If Greece quacks like a default …
James Saft is a Reuters columnist. The opinions expressed are his own.
The proposed bailout of Greece probably can’t escape the scarlet D of default, at least if the ratings agencies follow their own guidelines.
Even if the deal goes through, it is insufficient to solve Greece’s debt problems, only buying time for those involved to work out how best to engineer a transfer of bank losses to taxpayers.
Greece approved an austerity package on Wednesday, removing one road-block to further support, but it is still unclear how to get banks to participate in debt relief — a German requirement — without prompting a destabilizing event of default on Greece as a sovereign creditor.
French banks have proposed a burden-sharing plan, supposed to be voluntary, which EU officials are pushing as a means to thread this particular needle.
Under the plan, holders of Greek bonds maturing in the next three years would agree to roll over half of their exposure into new Greek 30-year bonds. Another 20 percent would go to fund a vehicle to act as collateral against Greek default.
The new Greek debt would have an interest rate of 5.5 percent, massively below Greece’s free-market funding cost, plus a potential sweetener of another 2.5 percent depending on Greek GDP growth.
Well, if it walks like a default and quacks like a default; it may just be a default.
This is a deal that is patently designed to avoid a default, and patently makes banks accept diminished economic returns, all important criteria of financial default.
Fitch ratings agency has already said it would very likely view such a deal as a default, and while the other agencies have not yet commented a look at their criteria points to a similar view.
Standard & Poor’s own definition of default labels a distressed exchange offer, “whereby one or more financial obligation is either repurchased for an amount of cash or replaced by other instruments” as a Selective Default.
Moody’s similarly considers a distressed exchange as a default, if either that exchange amounts to a diminished financial obligation compared to the original debt or, the exchange has the effect of allowing the borrower to avoid a payment default in the future.
The ratings agencies will be under massive pressure to bend their rules, so it is always possible that they, perhaps two out of three of them, allow the deal to skate through.
But why would the banks volunteer for this deal?
The French proposal cleverly allows banks to mark the new debt as “held-to-maturity,” meaning that they are not compelled to recognize their obvious losses. It also buys time, not so much time for Greece to recover, because the deal is not generous enough to allow that, but for EU politicians to work out some way for the losses to passed along to taxpayers to shelter the banks.
FORK IN THE ROAD
If the French proposal is labeled a default, it won’t go through, as escaping default is one of its preconditions. This leaves open the possibility of a disorganized default in coming months, an event that would be so destabilizing that Germany may eventually relent on its insistence that private creditors pay a share.
If Greece is downgraded to “default”, the ECB has said it would refuse to accept Greek bonds as collateral for liquidity loans, an act that would at a stroke vaporize much of the Greek banking industry. The obvious thing is for the ECB to bend its rules, but even if it did, you can expect that a Greek default would immediately bring Portugal, Spain, Italy and Ireland back into play, with investors declining to finance them, or even worse, pulling funds from their banks en masse.
Even if the French proposal goes through, it, in combination with the new austerity package has done nothing to lighten Greece’s debt load, only buying time for its economy to recover or for a different political reality to dawn. But Greece’s economy isn’t going to recover any time soon, given the weight of the debt load and the self-reinforcing dynamics of austerity. It will continue to contract, making the debt burden worse.
While the Greek economy needs to reform, that process will not be fast enough to solve these issues, and arguably will be retarded by the severity of the austerity.
Perhaps the hope is that in a year or so opposition to socializing Greek debts will ease in Northern Europe, allowing for a bailout that does not damage banks, or damages them less at a time they have been able to rebuild sufficient capital.
The overall impression is of an elaborate dance intended to shelter banks from damage they are not strong enough to withstand.
That’s not just unfair, and ultimately unproductive, it is a sobering comment on just how weak growth will be while the banks are allowed to heal.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)