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Germany nudges Greece towards default

I wonder if George Papandreou knew he would be so blatantly used when Angela Merkel invited him to Berlin.

The German chancellor hosted the Greek prime minister just ahead of a crucial Thursday vote in the German parliament to authorize the expansion of the European Financial Stability Fund, one of the vehicles through which European governments are bailing out Greece and other over-indebted countries of the European Union periphery.

In a pair of speeches to a business conference on Tuesday, Merkel seemed to support Papandreou’s impassioned plea for more time – and by implication, more loans – to recover from the popped economic bubble of the roaring aughties. But behind the scenes, Merkel is in fact trying to unravel the July agreement that was meant to extend Greece’s international bailout through 2014, and instead push Greece into what she apparently hopes can be a managed, relatively mild default. She wants the EFSF expanded not to save Greece, but to contain the contagion from Greece’s default.

I am not criticizing the German chancellor. On the contrary, I applaud this move, as belated as it is. I would applaud her even more if she accepted that Greece is heading inevitably towards a very severe default, and any foreign attempts to make it milder will only fail. But no matter. I suspect that as Greece is pushed towards a hoped-to-be-mild default, markets will quickly get ahead of the politicians.



The news that exposed Merkel’s machinations broke Tuesday afternoon in the Financial Times, which reported that Germany backed by up to six other European states was pushing to renegotiate a key component of the €109 Greek bailout extension agreed in July. On the other hand, the FT also quoted an EU official who said the German government was split between “hardliners” pushing for the renegotiation and “moderates” who weren’t, and there was no mention in the article of where Merkel stood personally.

In separate comments to Greek television on Tuesday, Merkel said the July bailout extension deal might have to be renegotiated, depending on “what the troika … finds and what it will tell us,” an apparent reference to experts representing Greece’s three main official creditors who were scheduled to arrive in Athens by Thursday.

You can take from that what you will. I ‘m convinced Merkel is leading this renegotiation drive.

The FT said the “hardliners” wanted to force bigger haircuts on Greece’s private creditors, most of whom have already agreed to accept a bond swap that effectively delays repayment until somewhere between 2026 and 2050 and sticks them with a choice between a 20% principal reduction or low, AAA-equivalent coupons. This planned swap has been described as a 21% haircut, but the math is debatable.

As I wrote in my September 4 blog post, “Playing Greek Chicken,” what makes the July bond swap deal so controversial is the very generous collateral that it offers to entice private investors into consenting. This collateral is worth 24% to 33% of the principal of the bonds being swapped, and can be claimed immediately, even by investors swapping bonds that don’t come due till as late as 2020. That is a big, sweet carrot. If Greece was cut off from aid and had to negotiate a debt restructuring with only its own resources, I submit that recoveries would be less than 24% and would be delayed for years.

According to official documents, the EFSF will have to fund an estimated €35 billion of collateral to entice private investors to swap €135 billion of bonds, the minimum threshold that private holders must commit for the deal to be completed. But since only an estimated €54 billion of the bonds to be swapped fall due by 2014, the swap would actually only reduce Greece’s funding needs during 2011-2014 by a mere €19 billion, according to the EU’s own estimates.

And, who would have guessed it, those are optimistic estimates. The €135 billion minimum threshold represents 90% of Greek government bonds due by 2020 in private hands. The EU assumes that an even 90% proportion of short-dated (to 2014) and longer-dated (2015-2020) bonds will be swapped. But since most people expect Greece to eventually default despite the bailouts, holders of longer-dated bonds have a huge incentive to swap now and claim some collateral, while holders of short-dated bonds have more incentive to decline the swap and try to squeak through to full repayment before the default.

The EU also assumes that one-quarter of private investors who take part in the swap will choose an option in which they commit to swap when their existing bonds come due, instead of immediately. Swappers who choose this pre-committed, deferred swap option don’t get their collateral until the deferred swap is completed. That would leave them without the guaranteed minimum recovery if Greece defaults in the interim. I’m not the only one who thinks that sounds like a much worse deal than the options to swap and obtain collateral immediately. As one potential swapper wrote in a Q&A published on a Greek government website, the option to complete the swap when bonds come due “would prove to be more interesting if it included a right on the Rollover Par Bonds Defeasance Assets [the collateral] right away from the day of choosing and committing to the options”.

Without the EU’s optmistic assumptions, the amount of bonds due by 2014 that are swapped could turn out to be as low as €37.5 billion, and the cost of collateral during 2011-2014 could turn out to be as high as €45 billion (or even up to €50 billion if 100% of privately held bonds were swapped). In other words, the bond swap could actually increase by up to €7.5 billion, instead of decrease by €19 billion, the amount that the EFSF will need to lend to Greece to keep it afloat through 2014. I strongly suspect that part of the reason Merkel is seeking to renegotiate the bond swap is that commitments to the swap deal are strongly tilted to long-dated bonds and immediate claims for collateral.

All of that assumes Greece makes it to 2014 without defaulting, which of course it won’t. The terms of the bond swap become even more discomforting when one realizes how much they benefit Greece’s private creditors at Eurozone taxpayers’ expense in the event that Greece defaults shortly after the bond swap is completed. The EFSF would need to fund up front at the time the swap is fully committed and accepted €31 billion of collateral, by the EU’s optimistic estimates, and up to a maximum of €50 billion. But the EU-estimated €54 billion (minimum €37.5 billion) of savings to the EFSF in terms of privately held bonds that are swapped instead of redeemed would accrue only gradually over the course of 2011-2014. And in fact there is a high probability that Greece will default very soon.

Instead of cutting Greece’s near-term debt-servicing costs, the bond swap adds near-term debt-servicing costs by offering too much collateral, and by being unnecessarily and expensively open to bonds that fall due after the bailout program’s planned end in 2014. The only motive I can imagine for doing that was to sneak through a back-door bailout of European banks, which would otherwise face smaller recoveries from a Greek default.

But reportedly only about €127 billion of commitments for the swap offer have been received so far, which leaves the deal open to renegotiation. That in turn leaves the whole €109 billion bailout extension agreement open to renegotiation.

Besides, there are other holes in the bailout extension plan that would have doomed it even if it weren’t renegotiated. Besides the likely shortage in the expected €19 billion of savings from the bond swap, the plan anticipates an unrealistic €28 billion of privatization sales. It also continues an already long tradition of underestimating the depth and duration of Greece’s post-bubble recession. Unfortunately, politicians on both sides of the Atlantic are so afraid that realistic economic forecasts would spread negative sentiment, they have become completely incapable of planning for anything other than optimistic outcomes.



Since the planning for Greece’s default is being done in secret, we have to be careful not to take any of the details that leak to the media as anything more than trial balloons. But the FT article jibes with hints that German government officials have been dropping for weeks suggesting that they were seriously discussing an “orderly default” option. It also jibes with the Greek finance minister’s recent statement in a report to the Athens parliament that a restructuring of Greece’s debt with 50% haircuts was under consideration.

In order to impose that large of a haircut, Greece and its official creditors would have to abandon all pretense of it being “voluntary”. Arbiters of credit default swaps, who shamefully agreed not to regard the July bond-swap deal as a default despite its obviously coercive nature, couldn’t possibly deny that 50% haircuts constitute a default. I’m no vulture bond investor, but from what little I know of the topic, it also seems very unlikely that Greece could impose a 50% haircut on private creditors while keeping non-senior official creditors whole.

In other words, there is nowhere to go from the current bond-swap deal except to a full default.

But anyone proposing that Greece impose 50% haircuts on its government bonds is implying that Greece’s foreign creditors will stay involved to guarantee and fund the partial recoveries. On only its own resources, Greece couldn’t afford to pay back even a quarter of its debt load. Greece still runs a large primary deficit. The ongoing contraction of Greece’s economy will only accelerate in the aftermath of default.

Without assistance, Greece would face great difficulty just honoring bank deposits, which after all were lent to the government and spent. They are gone daddy gone. It would be extremely difficult for Greece to reconstitute those deposits in whole in Euros without foreign aid. It would be much easier to reconstitute them by converting them into drachma of Greece’s own making.

In this light, Merkel’s strong insistence in her speech Tuesday that Greece should remain in the Eurozone jibes with the interpretation that she is working on plans to help keep Greece in the Euro after a default. I have to presume her plans include increased funding to recapitalize Greek banks well beyond the €20 billion included in the July bailout extension agreement.

A revised plan incorporating default might also acknowledge that Greek economic trends will probably not improve soon and privatization will probably not happen at all. Or perhaps I’m the one being overly optimistic now.

A revised plan incorporating default would presumably also have to recapitalize the European Central Bank, which holds Greek bonds both in its own portfolio and as collateral against loans to mostly Greek banks.

This all gets very expensive very quickly. Given Germany’s reluctance to commit more funds to the EFSF, or to countenance a more interventionist European Central Bank, I doubt very much that a Greek default can be kept “orderly”, or that contagion to other countries can be contained. Perhaps in the heat of desperation Merkel will be convinced to go along with one more pointless exercise of kicking the can down the road.

One way or another, Europe will be forced to recognize its losses on the aughties bubble, and on post-bubble bailouts and excessive deficit spending. There’s no painless way to get through it, but the earlier the process starts, the easier it will be.

(Originally published Sept. 28 on

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

Additional disclosure: I actively trade US and European equities in line with my bearish outlook.