Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Monday, 23 January 2012

The endless pointless argument over Greek debt swap

The wise men of the IIF have drawn a line in the sand about their willingness to accept losses on Greek debt. However, the argument on quantum of haircut and coupon is as relevant as figuring out how many angels can dance on a head of a pin. EU and IMF officials may delude themselves into thinking that PSI (Private Sector Initiative) can lead to debt sustainability but beyond a fear of EU’s iron hand, PSI participants are there to salvage something, anything out of their worthless holdings.

The other fantastical aspect in all these PSI shenanigans is the fact that the chief negotiator (IIF private-creditor investor committee) holds only about €47bn of the €140bn (approx.) worth of debt in private foreign hands and €350bn in total debt.

The fact that Greece would be unable to pay back most of its debt to private creditors was fairly clear by the middle of last year when PSI was first mooted. Since then the proposed haircut has gone from 21% to 70% without making an iota of a difference to future debt sustainability. Losses to private creditors are going to be almost 100% given their de-facto subordination to official creditors like ECB, EU, IMF and other Euro/non-Euro central banks. These losses will be spread over one or multiple restructurings as argued below.

Greek bondholding
Approximate holding (in EUR)
National Central Banks
Greek Central Bank
Domestic banks
Other domestic investors
Foreign banks
Other investors

Even if IIF does come round to an agreement with Greece which is unanimously accepted by its members (it doesn’t appear to be at this time), it only solves the problem for 127bn worth of debt (47 + 80 from domestic holders who will do as told a they are de-facto state holdings now). Assuming further that the remaining 90bn also agree (again doesn’t look likely) then let’s look at how the maths stacks up after all these benign assumptions.

A 70% haircut on notional outstanding (i.e. principal is cut from 100 to 30) achieves a reduction of 152bn. Note that this is higher than the reduction achieved by a 70% NPV haircut as currently envisaged. (Quick bond maths – A 70% reduction in NPV only reduces principal by 57% - 61% for a 4% - 4.5% coupon and 37% for a 2.5% coupon assuming a 9% discount rate)

This takes Greece’s debt to 198bn (90% of GDP). Great success!

Not that fast unfortunately because this would actually be a decapitation rather than a haircut for Greek banks as they take losses of 35bn on top of their current capital shortfall of 30bn. Adding this capital requirement to the debt would take debt back to 198 + 65 = 263bn, i.e 119.5% of GDP.

Now add the projected deficit of 5.4% in 2012 (and recall that from the time Greece has been in intensive care, it has never achieved the deficit target), the debt becomes 275bn, i.e. 125% of GDP.

Fortunately the economy will grow under austerity. Oh. A projected GDP shrinkage of 3% in 2012 (after 4.5% in 2011) leads to the final debt-GDP ratio of 129% at the end of the year.

At the end of 2012 official creditors would hold 210bn out of the 275bn total unless there are private creditors who would invest fresh money to finance the deficit or banks. (If there are such people and are reading this, I have a huge stack of Enron share certificates which offer great value). The next PSI or AEA (Another Euphemistic Acronym) will surely zero the remaining 65bn before touching the 210bn.

So why are the wise men wasting time arguing? There are two reasons:
  1. Coupons determine how quickly money gets repaid before the inevitable default. Therefore the incentive is to make the coupon as high as possible and hope that EU/IMF keep throwing other people’s money at the problem for as long as possible.
  2. Higher coupon bonds are an easier sale in a low interest rate world. With restructuring II likely to follow, banks need to unload restructured bonds to the greater f…”financial expert”. And an investment offering 4.5% coupon (2% higher than German government bonds) on “sovereign” debt is better in this respect.
Whether the talks succeed or fail, the result is going to be the same.

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