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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.

Source: Greece's Proposed 75% Haircut