May 9th: Greece: What’s next? Restructuring. When? Sooner than you think.

Jun. 10, 2011 4:42 PM ET
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This weekend’s not so secret meeting was the first step towards what could be a rapid end game of Greek debt restructuring.  The lenders are unlikely to give Greece the exact same terms as Portugal and seem intent on demanding collateral against future loans.  Greece must resist providing collateral since it now realizes it will not be able to pay back all the debt.  Greece will push hard for better terms, but if collateral is required, it will be in Greece’s best interest to restructure sooner rather than later.  Since the sovereign restructuring process is a negotiation without much ability to use the courts, Greece will find a way to minimize the damage to itself and its citizens while creating a debt structure that is sustainable.  This will all be done while retaining the Euro as its currency.  Greece may be looking at re-introducing new Drachma’s, but this round of restructuring will still be in Euro’s.
Greece is back at the table trying to get better terms
Greece finally pulled the “It’s not fair, you let my brother stay out until midnight, why can’t I?” card this weekend.
I’ve been arguing for what seems like years, that the problem in Greece is one of solvency, not liquidity.   The prior bailouts have not addressed the problem, if anything, the austerity may have added to the problem.  In Europe, the enthusiasm for being bailed out has diminished and the enthusiasm to bailout out others has also decreased.  Across the board it’s easy to see that support for bailout solutions is dropping and politicians who supported prior bailout schemes are getting kicked out of office.
Having said that, each country has to play with the cards they currently have.  Greece is having trouble making the payments.  The austerity programs that they have been forced to put in place are not helping their economy, and more importantly, are not helping their politicians get re-elected as resistance to the bailout within Greece grows.  Could Greece decide to stop paying right now?  Sure, but why play that card right now.  The moves of last week make perfect sense.  By demanding that they get the same terms as Portugal they would reduce their cost of borrowing, extend their repayment dates, and ease the austerity measures they have imposed.  It would make the economic problem slightly less bad and could ease some political pressure at home as they can be less austere if not lavish.  This threat doesn’t really take the default option off the table.  Greece retains the right to default, but in the meantime Greece might as well see if it can extract some more value from the lenders.
This is a difficult request for the countries funding the bailout to digest.  Germany in particular seems to have lost popular support for bailing other countries out.  By agreeing to the request, the EU would ensure that each of the bailed out countries gets the same terms.  Ireland, Portugal, and Greece would all get identical programs, and those programs would have the best terms possible for each of the borrowers.  The lenders will have demonstrated weakness.
In an effort to seem less weak, there is talk about any renegotiated package including collateral provisions.  Effectively the new bailouts would be secured.  That is clearly a much easier sell back home.  They could argue that the lower rates, extended maturities, and reduced control of the new loans are okay because they have taken collateral.  It makes sense for the lenders to talk about this.  Greece would be insane to accept that.
Providing collateral would destroy one advantage that Greece, as a sovereign issuer has, its ability to avoid the courts and negotiate an attractive settlement.
Sovereign Recoveries are far more Subjective than Corporate Recoveries
Back in the 90’s when I was flogging High Yield bonds to Europeans, investor after investor said they preferred Emerging Market debt, because “Sovereigns do not default”.  While sovereign defaults are less frequent than corporate defaults, the resolution of any default is much more complex.  When a U.S. corporation defaults, the creditors know what to expect from Chapter 11 or Chapter 7 bankruptcy.  They can analyze the situation.  They know the rules that will apply to the process and can make value judgments based on a set of rules.  The rules are different in each country, but there are rules that you can rely on when working with a company in bankruptcy.  The preferred solution is a negotiated settlement, but all the parties at the table know that at some point a judge will make decisions and will have to follow the laws when making those decisions.  This is not true for sovereign defaults.
Compare a Sovereign Bond Offering Circular with a Corporate Bond Prospectus.  The Greek bond offering circulars are short and sweet.  Your Status is as a direct, unconditional, unsubordinated, and unsecured lender.  There are no covenants, so I suppose that Greece could effectively subordinate you by offering other lenders security.  The only Events of Default are basically non-payment on this particular bond issue.  There is no cross default provision.  An Event of Default gives you the right to demand immediate payment of your obligation. A corporate bond prospectus is much more complex and the rights and covenants are much more explicit.
So, if Greece fails to pay on a particular bond, the holders of that bond can demand immediate payment from Greece?  What are the odds that Greece would then make payment on that bond?  Assuming there is no chance that it will now miraculously decide to make that payment, what do you as a bond holder do next?  You can sue Greece in a Greek court.  Even if you win a judgment against Greece in a Greek court, how do you enforce the decision?  The reality is that you won’t be able to enforce any decision, assuming you were lucky enough to win one, so you wind up having to sit down and negotiate a settlement with Greece.  Greece will argue that they have no money and can only offer you some new bonds for your old bonds.  The new bonds will have a lower coupon, longer maturity, and the exchange will not be 1 for 1, there could be a principle reduction.  Bondholders will argue that they have lots of money, that they will find ways to enforce their right to get paid, that they will make a nuisance of themselves, and that the offer on the table is so bad that no one will ever lend to Greece again.  The bondholders will demand a better deal than Greece offers.  Greece will counter that if they accept that deal, they will be back at the table in 6 months.  The negotiations will drag on for some time and eventually some settlement will be reached.  It will NOT be the same settlement for each bond and the defaulter is in a much stronger position than a corporation who has defaulted.
Greece should not agree to collateral provisions
So why would a country give up this beneficial negotiating standpoint by agreeing to provide collateral to some lenders?  I do not think it would.  A sovereign is much harder to collect from than a corporation.  Providing specific collateral would take away that benefit.  They should not agree to it. 
To the extent the IMF loans already have some collateral provisions this may accelerate the need to default prior to drawing down the full amount available.  There has been a lot of chatter that argues that Greece will not default or restructure prior to exhausting money available from the IMF.  At one time Greece believed their situation was more of a liquidity problem than a solvency problem.  They may not have been concerned about providing collateral because they fully expected to pay it back.  Now, even Greece understands that they will not be able to pay back all their debt.  If they are providing collateral to the IMF that can actually be seized or sold off, then Greece will not want to use this line fully before defaulting.  If it’s truly a secured line of credit then Greece will not want to use it.  My guess is that the IMF really doesn’t have a security interest that they can exercise, but it is a reason for Greece to default prior to using up the entire line.
Won’t a Greek Default hurt Greece?
I think Greece can do a lot to mitigate the damage to itself from a default.
Greek pension funds hold between 25 and 30 billion of Greek bonds (from what I have read).  Any restructuring would mean a big hit to the asset side of the pension fund.  On the other hand, the Greek government controls the liability side of the pension.  They could change their liabilities to offset the losses on the portfolio.  Heck, they can probably change some assumptions on the asset side and say that with all the changes, even post restructuring the asset side is better than it was before.  Smart people everywhere will realize they aren’t better off after taking a hit on the asset side, but there is no reason the government cannot come up with some spin that makes it attractive.  Moving out of the Euro (which I do not believe is on the table) would be a big deal for the pension.  Assuming the new currency would be very weak relative to the Euro, the liability side would drop massively relative to the asset side (I assume the plan is not 100% invested in Greek government debt).  So the hit to the pension plan, while big, can likely be managed by Greece through spin and some changes to the liability side.  Reduction of pension benefits would be tough politically, but people already know they are coming, and it would be a lot easier for the population to swallow the hit if they feel that foreign banks and hedge funds are suffering from the default. 
Reports show that Greek individuals hold about 6 billion of Greek bonds.  This is the group that the government would least want to hurt.  But as mentioned before, not every bond has to have the same settlement.  It is not clear to me that every holder of a specific bond will get the same settlement.  If I was Greece, I would offer Greek citizens, who hold the bonds in an on-shore account, a settlement where the first 500,000 Euro can be redeemed at par.  Assuming that Greek wealth is distributed similarly to how it is in the U.S., this number would cover most of the domestic holders of the bonds.  It would not help the extremely rich, but if some number like this ensured that 98% of Greek citizens were made whole it would solve the internal problem.  If this covered 5 billion of the 6 billion held, and the average settlement with foreigners was 50%, the cost was only 2.5 billion Euro. 
Is something like that even legal?  Why not?  A corporation could not do something like that, but the government can certainly try, and would likely be successful!  Didn’t the U.S. government increase the FDIC limit at the height of the crisis to prevent runs on banks?  Some investors might fight this hard, but for only 2.5 billion, would the ECB or European governments really make a big stink about it? 
That only leaves the bonds held by Greek banks. I do not think much can be done for them. Maybe Greece can construct a bond with such a low coupon and such a long maturity that they can offer a switch without a reduction in principle. Then in the wonderful world of hold to maturity accounting for banks they could probably keep these new bonds marked at par and not have an accounting loss that quarter. Greece could probably offer these bonds to any bank that holds their Greek debt in a non mark to market account. Personally I would want to short any bank that accepted that change and didn’t sell off in a big way, but it is one accounting trick that the politicians and small banks might believe they can use to fool the market.
Won’t a Germany or others flinch at the last minute?
If Greece seems truly serious about defaulting, won’t the lenders panic at the last minute? Won’t they give in because of the potential damage to banks? If they are anything like our government, the answer is no. They will be asking the wrong people the wrong questions when making their decision.   In Germany, the government will clearly have discussions with DB about their position. My guess is that DB is quite well prepared and positioned for this. They may have been caught off-sides initially when this problem surfaced, but I would be shocked if at this point DB hasn’t managed its position down to a very reasonable number. It will be similar for other big banks in the countries that have provided the most bailout money. What they will miss is the problem won’t be in the big banks who rely on mark to market are comfortable with credit derivatives. The problem will reside in the smaller, less sophisticated institutions. 
I still remember how concerned everybody was about the interconnectivity of the CDS market. The outstanding CDS trades were a big reason for saving Bear Stearns with an immediate guarantee by JPM of all trading lines. By the time Lehman came around, the government and regulators were comfortable that the CDS market was largely cleaned up and wouldn’t trigger a destructive wave of failures. They were actually largely right. What they missed was that the problems resulting from something as old and simple as repo lines and regular settlement periods would be far more destructive.
So if the governments are asking their big institutions what the impact will be, they may be hearing that it’s reasonably controlled. That could give them the confidence to let Greece go. Remember, they are experiencing political backlash at home about the original bailouts and tolerance for more is extremely risky in the pursuit of getting re-elected. In the end they will be surprised by the problems of a Greek default because it will hit everyone in ways no one expected.
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