Question Of The Day: Could Angela Walk Away?

by: Thomas Warner

As negotiations over Greece's debt restructuring and second bailout drag on, people are starting to doubt there's still time left to finish a deal and avoid default on a large bond payment due in March.

The slow pace of talks is indeed good reason to be nervous. Greek politicians swearing they won't accept more austerity as unions flex their muscles with demonstrative strikes are also good reasons to worry, some.

But here's the question that really matters. Is it possible the negotiations could fail completely? Could Angela Merkel, the German chancellor, call her lawyers home and tell Greece to fend for itself without further aid?

If that happens, there will be havoc. I would expect to see lines outside Greek banks the very next morning. Then would come an announcement that Greece was quitting the Euro and converting all Euro deposits in its banks to drachmas.

Europeans might think they're prepared for such an outcome, but seeing it on the evening news would be something else. Portugal, Ireland, Spain and Italy would likely see bank runs. Europe's recession would deepen and skepticism about its banks and sovereign debts would return with a vengeance. Bears would be back in charge across global markets.

But, as long as Merkel remains committed to completing the best deal with the Greeks she can get, there's not nearly so much in the near term to worry about. The proposal Merkel backed this week to keep aid to Greece in an escrow account shows that she is working seriously on making this deal happen.

The Greeks are also striving for the best deal they can get, using all the tactics they have at their disposal. They could drag out the talks long enough to give markets a serious fright. But they are in too dire of a situation to turn down Europe's aid.

For financial markets, any Greek deal, when it comes, will be judged a very good deal, even if astute analysts who dig into its details say that it only kicks the can down the road. If you're confident that a deal will eventually be done, you should put aside worries about deadlines and see this nervousness as a buying opportunity. If you think there's a significant chance the talks could fail, you should be reducing your exposure to risk.

Default Doesn't Have To Be A Trauma

Even if a deal were announced today, it might very well might be too late to implement the bond swap before Greece is due to repay about €14.5 billion of bonds in mid-March. Sovereign restructurings consume a lot of lawyer hours, and this is a very large and complex one.

But as long as the aid package is still in the works, it won't be any big trauma if Greece misses that March deadline and explicitly defaults.

Many people wrongly assume that European officials are desperate to avoid an explicit default by Greece because they're desperate to avoid triggering payouts on Greek sovereign credit default swap contracts. Actually, Greece will end up triggering its CDS in any case, because there's simply not enough money in this €130 billion bailout plan to avoid it.

The plan required doesn't give Greece enough money to pay in full as many investors as will inevitably refuse to accept the restructuring offer. There are expected to be some €50 billion of hold-outs. Greece has two options to deal with them. One is to "cram down" - to legally force them to accept the restructuring, using new legislation, or the cram-down clauses that already exist in the foreign-law contracts of a few Greek bond issues. The other option is to simply refuse to pay the hold-outs and let them sue (and stew). Either way, CDS would be triggered.

Besides, paying out on Greek sovereign CDS would apparently not cost all that much. According to the Depository Trust & Clearing Corporation, there's only about €2.4 billion of Greek sovereign CDS net exposure outstanding. The remaining €52 billion worth of Greek sovereign CDS are just circular claims that net to nothing for all parties involved, according to the DTCC. I know that sounds odd, maybe even too good to be true, but people who follow CDS markets say it's a normal situation.

There's another reason why European governments have been trying so hard to complete the restructuring without pushing Greece into an explicit default. The matter lies with the European Central Bank and its rules for what it will accept as collateral against its loans to commercial banks. The ECB's new chairman, Mario Draghi, is gaining a reputation for flexibility in this field. But even he could find it hard to justify deeming bonds that are unquestionably in default to be legitimate collateral.

If the ECB refused to accept Greek government bonds as collateral, Greek banks would have no other collateral to replace them with. The ECB would then have to demand immediate repayment of tens of billions of euros worth of its loans to Greek banks. The Greek banks wouldn't be able to repay. The ECB would have to declare the Greek banks in default.

I'll leave it to readers to decide for themselves how much to worry about that possible outcome. As I've already said, as long as Angela Merkel remains committed to completing the best deal with the Greeks she can get, I think there's not really so much in the near term to worry about. I assume the ECB would find some way to continue accepting defaulted Greek bonds as collateral pending the completion of the restructuring.

Merkel Looks To Keep Her Leverage

It's obviously difficult for anyone not on the scene to judge how much risk there is that the talks could fall apart and fail completely. Everyone involved surely knows that the costs of failure would be very high. But that doesn't mean rescue talks can't fail. You do remember Lehman Brothers?

It's clear that Merkel and others around her are fed up with Greece's reluctance to implement austerity. Some are even taunting Greece with public insults, most blatantly by leaking a proposal that would have demanded Greece temporarily cede formal sovereignty over its national budget.

The proposal was widely seen as an attempt to force the Greek government to publicly lick German boots in order to make Germans feel better about funding the bailout. Markets sold off that Monday, as people wondered whether Merkel was deliberately trying to goad Greece into quitting the talks. But only her economy minister from a different coalition party publicly endorsed the proposal. It quietly died.

This Monday, Merkel backed an alternative proposal, which sounds like it could better accomplish the aims of the previous one without going out of the way to humiliate Greece. The new proposal, which would have aid to Greece kept in an escrow account to be distributed only as Greece's club of creditors allow, is very strong evidence that Merkel is serious about finishing this deal.

The point is to keep leverage over Greece after the initial stage of the deal is completed. The tentative terms of the bailout deal announced last fall were very front-loaded. In the first stage, Greece would commit to reforms and a schedule for privatizing state assets and reducing its deficit, and in return receive funding to support the restructuring of its privately held debts and the recapitalization of its banks. In later stages, Greece would undergo regular reviews of its fiscal performance, and, if it passed, would receive additional funding to cover its (hopefully shrinking) deficits.

But those deficits would largely consist of the interest that Greece would owe on its debts to Germany and other Eurozone governments. If public creditors cut off funding, Greece would most likely stop paying the interest, and default on its debts to the rest of the Eurozone. Such a default would not immediately bring down Greek banks, since they would have already been recapitalized. But it would roil European markets and threaten other weak European states with contagion. By trying to punish Greece, Greece's creditors would mostly punish themselves.

Even an escrow account wouldn't fully solve that problem. No matter how the deal is structured, if Greece doesn't live up to it, Europe will again be faced with a decision between increasing aid or letting Greece default. Even after the restructuring, Greece's debts would be dauntingly large.

An escrow account is just the sort of middle-of-the-road compromise you would expect to see at this stage of talks that are heading to completion. It could take a while to agree on the rest of the deal - such as the nitty-gritty details of Greece's budget for the next few years. Market nervousness could heighten as the (not-so-important) March deadline approaches, or even gets missed. But I see this deal getting done.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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