in a union of democratic nations. And also because I think that even if perpetual transfer payments to Spain are justifiable, perpetual transfer payments to Greece are not. Either way, here’s the video.

Mark Dow has found an astonishing set of results from a February opinion poll in Greece; it’s hard to imagine that Greek attitudes to Germany have improved since then. Here’s just one of the 13 slides:

The final question, in particular, renders rather unfunny the joke about the German Chancellor flying to Athens for some meetings, and being stopped at immigration. “Name?” she’s asked. “Angela Merkel.” “Occupation?” “No, I’m just here for a couple of days.”

For his part, Dow seizes on a different question — one which shows that 51% of Greeks attribute Germany’s strong economy to corruption, and only 18% attribute it to competitiveness. Greek public opinion, it seems, is decidedly of the view that the only way Greece can compete with Germany is to become a lot more corrupt.

Stephan Faris, in his profile of Alexis Tsipras’s far-left Syriza party, writes:

Tsipras possesses not just a deep knowledge of the Greek electorate but a populist’s knack for channeling mass emotion…

Polls show Greeks are pulled by two seemingly contradictory desires. Roughly two-thirds of the country opposes the bailout conditions. Yet almost 80 percent say they want to stay in the euro…

Tsipras’s demand that other EU countries — namely Germany — renegotiate the bailout deal on Athens’s terms reflects a seeming indifference to the very real failures in Greece’s economy.

Looking at the poll, I see something different. The overwhelming majority of the Greek electorate believes that Germany, quite literally, owes Greece money. In the decades since World War II, Greece has been waiting patiently for its rightful reparations — and instead it’s finding itself in the midst of another attempted takeover by Germany, a Fourth Reich. Looked at through this lens, the Syriza position doesn’t seem contradictory or indifferent to the realities of the Greek economy. Instead, it’s noble resistance to a dangerous hegemon.

All of which is to say that the relationship between Germany and Greece is irredeemably oppositional, at this point. The Germans think of Greeks as corrupt scroungers, who just want to live on the fruits of Germany’s productive labor; the Greeks think of Germany as, well Nazis. (Check out page 2 of the opinion poll: when asked “What is the first word that comes in your mind when you hear the word Germany?”, and given one spontaneous reply, 32% of Greeks said something about Hitler, Nazism, or the Third Reich. And in general, again, the overwhelming majority of answers were highly negative.

This is not, in any real sense, a European Union: if two people with these feelings for each other were married, everybody would agree that they should get divorced.

Looked at from the US, it’s easy to see Tsipras as playing a deeply tactical game: he’s advocating that Greece call Germany’s bluff, and thereby continue to get EU financing while reducing the amount of austerity that Greece has to impose on itself in return. But looking at this poll, I don’t see tactics: I think that Tsipras is simply reflecting very real Greek attitudes to Germany — attitudes which consider Germany to be not only fascist, but also deeply corrupt. If you think you’re owed money by such a country, you’re not going to be particularly willing to accept onerous bailout conditions in order to receive it.

All of which says to me that Grexit is inevitable, sooner or later. These two countries have pretty much nothing in common, bar their current currency. And now the tensions caused by that common currency are surfacing in particularly ugly ways. Before things get much worse, it would surely be better for both of them if Greece decided to go its own way.

And yet, there’s a silver lining, here. As far as I know, these attitudes to Germany are not shared by most people in Spain, or Portugal, or Italy. It makes sense for the EU to allow Greece to leave the euro, and then to put a big and credible firewall up around Iberia. Greece really is a special case. And the other 14 members of the euro, if they join together, still have the ability to remain together.

One of the hardest questions to answer, when people ask about the European crisis in general and the Greek crisis in particular, is “why should we in the US care?” The simple answer is that well, this is an important part of the world, and it’s big news. But if you only care about news insofar as it directly effects the US, then the answer is harder.

One possible answer — I’ve heard this given in a number of places — is that another major crisis in Europe would spill over into the US, cause serious economic damage here, and could quite possibly make the difference between an Obama and a Romney victory. But just how likely is that? I’m no expert when it comes to assigning probabilities to events, but we can at least come up with a general framework which lets us answer the question.

Let’s start with the fiscal pact. Will all of Europe credibly commit to fiscal austerity going forwards? If so, that increases the chances of crisis and Grexit, since southern European countries in general, and Greece in particular, simply can’t operate under an austerity regime in the way that, say, the Baltics have managed, painfully, to do. On the other hand, everybody seems quite likely to break the fiscal pact in one way or another — which means that there has to be a good chance the pact will end up being honored mostly in the breach. Let’s call the probability of a Europe-wide austerity regime A; my best guess for A is roughly 15%, or 0.15.

So the next question is — what is the probability of Grexit, any time soon? That’s really two questions. First, what is the probability of Grexit if there’s Europe-wide austerity. Let’s call that B, and I’ll peg it at 85%, or 0.85. Second, what’s the probability of Grexit if Europe-wide austerity slips a bit? We’ll call that C, and I’ll say it’s 65%, or 0.65. Overall, we can define the chance of Grexit, D, as A * B + (1-A) * C. If you’re playing along at home, that’s 0.68, or 68%.

But just because Grexit happens, doesn’t mean it will necessarily affect the US election. For one thing, by definition, Grexit can’t affect the US election if it hasn’t happened by the time the election takes place. So the next question is: if there’s Grexit, what are the chances that it will happen by November? The Europeans have proven themselves very good at kicking the can down the road, so even if Grexit is inevitable, it’s still not inevitable by November. In any case, let’s define E as being the conditional probability of Grexit by November, given Grexit. I’ll say that’s 50%. Which means that the overall probability of Grexit by November, F, is D * E, or 34%.

Grexit, if and when it happens, will cause a lot of disruption in European markets, and certain deposit flight out of Spanish and Portuguese banks. Again, there are two ways this can play out. Either it will cause a series of further dominoes to fall, or else it will concentrate the Europeans’ mind and force them to build a large and genuinely effective firewall, drawing a line in the sand and saying “this far, but no further”. Will Europe let the Grexit crisis go to waste? Let’s say the probability of a credible, coordinated and constructive pan-European response to Grexit is G. Then the probability of Grexit causing a big European crisis is 1-G. What’s G? That’s a tough one, but I’ll put it at 35%.

For the purposes of this calculation, we’ll assume that Greece alone is too small to cause a big global crisis: you need contagion, for that. So we’re looking for H, the chance of a big European crisis before the US election. We can calculate that as F * (1-G), or 22% — that’s the chance of Grexit before November, multiplied by the chance of a bigger crisis if Grexit happens. (Note that a big European crisis can happen at any time; the chance of that is D * (1-G), which works out at 44%.)

If we have a big European crisis before the election, then that will certainly send US stocks falling. But will a sharp drop in the US stock market have any effect on the outcome of the election? Probably only if the election is reasonably close — and certainly not if Romney is in the lead. A European crisis, and consequent plunge in US stocks, would only be good for Romney and bad for Obama, just as the crisis in the fall of 2008 was good for Obama and bad for the incumbent Republicans. So what we’re looking for, here, is I, the probability that Obama will have a narrow lead over Romney — one small enough to be erased by a big stock-market plunge. I’ll peg I at 65%.

And thus, finally, we get to the big answer: what is X, the probability of Grexit toppling Obama? That is H * I, which using my off-the-top-of-my-head probabilities, works out at about 14%. But you should work this out for yourself. Come up with your own values for all these:

A: What is the probability of a Europe-wide austerity regime?
B: If we get Europe-wide austerity, what are the chances of Grexit, any time soon?
C: If we don’t get Europe-wide austerity, what are the chances of Grexit, any time soon?
D: What, then, is the probability of Grexit? This is calculated as A * B + (1-A) * C.
E: If we have Grexit, what are the chances it’ll happen before the election?
F: This is the overall probability of Grexit before the election, and is D * E.
G: If we have Grexit, what are the chances of it eliciting a credible, coordinated and constructive pan-European response?
H: This is the probability of a big European crisis before the election, it’s F * (1-G).
I: What is the probability of Obama having a narrow enough lead over Romney that it would be erased by a plunging stock market?

Put these all together, and you can finally come up with a number for:

X: The probability of Grexit toppling Obama. It’s H * I.

I’d be interested to know what results you get, but my guess is that most of them will come up with a number which is low and yet still significant. It’s something to bear in mind, but of course it’s also something which is pretty much entirely out of Obama’s control. That’s the way that crises work: individual politicians are rarely personally responsible for them, but whomever’s in power when they happen nearly always ends up getting the blame.

The size of the run on Greek banks is not at all clear: while it seems that something on the order of €1 billion has left the banks of late, it’s less obvious whether that was over the course of one day, three days, or two weeks. The big picture, though, is unambiguous:

What you’re seeing here is Greece down to its last €165 billion or so in deposits, and at the margin the rate of decrease is probably accelerating, despite the fact that most sensible Greeks will have already stashed their hard-earned euros safely outside the country a long time ago. I don’t know what the minimum amount is that Greeks need on deposit just to serve their near-term liquidity requirements, but we’re not there yet: Greece’s total population is only 11 million. So there’s a long way further this number can fall — especially since the Greek banking system isn’t receiving the support it needs from the ECB.

The more realistic constraint is simply that many Greeks lack the education and sophistication and language skills needed to move their money out of the country. This, for instance, is telling:

A 60-year-old textiles store owner who gave his name only as Nasos said he had transferred 10,000 euros over the phone to a bank in fellow euro zone state Cyprus on Tuesday afternoon.

If Greece exits the euro, there’s no doubt that there will be a massive banking crisis in Cyprus — it’s pretty much the least safe haven conceivable for someone looking to move their money from Greece. The only reason to move money to Cyprus rather than, say, Luxembourg is that they speak Greek there, and the logistics of moving money to Cyprus are easier than the logistics of moving money to any other country.

Meanwhile, in the rest of the eurozone periphery, foreigners are already pulling their deposits from Italian banks, while the Spanish banking system is only getting increasingly precarious:

All of which is to say that the causal relationship between sovereign crises and banking crises is rather more complicated than one causing the other: in reality, they cause each other, in a vicious cycle which clearly isn’t close to being broken in any of the southern European states. Greece is further along in the cycle than Spain or Portugal or Italy, but they’re all still moving in the wrong direction.

Greece’s banks, remember, are the mechanism by which the rest of Europe will force Grexit. Banks are the circulatory system of any economy: if they stop pumping money, the country dies. And so, in extremis, Greece will need to do a complete blood transfusion, replacing all euros with drachmas, if the only alternative is to see the flow of euros dry up entirely.

In the meantime, however, expect to see deposits continue to leave Greece — and the rest of the European periphery as well. Even if your euros are reasonably safe in a big Italian bank, they’re surely safer in a big German bank. And the first thing that all depositors want is safety. Now that questions have been raised about the solvency of various southern European banking systems, it’s going to be very hard to reconstitute the eurozone in a robust fashion. The Eurozone was never designed to cope with millions of Spaniards moving their money out of the country, behaving like middle-class Venezuelans with offshore accounts in Miami. And it also was never designed to cope with capital controls. But increasingly, it looks like we’re going to end up with one or the other. Or both.

The word on everybody’s lips these days is Grexit — Paul Krugman, for one, reckons it could be here as early as June. But how would such a thing happen? The FT, in its otherwise excellent Grexit explainer, fudges that bit:

Exit would occur because, without disbursements of additional loans, the government would run out of money to pay social security and public sector wages. In addition, the ECB could withhold needed funds from Greek banks, bringing them down. At this point Athens would need to pass a new currency law, redenominate all domestic contracts in a new drachma, impose exchange controls, secure the borders to limit capital flight and take steps to introduce a paper currency.

It’s true that Greece is currently running a substantial fiscal deficit, which is being funded by the EU. If the EU stopped disbursing loans, Greece by definition could not meet all of its obligations. But the thing that happens when you can’t meet your obligations is known as a default — and as we’ve already seen, Greece is more than capable of defaulting on its obligations without exiting the euro.

So the question is: given that leaving the euro would be political suicide for any Greek politician, why would any such politician go ahead and do it anyway?

Luke Baker has the beginnings of an answer:

The rules would appear to leave the decision largely in the hands of the departing country. But when asked if that were the case during a meeting in Brussels last week, German Finance Minister Wolfgang Schaeuble said it was not necessarily so.

According to a source present at the meeting, Schaeuble said contingency plans were being drawn up and indicated that life could be made so unpleasant for Greece that it would be left with no other option but to ask to leave.

That could involve shutting off all Greece’s official financing, not just from the euro zone’s EFSF bailout fund but from the European Central Bank too. Already there are signs of that sort of pressure being applied to Athens.

It seems obvious to me that if Greece were not receiving any money from the EU and the IMF, and the relationship there turned highly adversarial, with the EU effectively trying to force Greece out of the Eurozone, then Greece would feel no particular need to pay the EU what it is owed. And if Greece were to default to the EU, then at that point it would gain little from staying current on its other debts, too. It might still pay the IMF, and try to maintain some kind of decent relations there, but my guess is that Christine Lagarde would be foursquare behind Brussels, and the Greeks would see little point in paying her either.

Up until now, only pariah countries have defaulted to the IMF, but Greece is the exception to many rules. And given the choice between default and devaluation, it seems to me that Greek politicians — and the Greek population as a whole — clearly prefers the former to the latter.

Once you strip out Greece’s debt payments, the country’s primary deficit is pretty modest — just 1% of GDP or so. So could Greece make one more round of cuts, default on all its debts, and remain within the Eurozone?

I think the answer is no — and the reason is the banks. If the ECB were to stop funding the Greek banks, and if Greece were to default on its debts, all of Greece’s banks would be insolvent. And you can’t have a functioning economy without banks. Basically, Greek depositors need to be able to withdraw something from their checking accounts. And if the EU stops supporting the banks, that something can’t be euros any more.

Back on March 23, Christopher Whittall explained why we don’t have a good go-to measure of Greece’s creditworthiness, in the wake of its big bond exchange: Greece’s credit default swaps can’t trade yet. There’s something called a 60-day look-back clause in the standard CDS documentation, which means that if a country has defaulted in the past 60 days, somebody who owns credit protection can claim that there has been an event of default and ask to be paid out. Since we’re still well within 60 days of the default event on March 9, anybody buying Greek credit default swaps now could trigger them immediately.

But after today’s news, it’s far from clear that Greek CDS will even start trading after the 60 days are up. It turns out that while Greece managed to swap its old domestic debt into new bonds quite seamlessly and easily, the same’s not true of Greece’s foreign bonds.

In a statement, the Public Debt Management Agency said investors holding 20 of the 36 bonds in question either voted down or otherwise failed to approve key changes to the bond contracts…

Last week euro-zone finance ministers issued a statement which hinted strongly that they would back Greece if it didn’t make the payments on foreign law bonds.

On May 15, Greece must redeem one of those foreign law notes worth €450 million.

Basically, there are now roughly €9 billion of bonds outstanding which are still old bonds which haven’t been swapped. And those bonds are likely to be a real headache for Greece. The obvious thing for Greece to do would be to simply refuse to pay anybody who holds those bonds and didn’t tender into the exchange. I would certainly follow that course, if I were in Greece’s shoes.

But that would mean that there would be a second Greek default — and that going forwards, there would be a semi-permanent stock of defaulted Greek debt out there. In turn, that would make it difficult to trade Greek CDS, since Greece is likely to be in default, on billions of dollars of foreign debt, for as far as the eye can see.

Now it’s possible to ring-fence that debt and say that it doesn’t count towards a CDS trigger. Non-trivial, but possible. The question is whether anybody really has the appetite to do that. Or whether Greece, and the Eurocrats paying its bills, would actually be quite happy if Greek CDS didn’t trade at all from here on in.

It’s official:

The International Swaps and Derivatives Association, Inc. (ISDA) today announced that its EMEA Credit Derivatives Determinations Committee resolved unanimously that a Restructuring Credit Event has occurred with respect to The Hellenic Republic (Greece).

The word that jumps out at me here is Restructuring. In Europe, restructuring counts as a credit event; in north America, by contrast, it doesn’t. Which means that the derivatives market was pretty lucky here. If the standard Greek CDS documentation had looked like the standard US CDS documentation, there wouldn’t have been a credit event, as ISDA spokesman Steve Kennedy confirmed to me via email:

If you own CDS, and if you do not have restructuring as a credit event in your contract, it would not trigger if a CAC were invoked. You would know this going in. It is not a surprise.

The issue of restructuring as a credit event has been discussed for a decade. In other words, where restructuring is not a standard credit event (such as for US corporates), protection buyers buy the CDS protection knowing that there is no restructuring clause, that the credit event triggers are failure to pay and bankruptcy (for corporates) and repudiation/moratorium (for sovereigns), and the CDS is priced accordingly.

Now this isn’t quite as scary as it looks at first glance, because while US bonds do include CACs, if you want to amend the payment terms, you typically need 100% of the bondholders to agree to change the terms. A CDS holder could therefore buy a single bond and thereby ensure payment default and CDS payout.

But still, the whole CDS saga in Greece and elsewhere does rather feel as though ISDA is making it up as it goes along. Check this out, from the official FAQ:

How can an auction be held if there are no “old bonds” because they have been exchanged for new bonds?

The EMEA Determinations Committee will ultimately decide which of the obligations are deliverable under the Credit Derivatives Definitions for purposes of the Greek CDS settlement auction. It is important to note that Greece has outstanding a wide variety of obligations. Not all existing bonds are covered by the use of CACs. In addition, new bonds are being issued that might satisfy the requirements for deliverable obligations.

In other words, yes, the CDS market looks a little bit broken, but we’ll muddle through somehow, and hey, you never know, maybe the new bonds will work as deliverables after all.

There was a good hour’s worth of confusion about the credit event earlier today, when ISDA first declared that it had happened, and then pulled the release from its website — it seems because the original release couldn’t get the timing right for the associated ISDA press briefing and webcast.

Greece is now the second high-profile CDS case which could have gone horribly wrong for investors who thought they were actually protecting themselves when they bought protection. First came AIG, which ended up paying out on its CDS obligations at 100 cents on the dollar, although that decision was highly controversial. AIG’s Joe Cassano reckons that AIG shouldn’t have paid out anything at all, since the underlying obligations hadn’t actually defaulted. The problem was that AIG itself was downgraded, and couldn’t come up with the requisite margin; as a result, it had to unwind the CDS it had written at the bottom of the market and at enormous cost. And of course most of the rest of us reckon that because AIG was insolvent, its creditors/counterparties shouldn’t have got everything they were owed, and should instead have taken some kind of haircut.

Now comes Greece, which seems as though it will pay out at roughly the right level, if only because the EMEA paperwork had a restructuring clause, and because it had some obscure foreign-law bonds which can be used as deliverables.

Going forwards, then, I can’t imagine that investors will have much if any confidence that CDS will really perform the hedging function they’re designed for. My feeling is that if you look at the numbers for total single-name CDS outstanding, they’ll decline steadily from here on in. Because you ultimately can’t trust them when you really need them.

When I met with Peter Eavis to talk Greece, we finished our conversation with a predictions game: what percentage of Greece’s bondholders would accept its exchange offer? He said 84%, I said 89%. He wins: Greece won the participation of 85.8% of Greek-law bondholders, by value, and 69% of foreign-law bonds. As a result, the vast majority of Greek bonds will end up being exchanged, since the collective action clauses on most foreign bonds and all Greek bonds will now be triggered.

Ideally, Greece would like to bail in all of its bondholders, and so to that end it’s extending its exchange offer for the bonds issued under foreign law, until March 23. (The March 20 deadline no longer matters, because that represented the maturity of a Greek-law bond, which is now being swapped into much longer-dated debt.) There’s a new restructuring offer, too, for “holders of Greek law governed bonds issued by state enterprises and guaranteed by the Republic”, which should deal with the Greek railways loophole.

The Greek press release hammers home why holdouts should tender into the exchange, with a statement from finance minister Evangelos Venizelos:

Our invitations to offer to exchange, and submit consents with respect to, foreign law governed and guaranteed bonds will remain open until 23 March 2012, after which there will be no further opportunity for creditors holding those instruments to benefit from the package of EFSF notes, co-financing and GDP linked securities which form an important and integral part of our invitations.

Remember that the Greece exchange is a package deal with three parts. For every old bond tendered, you get (a) a new Greek bond; (b) new EFSF bonds; and (c) new GDP warrants. Venizelos, here, is saying this is a use-it-or-lose-it opportunity to get all three in one. Greece may or may not continue to swap its old bonds for its new bonds even after March 23. But there’s no way that holdouts will get the EFSF bonds. And the EFSF bonds are actually worth more than the new Greek bonds.

Because Greece is activating its CACs, there will be a credit event for the purposes of its credit default swaps — as there should be. If you sold protection on Greek bonds, then you’ll end up having to pay out roughly 75 cents on the dollar. But given where the CDS have been trading of late, you’ve almost certainly put up that much money in margin already. So there’s nothing unexpected here, and there won’t be any nasty surprises on the CDS front.

The exit yield on Greece’s new bonds is roughly 20%, which means that even after this enormous haircut, markets are still pricing in a very high probability of default on the new bonds. (Which, remember, are all being issued under foreign law, and will therefore be much harder to exchange, next time round.) I suspect that the new bonds could be a buy at these levels. Not because Greece is suddenly fiscally healthy again: it isn’t. But because if and when Greece is forced to do another debt restructuring, maybe when it leaves the euro, the debt servicing costs on its new foreign-law bonds will be relatively small. And it will therefore be easier for Greece to simply keep on paying the interest on those bonds than it would be to try to restructure its bonded debt a second time round.

That’s the silver lining to the step-up coupon on the new bonds: because it starts so low, at just 2% through 2015 and 3% through 2020, Greece doesn’t actually help itself out very much, from a cashflow situation, if it defaults or restructures these things a second time. The pain of the next Greek default, then, is going to fall overwhelmingly on the official sector rather than the private sector.

Of course, if Greece defaults on say the bonds being held by the ECB, then it’s very unlikely that the new Greek bonds would be trading at healthy levels. But what that means is that when you’re looking at the depressed price of Greece’s new bonds, you’re looking mainly at market risk, rather than credit risk: the risk that they will go down in price is much more salient than the risk that they will simply stop paying out altogether. If you have a strong stomach, and can hold on through what will certainly be periods of very high volatility, then there’s a reasonably good chance they will actually pay out in full, over the medium term.

The first maturity date on the new bonds is 2023, and realistically Greece has no particular reason to default on the bonds until then. Even in 2023, the amount coming due is modest enough that Greece would be better off paying it than suffering the consequences of a redefault. Basically, in the wake of this exchange, the new bonds aren’t a big issue any more, from a fiscal perspective.

The really big problem, for Greece — the one which isn’t going away — is the fact that the country still has a massive budget deficit, and that the only people willing to lend Greece the money to cover that deficit, at least for the foreseeable future, are its fellow European sovereigns. And their patience is wearing extremely thin. That particular tension has not been resolved today, and it’s going to come to a head much sooner than any problems with Greece’s new bonds. The next Greek crisis is going to be a crisis with official-sector financing, and it could come as early as this year.

“Greece’s private creditors are the lucky ones,” says Nouriel Roubini — which I think is putting it a bit strongly. Nouriel — who at one point was one of the world’s foremost econobloggers — is falling back on bad habits here: he says that “a myth is developing” about the official sector getting off scot free in Greece, and goes on to tell us how “the argument runs”. But he doesn’t link to any such argument — and I’d dearly love to know who he has in mind, and what exactly they’re saying.

Nouriel then gives a good overview of the degree to which the official sector really is bailing out Greece. This is important to remember: just because bondholders are taking a haircut, doesn’t mean this isn’t a bailout. It is. Greece is running a massive budget deficit, even before interest payments on its debt. It can’t borrow the money to cover that deficit in the markets, either foreign or domestic. Which means that the only thing standing between Greece and bankruptcy is the Troika, throwing billions of dollars at the Greek government to avert insolvency. As Nouriel says, this should give the Troika seniority, on the grounds that they’re providing the equivalent of “debtor-in-possession” financing.

Nouriel’s attempts to paint the private sector’s 75% haircut as a good deal which is “too little”, however, are less convincing. He’s right that once Greece’s new bonds are issued under English law, the Greek government can’t unilaterally convert them to drachmas — or to worthless scrip, for that matter. But as Nouriel well knows, that’s a fact of life for countries of dubious creditworthiness: the markets are always suspicious when they try to issue under their own laws. If Greece wants to give anything of real value to its bondholders, then it has to offer bonds issued under English law, because no one will believe its promises to pay, otherwise.

Put it this way: someone in the Greek government genuinely intends that the country is actually going to make all of its payments on the new bonds. Insofar as the Greek government is believed with regard to that promise, the new bonds are going to have real market value. But in order for bondholders to be able to realize that value, the bonds have to be issued under English law. If Greece came out with exactly the same offer but kept the new bonds under Greek law, then the haircut would be substantially larger than 75%, because the new bonds would trade at a significantly lower price when issued. So the governing-law aspect to all this is already incorporated in the haircut, and by choosing English law, Greece is simply maximizing the value of its bonds without increasing its total indebtedness by a penny.

And this argument of Nouriel’s makes very little sense to me:

Greece’s private creditors should stop complaining and accept the deal offered to them. They will take some losses, but they are limited and, on a mark-to-market basis, the debt exchange offers them a potential capital gain. Indeed, the fact that the new bonds are expected to be worth more than the old suggests that this PSI exercise has further transferred losses to Greece’s official creditors.

The job of the market — which it normally does quite well — is to anticipate how big a Greek haircut is going to be, and then arbitrage Greece’s bonds appropriately, pricing them at a level such that bondholders tendering into the exchange wouldn’t be better off simply selling their bonds instead. (If they would be better off selling their bonds instead, then the buyer of those bonds is pretty stupid, and is going to end up making a loss.) So by definition, an exchange offer always offers “a potential capital gain” to bondholders, just because the market price before the exchange has to be a little bit lower than the expected value of the new securities after the exchange.

What’s more, Greece has to offer something, or else there won’t be an exchange at all, and instead there would just be a chaotic default which would be extremely damaging to all concerned. Already, the majority of the value in the package being offered bondholders is not coming from the new Greek bonds, but rather from European EFSF securities. The value of the new Greek bonds is only about 10 cents on the dollar — a 90% NPV haircut. It doesn’t get much bigger than that.

There are very good reasons why Greece would love to remain a member in good standing of the international community — not least that it wants to remain a member in good standing of the European Union, with Greek banks retaining most if not all of their current deposit base. As such, it has to take its bonded obligations reasonably seriously. The last thing it wants is protracted litigation with bondholders a la Argentina, where bondholders have recently been winning small but important victories in the US courts. Argentina is going to have to spend the foreseeable future being extremely careful with its sovereign holdings, for fear that they will otherwise be attached by its creditors. Greece doesn’t want to be an international pariah like that.

So while I’m shedding no tears for Greece’s bondholders, who took a risk which didn’t pan out, neither am I going to go as far as Nouriel and say that they’re getting a good deal. They’re not. They’re getting 25 cents on the dollar. Just imagine what would happen if Greece tried to make that kind of offer to other holders of sovereign obligations, like its pensioners.

This, I think, is a major change of tune from Greece.

When Greece first launched its exchange offer, on February 24, the language about when and whether it would active its collective action clauses was long and complex. I’ve uploaded the original press release here; the relevant language is at the bottom of page 2 and the top of page 3, and has caused a lot of confusion. (Simone Foxman, for instance, reported yesterday that if Greece gets 90% participation, the CACs would not be activated. That’s the exact opposite of what Greece said in the press release, where it declared its intention “to declare the proposed amendments effective” in that event.)

Today’s press release, by contrast, is a lot simpler. Never mind the old distinctions about what happened if the take-up was less than 66%, or between 66% and 75%, or between 75% and 90%, or above 90%. Instead, we just get one, simple rule:

The Republic confirmed that if it receives sufficient consents to the proposed amendments of the Greek law governed bonds identified in the invitations for the amendments to become effective, it intends, in consultation with its official sector creditors, to declare the proposed amendments effective and binding on all holders of these bonds.

In other words, there are collective action clauses, and if Greece can trigger them, it will. End of story.

Greece has also now explicitly talking about default; as far as I can tell this is the first time it has done that.

The Republic’s representative noted that Greece’s economic programme does not contemplate the availability of funds to make payments to private sector creditors that decline to participate in PSI.

This isn’t quite as drastic as it seems at first blush. Remember that Greece has now said that if it can trigger the CACs, it will. So if more than 66% of bondholders tender into the exchange, then everybody will end up with new bonds, whether they tendered into the exchange or not.

But note that this only applies to the Greek-law bonds. The English-law bonds need a 75% take-up, on a bond-by-bond basis. So it’s possible that the Greek-law bonds will be successfully exchanged, while some or all of the English-law bonds end up in default.

The English-law bonds are ultimately something of a sideshow, except for purposes of Greece’s CDS, where they might well end up being the instruments tendered into the bond exchange. But this new stance from Greece now makes the outcome of the Greek CDS auction very uncertain indeed: if one English-law bond fails to get 75% participation and gets defaulted on, then that bond will certainly become the cheapest bond to deliver into the exchange, and the CDS payout will be much higher than current market prices are anticipating.

My feeling is that this press release is an attempt to maximize the participation of holders of English-law bonds. If they hold out, Greece is saying, then the exchange is very likely to go ahead without them, and they’ll be left behind with nothing to show for it except the prospect of a long and painful court fight. Under the terms of the original press release, Greece kept open the possibility that it might pay hold-out creditors in full. Now it seems to have closed down that possibility. Which makes the upside of holding out much smaller.