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First Act of Greek Default Proceedings Drawing to a Close

Global stock markets are up about 10% since the beginning of the year, volatility has collapsed, US economic data continue to defy even the mild slowdown proponents and the ECB seems to have backstopped the European banking system.

Yes, my dear reader. This is how quickly you move away from the apocalyptic abyss and back to normal. My base case is that we are close to excess complacency in equity markets and a sell off is overdue, but it is exactly also under these circumstances (where smart money start to hedge) that the market may deliver one final run up to get everyone and the postman in before hosing everyone.

In the short term, one of the only remaining stumbling blocks in the form of the ongoing default proceedings in Greece seems to be no match for the ongoing positive animal spirit of the equity market. Only a week ago, we got news that talks in Greece had stalled, but most recently we have been reassured that talks are back on track.

The main niggle on the first occasion appeared to be what kind of interest rate that investors would get on their new bonds and thus, ultimately, the loss of face value currently said to be 50% but also, by some, claimed to be as high 62.5%. Another issue would be whether Greece would pass legislation that forces investors to participate in the debt swap if a majority of investors agree to the PSI terms. This was specifically being discussed in the context of a particular group of investors holding both CDS contracts and the underlying bond and who would maximize their payout on the former by forcing through a hard default.

None of the terms seems have changed massively in the past week, but time is running out with March 20 set as the final deadline as this is when Greece would otherwise have to make a payment of 4.5 billion euros ($18.7 billion) on maturing debt. The general consensus is that if no agreement is reached, this date would mark the hard default. The reason for the optimism is then that we are very close to full surrender in the form of a 90% participation rate of creditors and, we are told, it is only a matter of time before the final 10% agrees.

The details reported so far are as follows;

Quote Bloomberg (21 Jan 2012)

The parties are near an initial agreement under which old bonds would be swapped for new 30-year securities carrying a coupon that would begin at 3.1 percent, reach 3.9 percent and go as high as 4.75 percent, Athens-based newspaper Proto Thema reported on its website yesterday, without saying where it got the information.

The desired macroeconomic outcome of all this is obviously well advertised. In 2020, Greece is supposed to have a government debt to GDP ratio of 120% and presumably some form of growth that would allow this level of debt to stay stationary or perhaps even decline over time.

Let me be clear, absolutely clear, here. Within any conceivably realistic macroeconomic model, there is no way that Greece can reach a stable debt level with moderate growth under these conditions. Under the interest rate scenario noted above (let us say with an average interest rate of 3.8% on the new debt) the nominal interest rate would still be substantially higher than the growth rate of the economy. The only way, the nominal debt level could then be kept stationary is by forcing the fiscal balance into surplus. However, the problem is that this affects the denominator in the debt/GDP calculation by sucking out demand (growth) from an economy already structurally impaired (within a currency union and all that).

The implications are obvious I think . The promises of stability that the PSI currently holds (even if it comes with considerable pledges of IMF money) are bound to disappoint.

First act of several to come

First of all, let us be clear. Despite, politicians’ mortal fright to use the D-word and the media’s acceptance of this fact on the basis that CDS contracts are not activated under the PSI, this is a stone wall default [1]. Anyone, who bothered to take merely a scant look at the history of sovereign defaults will see that the current Greek situation fits well within the framework. Indeed, the proposition that this is not a default because CDS contracts are not activated is ludicrous since in the vast majority of sovereign defaults, the debtor country begins negotiations with creditors well before the actual default is forced upon it. The fact that insurance contracts bought to protect a creditor involved in such negotiations have now been rendered useless says more about the nature of the our modern financial system than it does about the definition of a sovereign default.

Hence, we come to the real nature of this game.

The deal which now seems to be close to completed by no means closes proceedings. It is very likely in my opinion that private creditors who are currently the only ones being forced to take a haircut due to seniority of the IMF and the ECB will face a near 100% loss on their holdings. The argument is simple. Given the amount of debt held by the ECB and the IMF and the fact that these two institutions are senior debt holders the debt held by private creditors becomes junior debt and thus the tranche which takes the first (and in my opinion likely complete) loss in the event of a default.

Of course, once we reach this point the issue of CDS contracts will rear its head yet again since if a 50-60% haircut can be considered voluntary anything beyond this becomes very difficult to characterize as such. Any rating agency would find it difficult not to classify further losses as a default and thus begins the fun in earnest. And then comes the ECB and IMF’s share. It will be political dynamite if the ECB had to print on the liability side to cover losses on the asset side on Greek sovereign debt [2] or if the IMF had to ask its contributors for extra cash to cover for losses on loans made out to Greece or any other economy. Obviously, much will be done to prevent this, but just look at the numbers of Greece’s economy and you will see that it is not that outlandish, especially if Greece opts to stay in the euro zone. Finally, Greece only represents the starter here. Any deal agreed to  in Greece will be ardently watched in Ireland and Portugal who will feel they are entitled to the same deal with their private creditors.

Most tragedies have several acts, twists and turns. Investors should expect no less from the one currently being played out in the European sovereign debt markets.

[1] – I know that the legal smarty pants will wade in now noting that default is only used when a payment is missed, but fact of the matter is that sovereign debt restructurings and defaults throughout time have always been a long process. Claiming that the Greek situation is different because it is allegedly voluntary and CDS contracts not activated is pathetic in my view, nothing less really.

[2] – In practice the ECB could do nothing and see its balance sheet shrink with the amount lost on the asset side (i.e. reduce lending to the banking system (delevering) with the amount lost on the bonds). However, in the event of a large loss beyond provisions (if any) it is likely that the ECB would “need” to credit reserves with the amount lost on Greek bonds (hence printing money) it would do this by increasing open market operations (the LTRO essentially) on the asset side. I mention the liability side first though since the mechanism would essentially be deleveraging. Whenever a bank takes heavy losses on loans it usually responds by raising capital AND reducing lending. Since the ECB can’t really issue debt in the same way as commercial banks, it would need to either reduce lending OR if that is not possible, issue liabilities to match the loss of which it is, as a central bank, free to do at its leisure.

This post originally appeared at Claus Vistesen’s Blog and is posted with permission.

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Emre Deliveli The Kapali Carsi

Emre Deliveli is a freelance consultant, part-time lecturer in economics and columnist. Previously, Emre worked as economist for Citi Istanbul, covering Turkey and the Balkans. He was previously Director of Economic Studies at the Economic Policy Research Foundation of Turkey in Ankara and has has also worked at the World Bank, OECD, McKinsey and the Central Bank of Turkey. Emre holds a B.A., summa cum laude, from Yale University and undertook his PhD studies at Harvard University, in Economics.

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