Felix Salmon

Are you worried about Greece failing to come to some kind of agreement with its bondholders? If so, you’re far behind the curve. Because the new big worry is that Greece will fail to come to some kind of agreement with the Troika — the official-sector entities which are going to fund its deficits for the foreseeable future.

To understand what’s going on here, you really need to read two different things. The first is the latest paper from Mitu Gulati and Jeromin Zettelmeyer, entitled “Engineering an Orderly Greek Debt Restructuring”. It’s clear, it’s clever, and it explains exactly what Greece’s options are. The second is the leaked document from Germany, which has effective veto control over the Troika, laying out proposed conditions under which it’s willing to continue to fund Greece.

The mechanics of a Greek debt restructuring, as laid out by Gulati and Zettelmeyer, are absolutely fascinating to a sovereign-restructuring geek like me. But I’m not going to get into the details here. Suffice to say that in order for the restructuring to work, the Greek bonds currently held by the ECB need to be tendered into the exchange, somehow. There are various ways that this can happen: the ECB can tender its bonds directly; it can sell them to the EFSF, which would then tender them; or it could even sell them to Greece, which would tender them. But what it can’t do is sit back and continue to collect interest on those bonds while expecting all the private-sector bondholders to voluntarily take a massive haircut. Too many hedge funds own Greek debt now; if the old bonds continue to get paid out, then the hedge funds will simply refuse to tender, and the exchange offer will fail.

The point here is that the Greek bond exchange has to be worked out in very granular detail with the Troika, because the ECB is going to have to play a central role in making it work. If the markets think for one minute that the ECB’s bonds won’t be tendered into the exchange, the deal is almost certain to fail. On the other hand, as Gulati and Zettelmeyer explain, if the ECB’s bonds are certain to be tendered into the exchange, then Greece can structure a deal where it makes no sense to hold out at all, since holdouts would end up with illiquid and hair-cut Greek-law bonds, while anybody tendering would end up with English-law bonds which had much stronger bondholder protections and much greater liquidity.

So, what’s the Troika going to demand, in return for cooperating with the exchange and helping to ensure its success? More of a fiscal union, that’s for sure — which means real European control over how and where Greece spends its money. As the leaked document explains, “Greece has most likely missed key programme objectives again in 2011,” and “will have to significantly improve programme compliance in the future”, by “shifting budgetary sovereignty to the European level for a certain period of time”. That’s the reality of how bankruptcy works: if you run out of money, then anybody willing to lend you money can generally call whatever shots they want. And the fact is that monetary union, as we’ve seen, simply can’t work if there’s no fiscal union, with Europe having some kind of fiscal control over its member states.

The big problem with the leaked document is not the violation of Greek sovereignty, then. Rather, it’s the manner in which Greece’s new fiscal overlords are intending to treat the country’s debt burden. “Greece has to legally commit itself to giving absolute priority to future debt service”, it says, which is fair enough — California does something similar. Some bondholders like such things. But they don’t mean much to me: as I said in the Californian context, if you can break your promise when you default, you can break your promise to privilege bonded debt over other obligations, as well.

But the document goes significantly further than just giving Europe a say in Greece’s fiscal decision-making and asking for largely-meaningless promises from Greece. Check this out:

De facto elimination of the possibility of a default would make the threat of a non-disbursement of a GRC II tranche much more credible. If a future tranche is not disbursed, Greece can not threaten its lenders with a default, but will instead have to accept further cuts in primary expenditures as the only possible consequence of any non-disbursement.

In English, what this means is that Greece has to open itself up to a double fiscal whammy. Greece is going to be running deficits for the foreseeable future, and needs to get the money to cover those deficits from the Troika. Now, what happens in future, post-restructuring, if Greece gets into a fight with the Troika, and the Troika doesn’t give Greece the money it needs? As things stand, that would be a very bad outcome indeed. Greece could default on all its debt obligations, but it’s still running a primary deficit, so it would need to make even bigger fiscal cuts, or try to raise taxes even more, in order to bring its budget into balance. The result would be worse austerity, and an even deeper recession.

Under the German proposal, things get significantly worse than that, for Greece. Essentially, if the Troika cuts off funding, then Greece still needs to make all of its debt payments, on top of its primary deficit. The resulting austerity would be devastating — as Germany, of all countries, should know. After all, the burden of crushing German obligations after the Great War was largely responsible for the rise of… OK, enough. I’m not going Godwin here. But the point is that Germany is trying to take away Greece’s option to default. Interfering with Greece’s fiscal sovereignty is one thing, but this goes way too far.

I can see how Europe might want to give itself some kind of control over total expenditures and revenues in Greece. But the relative priority of expenditures — whether Greece wants to spend its tax revenues on debt repayment or on hospitals, for instance — must be left to the Greeks.

The reason all of this is going on, of course, is that the Troika’s interests and Greece’s are far from aligned. The Troika wants to stop having to fund Greece, and therefore wants Greece to regain access to private markets as soon as possible. Greece, on the other hand, is more interested in domestic growth at this point, so long as the Troika will continue to provide funding while private markets are closed. At the margin, then, the Troika wants more fiscal constraints (and hoped-for access to bond markets in future), while Greece just wants to get out of recession and start seeing some kind of light at the end of the tunnel.

Or, put it another way. Greece wants long-term debt sustainability, which means growth. The Troika, on the other hand, is less interested in the long term: it just wants the private sector to take over in terms of funding Greece as soon as possible. And the private sector, while it does care about long-term debt-sustainability calculations, also cares about many other things, like governing law and the constitutionality of default and the probability that Greece will continue making bond payments even if Troika funding dries up.

All of which means, weirdly, that bondholders would be better off lobbying the Troika than they are negotiating directly with Greece. After all, the Troika is really calling the shots here. And the Troika wants bondholders treated extremely well — after the restructuring. So if bondholders want things like English-law bonds and constitutional amendments, they should probably be asking the Troika for them, rather than Greece. Greece has no real reason to give them such things. But it can easily be forced to, if that’s what the Troika demands.

What happens if Greece puts forward an exchange offer which is acceptable to the Troika (the EU, ECB, and IMF), but unacceptable to bondholders — and only say half of them accept? In that event, there wouldn’t be nearly enough acceptances to be able to bail in the holdouts — and as a result, Greece would be paying out on its new bonds and would be forced to default on the old bonds which weren’t tendered.

Narrowly speaking, this would be good for Greece’s fiscal situation. After all, if it’s only making coupon payments on half of its private-sector debt, that saves it a substantial interest expense. But there’s no sense in which Greece actually wants this outcome — for two reasons.

Firstly, even if the ECB encouraged Greece to offer bondholders a very low coupon, it also doesn’t want Greece to be in indefinite default. Some kind of technical default which lasts for a couple of weeks, before the new bonds are accepted? That’s fine. But a protracted legal fight with bondholders trying to attach Greek assets around the world, and waving Greek obligations which are going unpaid? The ECB certainly doesn’t want that. It might be accepting just about anything as collateral these days, but even the ECB might well draw the line at lending against securities issued by a government which is clearly not paying a huge chunk of its debt.

The IMF, too, has rules against lending into arrears: it won’t lend new money to countries which are in default on old loans. This is a self-imposed rule which the IMF has broken many times, and might well break again, if it can say with a straight fact that Greece made a “good-faith effort” to keep current. But still, the bigger the number of holdouts, the harder it becomes for the Fund to continue to lend money to Greece.

The most devastating effect, however, would probably be on Greek banks. The obligations of Greek banks, pretty much by definition, are less safe than the obligations of the Greek government. Deposits in Greek banks are obligations of Greek banks. And so anybody with deposits at a Greek bank would likely move those deposits somewhere much safer, like Germany. That capital flight would weaken the balance sheets of the Greek banks and force the ECB to make a hard decision about lending not to Greece itself but rather to Greece’s banks. And even if the ECB did prevent Greece’s banks from going bust (certainly the Greek government doesn’t have the money to do that), those banks would be much weaker, much smaller, and much less willing to provide credit to Greek businesses. The Greek economy would surely be severely damaged as a result.

So it’s important, before March 20, that Greece puts together an exchange offer which a significant supermajority of bondholders will accept. It doesn’t need everybody to accept — there will be holdouts, especially when it comes to bonds issued under foreign law. But so long as those holdouts are obviously in the minority, that’s probably survivable. But Greece does need to be able to bail in all of the holders of its domestic-law bonds. Otherwise both the legal dynamics and Greece’s broader economy could become very nasty indeed.

The news out of Greece isn’t good. Remember here that Greece itself is basically just an intermediary, stuck between the Troika (EU, ECB, IMF) on the one hand, which is going to fund its deficits for the foreseeable future and therefore can demand anything it wants, and bondholders, on the other. And the problem is that what’s acceptable to the bondholders — a 4% coupon, basically, on restructured debt — is unacceptable to the Troika:

Euro zone finance ministers on Monday rejected as insufficient an offer made by private bondholders to help restructure Greece’s debts, sending negotiators back to the drawing board and raising the threat of Greek default…

Jean-Claude Juncker, the chairman of the Eurogroup countries, said Greece needed to pursue a deal with private bondholders where the interest rate on the replacement bonds was “clearly” below 4.0 percent.

In a way, this is a good thing, because it only serves to clarify the fact that Greece is defaulting in a way that’s going to make its bondholders very unhappy. All the talk of a “voluntary” restructuring was a way of attempting to paper over that fact, and that paper was always extremely thin. Maybe a bit of honesty will help people face up to reality in a way that they’ve been very reluctant to do until now.

Richard Barley has another idea which might help: the ECB could swap its Greek debt for EFSF debt, and then the EFSF could tender those bonds into the exchange. That, he says, could give Greece some €25 billion of extra debt relief, making the mathematics of a deal easier to work out.

I’m not entirely sure about this. The EU is already helping Greece enormously by funding Greece’s deficits going forwards. If the private sector were willing to do that, then it might not need to take such a big NPV haircut. Barley’s asking for Europe to both provide new money for Greece and take losses on the money it’s already lent, and I don’t see why Europe should have to do that now. Let’s do the private-sector restructuring first. The EU is surely going to take losses on its Greece loans at some point, but there’s no reason to do that at the same time.

No one thinks of this deal as a “one and done” restructuring. Bailing in the ECB or the EFSF at this point would just be denial: it would encourage the EU to think (or at least to say) that the Greek debt problem was solved for perpetuity, when it clearly isn’t. So let’s force the private sector to take its big NPV haircut now. And then the next step can come a few years down the road, when Greece discovers it can’t pay the Troika what it owes.

Stephen Fidler makes a good point today: the difference between a “voluntary” exchange and a “coercive” exchange, when Greece finally puts an offer to its creditors, is largely semantic. Or, to put it another way, the only real difference is that in a voluntary exchange, you have the IIF’s Charles Dallara saying nice things about the Greeks, while in a coercive exchange, you have the IIF’s Charles Dallara saying nasty things about the Greeks. But the fact is that precious few bondholders who are going to change their vote based on what Charles Dallara thinks.

Most of the bondholders are European banks, and as Fidler says, European banks are subject to “moral suasion” — having their arms twisted by their national governments — which is much more likely to affect their final decision than the official judgment of Dallara. Meanwhile, an increasing proportion of the bondholder base is made up of hedge funds, who certainly don’t care what Dallara thinks.

Landon Thomas reports that the two sides are getting closer to agreement; the sticking point seems to be the coupon on the new bonds, and the likely outcome, on that front, is likely to be just below 4%. No word on the governing law of the new bonds, though I suspect that Greece will go along with doing the market-friendly thing of issuing its new debt in London.

The reason why none of the negotiations really matter very much is, as Fidler says, that “if they don’t agree, the holdouts will have the ‘voluntary’ deal forced down their throats”. Greece is going to bolt collective action clauses onto its outstanding bonds — and use those clauses in what’s known as a “cram down”: the minority has to do whatever the majority wants.

Now with most collective action clauses, this would be non-trivial. Often these clauses require a large supermajority of bondholders to agree before the CAC is triggered — 85%, say. And they’re generally done on a bond-by-bond basis, making it much easier for a hedge fund to build up a blocking stake in one bond.

But Greece is in the very nice position of being able to craft its CACs now, rather than at the time the bonds were issued. As a result, it can set the CAC threshold very low, if it wants, and it can also draft them so that the percentage which matters is the percentage of all bonds tendered into the exchange, rather than the percentage of any individual bond.

All it needs to do then is have a quiet word with the technocrats at the EU, who have a very good idea how much moral suasion they can wield. Greece has a pretty good idea what the minimum take-up of any exchange offer is likely to be. And it just needs to set its CAC level at or just below that minimum take-up level.

Of course, the lower the CAC level, the more coercive the Greece exchange will be considered. If the CACs are set at 85%, the deal will be “voluntary”; if they’re set at 51%, it will be highly coercive. But either way, the deal will get done. And Greece has absolutely nothing to worry about with respect to hedge funds threatening to sue the country in the European Court of Human Rights. Good luck with that one, guys, you’re going to need it.

The only real risk for Greece, as I see it, is that its offer is so bad that less than 51% of bondholders tender into the exchange: you can’t set a CAC below 50%. But I doubt we’ll see that. Banks hate holding defaulted debt. Greece is going to offer them a choice, between holding defaulted debt and holding new instruments which are paying in a timely fashion. When push comes to shove, the banks are going to take the new instruments. Whether Charles Dallara likes it or not.

Greek prime minister Lucas Papademos gave an important interview to the NYT on Monday night. Think for a minute about the natural fractiousness of bondholders, and then read this:

Mr. Papademos said that if Greece did not receive 100 percent participation in a program in which bondholders would voluntarily write down $130 billion from Greece’s unwieldy $450 billion debt, the country would consider passing a law to require holdouts to take losses.

“It is something that has to be considered in the light of expectations about the degree of the participation to be achieved,” Mr. Papademos said. “It cannot be excluded. It is contingent on the percentage.”

This is a pretty clear message: if the bondholders don’t agree to Greece’s terms, then Greece can simply force them to join the exchange. Greece’s bonds are issued under Greek law, and Greece can change its own domestic law any time it wants.

My guess is that this is exactly what’s going to end up happening. Papademos has two sets of advisors: its bankers, Lazard, and its lawyers, Cleary Gottlieb. Lazard’s Greece team is headed by includes Mark Walker, the former managing partner at Cleary Gottlieb, and Cleary’s Greece team is headed by the dean of sovereign debt advisors, Lee Buchheit. Bondholders, in general, have a lot of experience going up against Walker, Buchheit, and Cleary generally. And whenever that’s happened, the sovereigns have won, and the bondholders have lost. Just ask anybody who held Russian domestic debt in 1998: Russia’s lawyer, back then, was Mark Walker.

Meanwhile, the lead negotiator on the creditor side is the IIF’s Charles Dallara, an amiable buffoon whose main purpose in life is to try to make sure that everybody likes him and thinks that he’s important. When faced with hard-nosed and single-minded Cleary types, he’ll be useless — especially given that the banks have already cut him off at the knees by refusing to let him negotiate on their behalf. He can wave his hands around and agree in principle to a deal, but he can’t actually commit any bondholders to participating. Which means that the “negotiations” are really just an opportunity for Dallara to talk a lot (he likes doing that), and for Greece to flatter him into “agreeing” to whatever it is they’re going to do in any case.

In her interview with Papademos, Rachel Donadio says that “European leaders are set against” the idea that Greece’s credit default swaps should be triggered, on the grounds that it “could ignite a chain reaction with unpredictable and potentially catastrophic results for the world financial system”. She’s wrong about that: it couldn’t. The only thing a CDS trigger does is make sure that people who bought insurance on a Greek default get paid when Greece defaults. It would mean that the people doing the insuring lose money, of course. But anybody writing an insurance policy has to be willing to pay out on it — especially when you’re insuring a credit as risky as Greece. A CDS trigger would not be catastrophic at all, and there’s really no reason to try to avoid one.

The real negotiations are the ones which are certainly going on behind the scenes, between the troika (the EU, the ECB, and the IMF) and the Greeks. The one thing which Greece needs is for the troika to keep on funding Greece’s deficits. And so it’s the troika — the organizations who are actually providing money, here — which holds all the cards. As in any bankruptcy, if you put up cash, you call the tune.

So the only thing that needs to happen here is for Greece to quietly find out from the troika what kind of bond-restructuring terms would be acceptable to them. Greece then puts those terms into a formal offer, and makes acceptance of that offer effectively compulsory for bondholders. The troika declares a successful bond exchange — because it happened on exactly the terms that they wanted — and continues to lend Greece the money it needs to function as a viable sovereign. Game over, at least for the time being.

Now politically, the EU would very much like to have a bunch of smiling bankers going around saying that they’re happy with the bond exchange, rather than a group of extremely irate creditors who feel railroaded into a dreadful deal. So everybody’s going to try to be as nice to the bankers and Dallara as they possibly can be, to try to get as much good PR for the deal as possible. And maybe, at the margin, the banks can extract some concessions in return for their smiles — perhaps the new bonds will be issued under London law rather than Greek law, for instance.

But the big-picture game plan is clear. Greece is going to default, on March 20, and there’s really nothing the banks can do to stop it. If you’re not willing to accept whatever deal Greece comes up with, you probably shouldn’t be holding Greek bonds at all.

Update: Lazard informs me that its team leader in Greece is Matthieu Pigasse, the head of the bank’s sovereign advisory team, not Mark Walker. They also say he didn’t work on Russia.

The big deadline in Greece is March 20 — that’s when the country has a €14.4 billion bond maturing that it can’t afford to repay. So Greece and its creditors are playing chicken with each other right now. Both want to do a deal, which would involve a cash payment of about 15 cents on the euro being paid out by a rescue committee comprising the EU, the IMF, and the ECB. Existing bondholders would get shepherded into new debt which would be worth less than the old debt but at least would remain current, while Greece would avoid the parade of horribles associated with a “hard default”, with its banks retaining access to funding from the international community in general and the ECB in particular.

The logical outcome, then, is that a deal gets done — probably along the lines that Marathon Asset Management CEO Bruce Richards sketched out to Peter Coy today. Richards’s math is a bit hard to follow:

The new bonds will probably pay annual interest of 4 percent to 5 percent and have a maturity of 20 years to 30 years, Richards said. They may trade for about half of their face value, he predicted. Altogether, the net present value of the deal for the bondholders will be about 32 cents on the euro, he estimated.

This doesn’t add up: if face value is 50 cents on the euro, then half that would be 25 cents; add in 15 cents of cash, and you get a total of 40 cents on the euro, not 32.

Update: OK, I understand how the math works now. The headline 50% haircut includes the 15 cents in cash: it’s 35 cents in bonds plus 15 cents in cash for a total of 50 cents. If you value the 35 cents in bonds at 50 cents on the dollar, then the bonds are worth 17 cents; add that to 15 cents in cash, and you get a total of 32 cents. Note that Greece, in this scenario, is getting a 65% face-value haircut, rather than a 50% haircut, and is getting coupon relief as well — all in all, Greece is swapping bonds it issued at par for new instruments worth 17 cents on the dollar. Which is an 83% NPV haircut. You can see why the market might object to a haircut that big.

But either way, the market is saying that a deal along those lines isn’t going to fly. The March 20 bonds are currently bid at 42, offered at 44, and no one is going to accept a deal worth 32 cents or even 40 cents if you can just sell those bonds outright for 42 cents. And similarly, no one buying the bonds right now at 42 is going to accept any deal at 32.

And it’s much harder to reach a deal now than it was a few months ago, because many of Europe’s biggest banks have quietly sold their holdings of Greek debt to aggressive hedge funds.

Even if a deal is done, remember that the people sitting on the other side of the table are the IIF, the hapless and toothless trade body representing the big banks without really being able to commit them to anything. And if the IIF can’t deliver the banks, it certainly can’t deliver the hedge funds, which are much less susceptible to arm twisting moral suasion.

As a result, we’re not going to see all $14.4 billion of bonds tendered in to any exchange — and there’s an extremely high chance that there will be enough holdouts to trigger Greek CDS contracts. That’s not the end of the world, although many people seem to think it would be; Greece is defaulting, so it stands to reason that default swaps would be triggered.

My expectation is that there will be an exchange; that it won’t be particularly successful; that it will trigger CDS; but that all the same it will be good enough for the EU, which will stump up its €30 billion and keep the can going on its bumpy path down the road. A bunch of hedge funds will be left with a large amount of defaulted Greek debt, and will start all manner of litigation, which will go nowhere for the foreseeable future. And no, there’s no way that Greece will pay those hedge funds just so that it can avoid the CDS being triggered.

Richards will be fine: he’ll tender into the exchange, get the cash and the bonds he’s expecting, and probably sell them at a small profit. Banks who lent to Greece at par will have to take very large losses. And the holdouts will start complaining loudly about the sanctity of contracts to anybody willing to listen, which will be a very small group of people indeed.

Frankly, it’s taken much longer than I thought for the actual default to arrive — seeing as how it was clearly signalled by Greece as long ago as July. That default would have been positively painless compared to this one. But at least we have a date, now. Greece will officially default on March 20. The only question is whether the EU will continue to fund the country after that date. For the sake of the euro zone, we had better all hope the answer is yes.

One of the most important parts of Greece’s restructuring deal — the agreement with its private creditors over what’s going to happen to its bonds — is still very much up in the air. The idea was originally that there would be an agreement by the middle of next week, but no one’s holding their breath, and it now seems as though it won’t be until the end of January at the earliest before any deal is done.

The banks, unsurprisingly, aren’t in any rush to do a deal: they only just hired representation. But the official sector, too, Greece itself included, seems more interested in playing hardball than in getting agreement.

The banks have agreed, pretty much, that they’re going to be OK with a deal where they get 50 cents on the dollar. But that’s just the beginning, not the end, of the negotiations. Because the 50-cent number applies only to the nominal principal amount on the bonds — the amount that Greece will eventually repay, many years down the line, assuming it doesn’t default again. What’s equally important is the size of the coupon that the new bonds carry. And Greece has reportedly decided that if it’s going to restructure, it’s going to restructure right — by slashing the income associated with the bonds to such a low level that when they start trading, each $1 in old bonds is going to be worth just 25 cents on the open market.

This is called the “NPV haircut” — and if you’re a holder of Greek bonds, it’s the main number that you care about, since it determines how much your new bonds are worth. The nominal haircut is important, too: since banks hold most Greek debt, and can keep that debt on their books at par, they might well be able to say that the new bonds are worth 50 cents, for regulatory purposes, rather than the 25 cents they’d get if they sold them. But you can be quite sure that they will be fighting very hard to minimize the size of the NPV haircut in negotiations this week.

From Greece’s point of view, if you’re going to default then it makes all the sense in the world to maximize the haircut involved: the cost of default is constant, while the benefit increases steadily the lower your total future debt burden.

On the other hand, Greece also needs to get the banks to agree to an exchange, because a “voluntary” agreement, where the banks tender their old bonds in exchange for new ones, is much less painful and disruptive than a simple repudiation, where Greece just stops making its interest payments on the old bonds until the banks cry uncle and accept anything that Greece wants to give them.

So the negotiations are likely to be very tough indeed. And I’m glad that the professionals are taking over to represent the buy-side here: up until now, the banks have been represented by a trade organization, the IIF, which couldn’t really commit them to anything and which always wants to appear statesmanlike. When negotiations get tough, you want someone fighting your side hard, rather than someone grandly proposing compromises all the time.

At the same time, it’s in no one’s interest for these negotiations to drag on too long. The longer that Greece waits, the less faith the international community — and the markets — will have in its ability to extract itself from its current fiscal crisis. And the higher the discount rate that the market will apply to Greece’s new bonds.

What that means in practice is that Greece’s NPV haircut is growing by the day, even — especially — if the negotiations go nowhere, just because the discount rate used to determine it has been steadily rising. 75% seems like a big number now. But if and when it finally gets formalized in 2012 some time, it might seem much more reasonable.

Why did Gretchen Morgenson write that column on Sunday about Greek credit default swaps? The answer is that the irresistible lure of writing about CDS lured her into the very murky waters of the Greek basis trade — the trade where you own Greek bonds and then hedge them by buying credit protection on Greece. Now this trade is emphatically not a big deal even in the context of the Greek debt restructuring: it’s probably a couple of billion euros in total, and won’t make much difference either way. But the outcome of the trade is likely to set an important precedent for the sovereign CDS market more generally, so it’s worth looking in a bit of detail at exactly what’s going on here.

Basis trades belong to a set which is relatively common in financial markets: things which are meant to be very safe but which, in fact, aren’t. Merrill Lynch reportedly lost somewhere in the region of $15 billion on basis trades, and at the height of the crisis I proposed that the US government should step in and start buying bond-and-CDS packages as a way to make money and get a bit of price discovery and liquidity into the fixed-income markets.

In theory, basis trades are simple: you buy a bond, which either pays off in full or doesn’t. If it does, you’re golden. If it doesn’t, then any losses you make on the bond can be recouped by profits on the CDS. So long as you buy the bond at a higher spread than the cost of credit protection, you should be guaranteed a modest profit.

But the question is how do you get there from here. Because CDS are derivatives, they’re subject to margin calls, and if you can’t meet CDS margin calls, you might be forced to unwind your trade before maturity. And that can be very expensive, if the basis has widened and markets have moved against you. So while the US government can play the basis trade without worries, everybody else has to treat it with a certain amount of caution.

And all of that was true before various EU member governments started deciding, in a killing-the-messsenger kind of way, that there was something profoundly evil about the sovereign CDS market and that they wanted to start trying to ban it.

There are two main forces putting the Greek restructuring together: the Greeks, and the EU. The Greeks, frankly, don’t care about CDS; what they care about is their debt, and their debt-service payments, both now and in the future. The CDS market, like all derivatives markets, is a zero-sum game, and whether CDS get triggered or not makes little substantive difference as far as Greece is concerned. That’s why I was highly skeptical of the idea that BNP had a conflict of interest when it was working for the Greek government while sitting on a key CDS committee: the Greek government really doesn’t have a dog in this fight.

The EU, on the other hand, has quite a lot of politicians and technocrats who hate the sovereign CDS market and would love to see it die. Bonds can be illiquid; CDS are the market’s way of pricing sovereign debt as accurately as it can. And when sovereign spreads are spiking nastily, it’s easy to blame a relatively small number of CDS traders for scaring the market, exacerbating very real problems, and making it harder to persuade people that things aren’t actually all that bad.

So, if the EU wants to throw a wrench of some kind into the spokes of the CDS market, what could it do in Greece? One thing would be to simply encourage Greece to do a “voluntary” bond exchange which doesn’t trigger the CDS. If bondholders playing the basis trade end up taking a 50% haircut on their bonds but getting nothing from their CDS, then clearly the CDS hasn’t provided them with the protection they thought it would.

There’s been a significant drop in the net notional amount of Greek CDS outstanding, of late, and that might indeed be a function of people unwinding their CDS trades in the face of uncertainty as to how they’ll be treated. But here’s the good news, as far as the CDS market is concerned: as the unwind has been going on, Greek CDS have continued to trade at extremely elevated levels. On a mark-to-market basis, anybody in the basis trade is fine. If they bought protection quite cheaply, they can unwind that trade and sell it at a high price, which will give them profits to offset against any losses they are forced to take on their bonds. In that sense, it doesn’t really matter what happens after the exchange: the trade is over, and it’s done what it was designed to do. More or less.

Meanwhile, as the unwind has been going on, the size of the Greek CDS market has been shrinking, so the number of people affected by the final decision as to whether or not the CDS is triggered has also been shrinking. That could be seen as good news for the EU and for people wanting to kill off the CDS market — but there’s a case to be made that the basis traders have simply moved on to Italy instead, which isn’t really a net improvement.

And the EU doesn’t just want to shrink the sovereign CDS market, it would ideally like to harm it in some way, in the hope that, once burned, the CDS traders stay away altogether next time.

Which brings me to the threats that BNP’s Belle Yang reportedly made in conversations with bondholders. Gretchen Morgenson didn’t explain them very well, partly because — I’m told — Yang herself was a little bit incoherent in what she was saying. But one bondholder did explain to me what he took away from the meeting.

The thing to remember here is that if the CDS isn’t triggered in the bond exchange, it doesn’t just disappear in a puff of uselessness. It still exists, and it still protects bondholders from a payment default. If you hold the old bonds — if you haven’t tendered into the exchange — then in many ways your basis trade hasn’t changed. Either Greece continues to make the coupon payments on the old bonds, or else it doesn’t, at which point the CDS really should trigger and make you whole.

But there are two ways that the sovereign CDS market really could be damaged in the aftermath of an exchange. The first is if the untendered old bonds got impaired significantly while the CDS remained untriggered. For instance, let’s say that Greece, using its own domestic law as the instrument, changed the payment terms on the old bonds so that they were paying out only a fraction of what they were paying before the exchange. That would almost certainly be a credit event under the ISDA definitions, and would trigger the CDS. But under one reading of what Yang was saying, Greece and/or the EU might attempt to impair the old bonds and pressure ISDA to declare that the impairment doesn’t count as an event of default. I very much doubt that ISDA would ever make such a determination. But if it did, then that would be a serious blow to the sovereign CDS market.

The second possibility is that Greece continues paying the old bond coupons in full, alongside its new bond coupons. And the Greek CDS market continues trading without any credit event. Until, one day, Greece being Greece, the country defaults again — on both its old bonds and its new ones. At that point, the CDS triggers. And to collect your payment on your CDS, you need to give up your bonds. But here’s the cunning bit: Yang has been hinting, I’m told, in her meetings with bondholders, that the EU and/or Greece will find some kind of way to change the law so that the old bonds aren’t eligible to be deliverable into the CDS exchange — to get paid out on your CDS, you’ll need to pay for new bonds, and your old bonds will be worthless.

If this were a credible threat, it would certainly be a good reason, at the margin, to tender into the current exchange rather than hold out. I don’t think it is a credible threat, but it’s easy to see how some investors might not want to take the risk.

The thing is, CDS is a young market, which hasn’t been tested in lots of different circumstances. No one can know for sure how it’s going to play out in future. So far, the CDS market has held up pretty well — everybody prophesying doom in the wake of the Lehman bankruptcy, for instance, was proved wrong. And when CDS were triggered on Fannie and Freddie despite the fact that there was never any payment default, the market coped with that well, too. My guess is that CDS will do what they’re meant to do, in Greece. But BNP is trying to spread a certain amount of fear, uncertainty and doubt over whether that’s necessarily the case.

As a result, anybody in the Greece basis trade needs to have a good degree of self-confidence that they know what they’re doing. Which, frankly, they should have had all along. Using derivatives to arbitrage securities is always a little bit messy and fraught with legal risks. If you don’t have confidence in what you’re doing, you shouldn’t be doing it in the first place.

Why oh why does Gretchen Morgenson insist on writing about credit default swaps as though she understands them? She’s done it again today, with an article about Greece which ratchets the conspiracy theorizing up to frankly bonkers levels:

The money managers with whom I spoke said BNP Paribas seemed to be motivated either by its desire to generate fees from the exchange or, perhaps, by worries about its own exposure to Greece. They wondered, for instance, if BNP Paribas has written a lot of insurance on Greek debt. If so, getting people to unwind such swaps now would be less costly for BNP than having the insurance pay off.

Note the levels of deniability here: if you look at how BNP’s actions “seem” to be motivated, they are “perhaps” being driven by BNP’s own exposure, which could be reduced “if” it has a lot of CDS exposure to Greece. And, of course, the whole thing is wrapped up in its own invisible quote marks — it’s all the opinion of anonymous money managers, without Morgenson giving us any indication at all of why we should be listening to them in the first place, or what their conflicts might be.

(There is actually a truth to the matter, here, as Peter Thal Larsen points out: BNP Paribas had €5 billion of direct exposure to Greek debt at the end of 2010, and a mere €0.1 billion of indirect exposure.)

The other explanation of BNP’s actions in this passage is simultaneously obvious and very weird: the bank, says Morgenson, might be “motivated by its desire to generate fees from the exchange”. Which is pretty much the most prejudiced possible way of saying, simply, that BNP has a job to do, and it’s doing that job.

BNP, you see, has been hired by the government of Greece to gin up interest in Greece’s bond exchange and try to ensure it goes smoothly. That’s a smart move by Greece, because BNP is one of the largest holders of Greek government debt. And this is quite an elegant way of Greece ensuring that BNP, rather than having to be persuaded to go along with the deal, will in fact be trying to persuade everybody else to go along with the deal.

But that obvious and true explanation of what BNP is doing isn’t good enough for Morgenson, who instead indulges anonymous money managers in flights of fancy about how BNP might have “written a lot of insurance on Greek debt”. There’s no evidence for this whatsoever — and I don’t believe for a minute that it’s true. In fact, I can’t think of any bank which has ever amassed a significant long position in any given name, through the CDS market, for any significant length of time. The poster children for that kind of misbehavior were the big insurers, including AIG, who ended up with long positions in highly-bespoke CDS. The closest thing I can think of at a bank was Howie Hubler’s disastrous mortgage-bond trade at Morgan Stanley, where a relative-value play blew up in his face. But the one thing all those blow-ups had in common was that their long position was in super-senior debt which was considered ultra-safe.

And in any case, if BNP had indeed written a lot of protection on Greece, it’s very hard to see how (a) it could manage to get the Greek government’s mandate because it had that position; or (b) how having the mandate would actually help the bank at all with respect to its position. Morgenson makes a very big deal out of the fact that one of the BNP bankers — Belle Yang — is on ISDA’s determinations committee for Europe, and can therefore help influence whether Greece’s CDS pay out or not — but that would be the case whether or not BNP had the mandate.

What’s more, Morgenson is objecting to some extremely unexceptional statements by Yang. Here’s Morgenson:

The BNP Paribas bankers have been telling bond holders that their credit insurance may not pay off down the road, because after the restructuring is completed, the terms of the old debt might be changed, these money managers said.

Normally, investors would shrug off such an argument…

According to one of the money managers, Ms. Yang told the investors that one potential hitch would be if Greece were to change the terms of its old bonds…

If investors think debt terms can be changed by fiat, they will flee the market. Ditto if they find that their insurance can be made worthless. Indeed, some of the volatility in European debt recently may be attributed to investor fears about these issues.

Morgenson’s saying, here, that it’s unthinkable for Greece to unilaterally change the terms of its old bonds, and that no one even considered such an eventuality until recently, when “some of the volatility” we’ve been seeing of late might be a result of investors suddenly realizing that it’s possible and that one of the ISDA committee members might somehow allow it to happen.

This is ludicrous. Everybody knows that Greece can and should take some kind of tactical advantage of the fact that most of its debt has been issued under Greek domestic law. Never mind the fact that a BNP banker sits on an obscure ISDA committee: why not look instead at what’s been written by the dean of sovereign-debt lawyers, Lee Buchheit, on this very subject? Buchheit works for Cleary Gottlieb, and is working directly for the Greek government. And more than 18 months ago he laid out Greece’s options very clearly, in a paper which was posted freely on the internet and which has been downloaded thousands of times, not to mention being passed around in PDF or printed-out form to pretty much everybody who’s involved in making decisions about Greek bonds. Yang, it turns out, was saying nothing which Buchheit wasn’t saying in May 2010:

The greatest advantage that Greece would enjoy in a restructuring of its debt derives from the fact that so much of the debt stock is expressly governed by Greek law. This raises the possibility, discussed in more detail below, that the restructuring could be facilitated in some way by a change to Greek law…

International investors are often leery of buying debt securities of emerging market sovereign issuers that are governed by the law of the issuing state. Why? Because investors fear that the sovereign might someday be tempted to change its own law in a way that would impair the value or the enforceability of those securities. Such changes in local law would normally be respected by American and English courts if the debt instruments are expressly — or otherwise found to be — governed by that local law.

Buchheit proposes one action that Greece could take — a “Mopping-Up Law” which would essentially change the payment terms on untendered bonds so that they were the same as the payments being received by bondholders who tendered into the exchange. There are many others: a sovereign country can change its own law pretty much any way it likes. And although there would surely be legal challenges if it tried to do so, I don’t think there’s anybody who’s optimistic such challenges would succeed.

If there were any investors out there, 18 months ago, who didn’t realize that Greece’s debt terms can be changed by fiat, there weren’t any after Buchheit’s paper came out. So when Morgenson says that investors “will” flee the market when they work this out, she’s at least 18 months behind the curve. And indeed one of the big reasons why Greece’s debt is held overwhelmingly by banks rather than by institutional bond investors is precisely this one.

More generally, Morgenson’s simply wrong when she says that the treatment of CDS is a “a big point of contention” in this restructuring. She’s been talking to an unknown number of “investors” and “money managers”; the only one she names is David Kotok, of Cumberland Advisors. But as everybody involved in the Greece deal knows, institutional investors in general, and American institutional investors in particular, are essentially an afterthought here; the deal will succeed or fail based entirely on the degree to which it’s embraced by Europe’s banks.

The funniest part of Morgenson’s article is this:

Investors who own Greek debt and have bought insurance on it, in the form of credit default swaps, wonder why they should accept the offer that’s on the table…

The discussions with BNP Paribas confirm the view of some investors that credit default swaps are not insurance at all.

Does Morgenson really believe that CDS is an insurance product and used that way by investors? That there’s a bunch of bond investors out there who bought Greek bonds, and then, rather then selling those bonds, bought protection on them instead, using that protection as insurance against a bond default?

The truth of the matter is that the set of “investors who own Greek debt and have bought insurance on it, in the form of credit default swaps” is utterly minuscule, and that every single member of that set is a highly sophisticated player who knows all about issues surrounding Greek domestic law and the potential problems with this kind of basis trade. The last thing that any of them need or want is Gretchen Morgenson going to bat for them on the front page of the Sunday business section of the NYT. And their plight is certainly not of interest to the NYT’s readership as a whole.

Update: Just when you thought this whole thing couldn’t get any sillier, it now emerges that BNP might not actually be advising the Greek government after all! Athens News reported on November 6 that Greece “has terminated its collaboration” with BNP, Deutsche Bank, and HSBC.

Sometimes the conventions of dead-tree newspapers are much more effective at getting a story across than the same article on a website. Landon Thomas’s 1,100-word piece on George Papandreou is a case in point: you can work through the whole thing, or you can glance at it in the paper, where a pair of sub-heads do the job rather effectively. “Prime Minister Lacked Forcefulness” says one; the other tells us that “a leader proved unable to connect with constituents.”

Meanwhile, a similar prime ministerial ousting seems to be taking place in Italy, where the highly forceful Silvio Berlusconi — a man who connects viscerally with his constituents — looks as though he might get pushed aside in the national interest much as Papandreou was.

What we’re seeing here is the crucial role that national leadership has to play in sovereign debt crises. There have been questions over Italy for a while, but conventional wisdom has generally had it as being either the third or the fourth of the PIGS dominoes to fall. Instead, it now looks as though it’s falling so fast it could even, conceivably, overtake Greece.

The amorphous blob known as the “international community” — as represented by the likes of the ECB, the IMF, and even the US Treasury — is playing a dangerously technocratic game in Italy, largely oblivious to the enormous tail risks involved. The general idea seems to be that Berlusconi is a massive liability, but that underneath it all, the fiscal program he’s being forced to agree to is a good one. Kick him out, install a more professional technocrat, and all should be fine.

But just look at Greece, and the fate of Papandreou — the very model of a modern professional technocrat. When the populace is revolting and the government is imposing tough choices on its citizens, you need someone in charge who can do more than navigate committees and corridors in Brussels and Washington. In fact, that kind of thing is best delegated to finance ministers and central bank governors. The leader of the country has a much more important job — which is to lead the country.

I’m thinking here of Brazil, which managed to come out of its own debt crisis, in 2001, thanks to some very smart and able technocrats at the finance ministry and central bank. But — and this is crucial — it was also led by a popular and charismatic leader, who managed to persuade the country that he was acting in its best interests. There are many people who deserve credit for the fact that Brazil avoided default in 2001-2, but Lula — an uneducated union leader without a technocratic bone in his body — has to be at the top of the list.

At the same time, and crucially, Lula had the full support of the international community in everything he was doing. At no point was any entity as powerful as the ECB or the German government using sticks, threatening to force him into default if he didn’t do what they wanted. Everybody understood that their interests were aligned, and that it would be best for all concerned if they tried as hard as possible to work with rather than against each other.

And this is why the current Europe crisis is looking so bad. Interests aren’t aligned at all: everybody wants to push the costs of the crisis onto someone else. And in the past couple of weeks, things have gotten significantly worse: the northerners have started quite explicitly threatening the southerners with a lack of cooperation and the consequent inevitable default if they don’t pick up their game.

This is a strategy which is almost certain to end badly. It can work in the short term — but only in the very short term. Because if the markets think there’s a serious risk that the Eurozone powers might let Italy fall, then they will simply walk away. And suddenly the entire burden of financing Italy’s budget deficit for the foreseeable future will fall on the ECB, Germany, and the rest. Which is a situation which is simply unsustainable.

Or, to put it another way: Europe has a leadership problem raised to the 17th power. One weak or bad leader — Papandreou, or Berlusconi — can suffice to hole the euro project below the waterline. But parachute in the best of all possible leaders into Greece and Italy, and you still have a problem. There’s Germany, and France, and the ECB, and even the likes of David Cameron and Tim Geithner meddling where they’re not really welcome. And the only way that this crisis can work itself out effectively is if they all agree on the same solution.

But the essence of leadership is, well, leading. It’s not simply agreeing to do the same thing that the other 16 guys want to do. In Brazil, Lula set the course, and the international community — as well as his own technocrats — implemented it and made sure it worked. There was no doubt who was in charge. In Europe, no one has a clue who’s in charge, and 17 different people all want to set the course. Which means, I fear, that it’s doomed.

George Papandreou is Davos Man, literally: he’s been there for the past couple of years, and even if he steps down now I suspect we might see him up the alp in 2012, too. Matt Yglesias reckons this is bad for the Greeks:

At the end of the day, had Greece played chicken and insisted on a better deal, I think the Germans would ultimately have paid up…

That it’s playing out this way is, I think, an example of a benign consequence of the rise of the global ruling class. The leadership of a small upper-middle-income country is willing to do something unpopular and likely contrary to the interests of its population for the sake of the greater good. Still, as a structural matter I think it’s a fairly disturbing trend.

It’s definitely possible for national leaders to act in the best interests of Davos, rather than in the best interests of their own country. Or, rather, to kid themselves that what’s in the best interests of Davos is in the best interests of their own country. Exhibit A is probably the 2008 decision by Irish finance minister Brian Lenihan to guarantee all the debts of Ireland’s banks — although ultimately that decision hurt the entire Eurozone much more than it helped a relative handful of Irish bank creditors.

As for the decision by Greece’s leaders to close ranks and refuse to allow the Greek populace to throw a spanner in the works of a bailout, it’s certainly possible to see this — as Yglesias does — as a capitulation to Germany and the international community. On the other hand, it’s easier to see it as a way of cutting off some very nasty tail risk. Even if Yglesias is right and the Germans would ultimately have paid up, there’s a significant non-zero possibility that they wouldn’t have done, and the whole situation would have ended up collapsing, with Greece getting nothing. And that would have been disastrous, not only for the eurozone but especially for Greece.

More generally, it’s really hard for a country to play chicken with its lenders when it’s running a massive primary deficit. In fact, I can’t think of a single case where that ever happened. Greece needs Germany more than Germany needs Greece, both of them know it, and Germany is looking increasingly willing to cut Greece off if it refuses to cooperate.

The only way for Greece to get real negotiating leverage over Germany would be to start running a primary surplus, thereby giving itself a credible threat in terms of simply repudiating its sovereign debt. But of course running a primary surplus would require significantly more austerity than even the riot-inducing policies currently in place. For the time being, Greece finds itself in the same position as most distressed debtors — ceding control and authority to its creditors. That might not sit well with Greece’s proud citizens. But it’s a natural consequence of borrowing so much money from other European countries and international banks.

This is beginning to feel like 2008, complete with all the rumor and chaos and volatility we saw back then. MF Global is a bit like those Bear Stearns hedge funds which went bust — an isolated datapoint in one respect, but ominous in many others. And right now the best case scenario is that Greece ends up being Bear Stearns, rescued by an international community petrified of what might happen in the event of a chaotic collapse.

But Greece being Greece, of course, a chaotic collapse has to be pretty much an inevitability at some point.

Of the many ways in which the euro project was fundamentally misguided, this might be the proximate cause of its demise: it was never robust to the messy world of political reality. And in the real world, people — including heads of state — make stupid decisions all the time.

So it’s a bit silly, frankly, second-guessing George Papandreou’s fateful decision to call a referendum on the latest Greece bailout. It might not have been the most statesmanlike thing to do, but the fact is that, judged by the standard of most Greek prime ministers, Papandreou’s pretty much the best that Europe could reasonably hope for. (Just think: Greece could be run right now by someone more like Silvio Berlusconi. Or, for that matter, Jon Corzine.)

In Greek tragedy, humans don’t rise above events to triumph; rather, they are crushed by forces greater than themselves. (It’s one reason why The Wire was such an innovative piece of television: it reached back past that great humanist, Shakespeare, to his Greek antecedents.) The architects of the eurozone displayed classic hubris: they saw the increasing economic ties between the various countries and locked themselves in to a momentum trade where such ties could only ever strengthen and never weaken.

And in the event it took much less time than even the skeptics had anticipated before that hubris resulted in the inexorable nemesis.

There is a decent chance that the G20 summit will somehow muddle through in Cannes. There’s even a possibility that Greece will manage to extract itself from its current political mess, implement the reforms that Merkel and Sarkozy are insisting on, and live to collapse some other day.

But at this point I see no sign of the pan-European unity at the head-of-state level which is needed to preserve the eurozone project over the medium term. Commeth the hour, commeth the backbiting and finger-pointing and recriminating. Greece is going to default and leave the euro; the only question is when. And when it does, the EU will find that its protections against contagion are about as effective as that $1.6 billion tsunami breakwater in Kamaishi.

Greece can fall and the eurozone can still survive. But Italy — which is just as politically dysfunctional as Greece — can’t. Which is why those Olympian forces will ultimately spell the end not only of Greece’s membership in the euro, but also of European monetary union more generally.

All the talk about sovereign CDS of late — pegged off the fact that the Greek restructuring might not trigger an event of default — is I think missing three big points. First, why ISDA’s rules make sense. Second, why Greece’s CDS spreads are still extremely wide. And third, what sovereign CDS are used for.

But before we get to any of that, it’s important to understand the big picture. Greece has a lot of private-sector debt; most of it is held by banks. There is a small amount of sovereign CDS outstanding, which references that Greek debt. To give you an idea of the orders of magnitude here, we’re talking about roughly €200 billion in Greek bonds, and less than €4 billion in net CDS exposure. Even if all of the net CDS exposure was held by bank creditors, it wouldn’t remotely offset the write-down they’re going to have to take on their bonds.

In reality, the banks have de minimis net CDS exposure. They might trade the CDS, and have either a long or a short position on their trading books at any given time, but they’re not using the CDS to hedge their bonds.

Those bonds are freely tradeable: if at any time a bank wants to reduce its exposure to Greece, all it has to do is sell some of its bonds. Doing so would almost certainly involve taking a loss, of course, since the bonds are trading at about 40 cents on the dollar. Which is why the banks are even thinking about accepting an offer at 50 cents.

And in fact, an offer at 50 cents is exactly what Greece is going to give them. Although it’s not really 50 cents in cash; it’s 50 cents in partially-collateralized new Greek debt, which your guess is as good as mine where it will trade if and when any exchange is finished.

The banks may or may not have much of a choice when it comes to accepting Greece’s offer. Some of them are having their arms twisted extremely hard by their respective governments, and feel that they have to do what they’re told. Others are more prone to asserting their independence. Again, it’s going to be a while until it’s clear what the final outcome of any exchange offer will be. But one thing I can guarantee you: there won’t be 100% take-up. In fact, there almost certainly won’t even be 90% take-up. All we know for sure is that if and when this exchange offer comes along, some bonds will be tendered into it, and others won’t be.

Now the way a credit default swap or an insurance contract works is that it’s contingent on some bad event happening out there. If that bad event happens, then you get paid out. The person who owns the CDS or the insurance contract is a passive player in this game — they can’t unilaterally determine whether there’s a payout. So the event of default cannot be a decision to tender a bond into a bond exchange — because that decision is taken not by the debtor but rather by the creditor. Debtors can offer to buy back their debt any time they like, at any price they like. That’s not a credit event, it’s a market.

Now if the offer to buy back the debt is coercive, then things change. But again, the question is who is doing the coercing. Is it the debtor? Is Greece promising to do unspeakable things, under Greek law, to any holders of outstanding bonds who don’t tender into the exchange? Is it threatening to default on those bonds? Is it going to take actions which make the bonds untradeable? If so, then we’re looking at a credit event, since bondholders would be damaged greatly either way.

On the other hand, if it’s France and Germany and other European governments who are being coercive, things change, because the coercion is creditor-specific. It’s in the fundamental nature of bonds that they’re fungible: if we both own the same Greek bond, then anything which is true of my bond must be true of your bond. (I believe this is related to Leibniz’s law of the indiscernibility of identicals, but let’s not go there right now.) France and Germany might be able to twist the arm of BNP Paribas or Deutsche Bank. But if I’m sitting at home in New York with a few Greek bonds in my brokerage account, I’m not going to care very much what Sarkozy or Merkel say. No matter how much they scream and shout, that screaming and shouting can’t constitute a credit event on my bonds.

So let’s wait until Greece does something coercive which seriously damages its outstanding bonds. At that point, we can declare a credit event, and move on.

And that’s going to happen: all you need to do to understand that is to look at where Greek CDS are trading. The tender offer itself might not be a credit event — although it might, if Greece starts larding it up with exit consents and the like. But at some point, there’s going to be a credit event on those reference obligations, if only because no European politician is going to stand for free riders holding on to their old Greek bonds and happily cashing coupon checks at 100 cents on the dollar. Once Greece has swapped out most of its old bonds for new ones, don’t for a minute expect that the holders of the old debt will be free and clear.

And if you want to take the Greek government to Greek court for the money they owe you under Greek law — well, good luck with that. Basically, post-exchange, the cost of default for Greece is tiny. So there’s no reason for Greece not to do it.

Sovereign CDS aren’t dead, then — they just take a little longer to pay out than some people in a hurry might like.

And that’s fine, for the kind of people who actually use sovereign CDS for anything beyond purely speculative reasons. These instruments aren’t used by banks to directly hedge their Greek bond exposure. Instead, they’re used by institutions who are financially exposed to the country of Greece, and who want to hedge their country risk. If you do a lot of business in Greece, or if you have a lot of receivables from there, or if you partner with Greek companies whose failure would hurt your business — then there aren’t many ways of hedging that exposure, but Greek CDS is one of the best of a bad bunch.

Greek CDS is useful even for hedging indirect exposure — a small holding of Greek CDS, for instance, can partially help offset a larger and vaguer exposure to the eurozone as a whole.

And the market in Greek CDS has been pretty efficient when it comes to this role. As Greece has got ever riskier, the price of buying credit protection on Greece has risen, and people owning that protection have made money. That’s the way it’s meant to work.

The only reason that Greek CDS spreads didn’t spike when the latest euro bailout was announced is that they were essentially already pricing it in. If and when Greek CDS spreads come down even as Greece’s creditors are forced to take a 50% haircut, I’ll concede that the sovereign CDS market is broken. But for the time being, it seems to be working OK.

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%.

It’s looking increasingly as though the proximate cause of the next big global crisis is going to be a liquidity crunch at French banks, rather than a European sovereign default. This is not the kind of stock chart that any leveraged institution likes to see:

BNP Paribas started July trading at €55 per share; it’s now at €27, and there’s no bottom in sight. And that’s making lenders very nervous, according to Nicolas Lecaussin.

“We can no longer borrow dollars. U.S. money-market funds are not lending to us anymore,” a bank executive for BNP Paribas, who declines to be named, told me last week. “Since we don’t have access to dollars anymore, we’re creating a market in euros. This is a first. . . . we hope it will work, otherwise the downward spiral will be hell.”

And Andrew Ross Sorkin, today, points out that Christine Lagarde, after being forthright about the need for European bank capitalizations, has recently been, well, less so. Banks live or die on confidence, and it helps no one if the managing director of the IMF does anything to erode that confidence during a liquidity panic. Largarde’s right that European banks in general — and French banks in particular — need to be recapitalized. But now is not the time to be saying such things, just because statements along those lines, in today’s febrile environment, can cause banks to collapse even before new capital is lined up.

It should go without saying that the banks themselves have to be upfront about the current situation. This kind of thing only makes matters much worse, since it causes markets to discount everything they say:

In the opinion of BNP Paribas, the largest French bank, the market for Greek bonds is inactive, never mind the fact that there are trades every day. It pointed to “the lack of liquidity seen during the first half of 2011” as it concluded market prices were “no longer representative of fair value.” It is now using a model to determine value…

Many banks applied a haircut to all of their Greek bonds, including the long-term ones not covered by the proposed exchange. But some banks, including BNP Paribas and Société Générale in France and Intesa Sanpaolo in Italy, decided to carry the long-term bonds at full value, on the theory that it would all work out and that European governments had promised not to force exchanges of longer-dated bonds…

On Thursday, the average trading price for such bonds was about 37 percent of par value.

The market has good reason to be worried about the French banks. They own $57 billion in Greek sovereign and private debt — more than all German and British banks combined. And they have well over half a trillion euros in Spanish and Italian debt, most of which is trading at a substantial discount to par, if it trades at all.

As a result, the only way for the French banks to be able to project a credible degree of solvency is for the Eurozone to inject a huge amount of money somewhere. Either it goes into the countries the French banks have lent to, and will then be used to pay back the French banks what they’re owed, or else it just goes into the French banks directly — the TARP solution. But if the EFSF isn’t beefed up and deployed very soon, we could see some extremely big French banks either collapse or get nationalized in very short order. And nobody wants to see where the chain reaction from that would lead.