One of the greatest con jobs in the debt markets' history is happening right before our eyes. And it might well have long lasting implications.
What is that con job? It's the "voluntary" restructuring of Greek debt held by private investors. And why is it a con job? Because it has nothing voluntary about it, yet it's being called so in an effort not to trigger the CDS payouts.
How does the con job work? There are a number of organized Greek debt holders that are negotiating with Greece a debt swap, where the private creditors swap their present Greek bonds for new bonds, taking around a 70% present value haircut (or around 50% in terms of face value).
Now, if this were a truly voluntary debt swap, those creditors that did not accept the deal would still keep their (long haired) old bonds. And if they didn't get paid when those matured, then you'd have an old-fashioned default, which would surely trigger every CDS written on Greek debt out there.
So how are Greek authorities going to try and avoid having to pay out on every creditor that doesn't accept the deal? They're going to retroactively change the law on that debt! They'll write "collective action" measures into the contracts, in such a way that, if a given percentage of debt holders accept the deal, all others are bound by it! That is, you won't get paid, you will have to eat the debt swap and the haircut, but it will all be "voluntary" because a large part of the creditors accepted it.
In other words, that is the con job.
But there is more
Not every investor was born the same. So now there's talk that the ECB will swap their own bonds into the bonds … without getting an haircut! And worse still, since the ECB doesn't take losses on the old bonds, it's likely that it will keep this privileged status, or higher seniority, in the new class of bonds as well. Which means that if, and when, this new class of bonds also needs to be written down, again the private bondholders in it will be subject to a larger haircut, since they are in a junior class of debt (even though it's supposed to be all the same, as the old debt was).
What can happen now?
It's likely that some debt holders will challenge the collective action clauses. Now, if these debtholders hold enough Greek debt (a minimum qualifying amount, around just $10 or $15 million), the very fact that they're forced by these clauses, or that that they don't get paid, will be enough to trigger the CDSs.
Can this be avoided? It can, but it will set another troubling precedent - it would involve paying out in full only to the debt holders that refuse to convert their old debt.
Finally, it would seem that this would create an incentive not to convert. So what does the deal include? It includes a tranche paid for not by Greece, but by the troika, of some 30 billion euros, called a "sweetener". This tranche will just be paid to those debt holders accepting the conversion, so anyone not accepting it takes the chance that it will be forced to convert at what amounts to a lower value.
Conclusion
These shenanigans are wildly negative for U.S. banks such as JP Morgan Chase (JPM), Citigroup (C) and Bank of America (BAC) or the sector in general, as represented SPDR Select Sector Fund - Financials (XLF), as well as for European banks. They set several precedents that are hard to justify, with clearly discretionary payments to some debt holders, as well as deep subordination of all the debt holders to the ECB / other official institutions. Over time, these actions mean that whenever there's a default, the recovery that the private sector can expect is much lower as a result. Obviously, the banking sector is more often than not, part of this "private sector". The deal does have positive implications, too, in the way it might avoid the triggering of the CDS contracts, in which the U.S. banks are thought to be net writers. However, as explained about there's still likelihood that they'll be triggered anyway, unless a further discretionary precedent is set (by paying off at par whoever decides not to convert).
They are also negative for the Euro (FXE). This is so not only because we've just witnessed the first massive default of a Euro country (after all, Greece is handing out 74% losses to the private holders of its debt), but also because of all the discretionary actions involved in trying not to set off the CDSs and trying to protect the ECB from losses. These actions show us that investing in Euro debt is subject to very high levels of uncertainty, as the rule of law cannot be taken for granted, and the letter on debt contracts is hardly worth the dematerialized paper it's written on.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
