Greek ELA growth poses increasing risks for the Eurosystem

As discussed before, the longer it takes for Greece to exit, the more painful it will be for the remainder of the Eurosystem. The latest estimates by Barclays Capital now show intra-Eurosystem liability of €125.5bn (note this is only the central bank liability - does not include EU/IMF loans to Greece, etc.). What's more, this amount is continuing to grow as Bank of Greece (BoG) lends to the banking system via the emergency liquidity assistance (ELA).

The program however was meant to be used in rare cases, not on a mass scale it has been deployed in Greece. Here is what the ECB had to say about the ELA program.

The ECB: - One of the specific tools available to central banks in a crisis situation is the provision of emergency liquidity assistance (ELA) to individual banks. Generally, this tool consists of the support given by central banks in exceptional circumstances and on a case-by-case basis to temporarily illiquid institutions and markets. This support may be warranted to ease an institution's liquidity strains, as well as to prevent any potential systemic effects, or specific implications such as disruption of the smooth functioning of payment and settlement systems. However, the importance of ELA should not be overemphasised. Central bank support should not be seen as a primary means of ensuring financial stability, since it bears the risk of moral hazard. Furthermore, ELA rarely needs to be provided, and is thus less significant than other elements of the financial safety net, which have increased in importance in the management of crises.

But ELA has now become the primary form of funding provided by BoG to the banking system.

Source: Barclays Capital

The ECB is not openly discussing this, but these ELA euros are coming from TARGET2, further raising GoB's liability to the rest of the Eurosystem. Furthermore the collateral requirements for ELA are far less stringent than the ECB's standard financing facilities such as MRO and LTRO. In case of a possible re-denomination, the ability to recover ELA collateral with any material value will be quite minimal.

And in the mean time more requests for ELA funding are coming in:

Reuters: - Credit Agricole has renewed a request for the Greek Central Bank to grant its Emporiki unit access to a liquidity facility which has been made available to some other local banks, the French bank's chief executive said on Tuesday.

Jean-Paul Chifflet said the request was part of a wider range of measures aimed at reducing its potential exposure to Greece, including 1.6 billion euros ($2.04 billion) in European Central Bank financing for Emporiki.

"Finally, we have seriously reiterated our request to take advantage of a direct financing line from the Greek Central Bank, via the ELA (emergency liquidity assistance), the public tool of access to banking liquidity," Chifflet said in prepared remarks at the bank's annual shareholder meeting.

Credit Agricole has suffered some 6 billion euros in estimated losses related to Emporiki since it acquired the Greek bank in 2006.

SoberLook.com

The Ukrainians learning from Greece about "debt restructuring"

The Greek PSI restructuring is giving some indebted nations an idea. Debt restructuring is very doable. Debt holders? That's OK, they will be back. Plus who needs them anyway when you have the IMF, which is easier to push around. One nation that is thinking about taking this route is Ukraine.

Bloomberg: Ukraine invoked Greece’s record debt restructuring in a bid to stave off repaying $3 billion to the International Monetary Fund as Standard and Poor’s warned of funding risks and cut the country’s rating outlook to negative.

First Deputy Economy Minister Vadym Kopylov cited last week’s “huge” deal between Greece and holders of its bonds, saying Ukraine may seek a 10-year delay in repaying the IMF under a $16.4 billion rescue program granted in 2008. The lender said it hasn’t been asked to reschedule payments.

Recently the Ukrainian government decided to increase spending on social programs by at least 1.2% of GDP above what was targeted in the budget as part of the original IMF financing. This is how politicians get reelected (not much different than in the US).

A couple of weeks ago Prime Minister Azarov also said that Ukraine should receive new IMF financing - just because... The new funds would be used to pay interest on the 2008 loan. Of course the IMF didn't go for that proposal.

Now the Ukrainians are having a tough time negotiating natural gas purchases from Russia and may end up buying gas elsewhere. They are looking to get sizable discounts because the nation is running out of funds. Given that the Russians control most natural gas supplies in Europe, it's not exactly clear where Ukraine would be buying it from. And as before, the Russians could simply turn the spigot off. If that were to happen, the Ukrainians would have other things to worry about than the $3bn IMF payment they need to make this year.

Ukrainian CDS widened last week to 757bp. This is far above the Markit iTraxx SovX CEEMEA index of sovereign CDS, which comprises of 15 emerging markets names in the Central  and Eastern Europe, Middle East and African countries (a good benchmark for emerging markets CDS). The chart below is the spread between Ukrainian CDS spreads and the SovX CEEMEA index.

Ukrainian CDS - SovX CEEMEA (Bloomberg)

Bloomberg: Negotiations to restructure Ukraine IMF debt “are on,” Kopylov told reporters yesterday in the capital, Kiev. “Why not? If we have Greece and such huge debts.”

Max Alier, who heads the IMF’s office in Ukraine, said yesterday that the fund has no “mechanisms to restructure or reschedule payments” and hasn’t received “any requests” from the government to do so.

No mechanism to restructure IMF debt? That's too bad, because that's exactly what the Ukrainians may be intending to do. After all they've learned from the best in the debt restructuring business.

SoberLook.com

The latest on the Greek saga

As predicted, the PSI results have triggered a Credit Event. Greece is officially in default. Again, the reason for the big fuss (with some in the financial media completely confused) about the 85% vs. 95% yesterday is that 85% would have resulted in CACs while 95% would not have. That's because 95% would have given Greece enough of a debt reduction without the need for CAC.

The actual number ended up being 83.7% participation for all Greek bonds, 85.8% for Greek Law bonds and 69% for Foreign Law bonds. Here are the results.

Source: BNP Paribas

This afternoon the equity markets reacted negatively to the ISDA announcement that a Credit Event has indeed been triggered. Market's reaction is a bit surprising, given the trigger was fully expected. Some traders are still scared of the old Greek CDS bogeyman.

So what will happen to the holdouts? The 25bn of bonds under the Greek Law will be "CAC'ed" as the chart above shows. They will be forced to deliver their bonds in exchange for the shiny new Greek bonds. The 9bn holdouts of Foreign Law bonds will be looking for door # 4. Some will get "CAC'ed". Others will be able to form blocking positions (each bond will be treated separately).

In the case of a relatively small amount of Greek government guaranteed railway bonds (about 400 million euros issued by Hellenic Railways) there is a chance that bond holders will get paid more than what they would get via the PSI exchange. Here is a good write-up on why that is.

The other holdouts are taking a big chance, although they still have some time (Greece is extending the deadline for Foreign Law bonds tender until  March 23d.) Trying to take on Greece in a UK or a Swiss court is very risky and likely to backfire. Getting a 53.5% of face value haircut is better than getting 100% haircut - plus massive legal bills and years in court (as some have found out the hard way with Argentina). It's not a good idea for the simple reason that Greece simply doesn't have the money to pay them and is unlikely to do so (as it clearly stated again on Friday).

Greece will have a tough enough time just making the ECB whole. The ECB is holding Greek bonds with relatively short maturities (€4.6bn maturing this month alone) and is expecting to be paid par. With the ECB's seniority, Greece will have no money left (see the IFR article on the topic) to pay the holdouts. As the saying goes, "you can't squeeze blood from a stone". The sad fact remains however that unlike many corporate restructurings which are meant to turn the company around, the situation with Greece is grim even after the debt reduction.

IFR: ...one sovereign restructuring adviser said that the situation remained unattractive for bondholders since Greece would remain in such a tough economic position with a heavy debt burden even after the deal cuts out €100bn of liabilities.

“Normally, people tender into an improving situation because they see the debt burden will be reduced and the economy will recover,” he said. “But with Greece it’s very depressing. People tendering here have no option. And I can’t see a significant upside soon.”

And unlike Argentina who has natural resources and was able to rebuild its economy after the default plus a restructuring (although still has major issues), the future for Greece is quite bleak. The likelihood of another default (this time on the new, post-PSI bonds) and an eventual exit from the Eurozone remains high.

Greek unemployment rate (Bloomberg)

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There is no door # 4 for the Foreign Law Greek bond holders

Here is some friendly investment advice for those holding a portion of the €18 bn of the “Foreign Law” Greek bonds. You have 3 "doors" to exit your position.

Door #1: If you can still sell your bonds at a premium to the “Greek Law” bonds, that's your best option, but you should sell soon. That premium will be going away shortly and you will have no choice but to participate in the PSI exchange or deliver your bonds to the CDS auction.

Door # 2: If you don’t sell your bonds now, you may have to exchange them in the PSI. In which case your premium to the Greek Law bonds is gone.

Door # 3: When Greece enforces the Collective Action Clause, which they have recently installed into their bonds, the CDS Event of Default will be triggered (subject to ISDA Determinations Committee decision). Your last exit will be to deliver these bonds into the CDS auction.

Many Foreign Law Greek bond investors are holding out for Door #4, in hopes of creating a “blocking position” that would block the CACs already built into these bonds. The thinking is that it would pressure Greece into some sort of negotiations and incremental value would be extracted. But if you are one of those investors, here is some bad news for you. If you haven’t yet exited via the 3 “doors” (above) and still holding the Foreign Law Greek bonds (after the PSI exchange and the CDS auction), there will not be a door #4. Greece will simply not pay you the coupon or the principal (unless of course you are the ECB.) Remember that by deploying the coercive exchange (CAC) on the Greek Law bonds, Greece will have officially defaulted. There is no reason for them to pay you anything, because the rating agencies will already have Greece declared in default and the CDS will have already triggered. A second default that will occur when you don't get your coupon payment will have no incremental consequences for Greece. Thus a blocking position in the Foreign Law Greek bonds is of no value, since these investors have no negotiating leverage. There is nothing they can do to Greece that hasn't already been done.

Some analysts have thought that by defaulting on Foreign Law Greek bonds after the new (“post-PSI”) bonds have been issued, Greece will trigger a cross-default, effectively defaulting on these new bonds as well. But Greece promptly took the cross-default (proposed) provision out of the new bonds. As far as the Greek government is concerned, they will only have the one new set of bonds. And if you held out on the Foreign Law bonds (and did not take doors 1-3), that’s too bad - you'll just end up getting a doughnut.

SoberLook.com

The market is already quoting CDS on the new Greek bonds

The Greek credit event is now fully priced in. The 5yr CDS is trading at 75/78 points upfront with the cheapest to deliver bonds trading in the low 20s. The points upfront pricing for the one-year CDS is almost the same as that for the 5-year contract - typical pricing for a defaulted credit (CDS of all maturities will settle the same way). The CACs will be enforced this Thursday and the ISDA committee will rule this to be a credit event.

The Telegraph: Authorities in Athens are ready to enforce the controversial collective action clauses, or CACs, to impose the restructuring deal on all bondholders as the number of voluntary agreements look set to fall short of the required amount.

What's next? Well, some technical issues around the auction are yet to be worked out. There is also the issue of funding Greek banks which will no longer qualify for standard ECB funding.

The Telegraph: "Greek banks will probably be barred from normal ECB funding and have to turn to the Emergency Liquidity Assistance [provided by the ECB] instead but for how long, we don’t know.”

And then... the sun will rise and the world will go on as usual. The dealers are already quoting CDS on the new PSI exchange Greek bonds. These are quoted at around 20 points upfront and the bets are on for the next Greek credit event. But the markets are starting to shift focus away from Greece and onto Portugal, with volumes for Portuguese sovereign CDS picking up and spreads continuing to stay wide.

Portugal 5yr CDS spread assuming 40% recovery

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Greek PSI exchange summary - an offer you can't refuse

Here is a brief summary of the PSI exchange offer. It's a great deal - why would anyone become a holdout?

For every €100 notional value of the old Greek Government Bonds investors will get:

• €31.5 euros of new Greek Bonds containing Collective Action Clause under the British law with special features like the Co-Financing Agreement. Note that this doesn't mean 31.5 cents on the euro because the new bonds are nowhere close to being worth par.

• The new bonds will be in 20 different maturity tranches ranging from 2023 to 2042. Coupons will step up over time: 2% through 2015, 3% for 2016-2020, 3.65% in 2021, and 4.3% after that. This creates a principal amortization structure similar to a US 30-year mortgage (except the amortization starts in 10 years rather than immediately).

Source: BNP Paribas

• €31.5 of GDP-linked notes (capped payoff of 1%, start paying from 2015 onwards)

• €7.5 mm 1y EFSF notes (PSI Payment Notes) 
• €7.5 mm 2y EFSF notes (PSI Payment Notes)

• Accrued interest on the old Greek Bonds paid with EFSF 6m T-bills.

This results in the face value haircut of 53.5% and an NPV haircut of over 74% (less than 26 cents on the euro) ignoring the GDP-linked notes. The NPV of the GDP-linked notes is €1-2 assuming they pay maximum amount. And for those who believe these will pay the maximum amount because the Greek GDP will recover, I have a bridge in Manhattan I’d like to show you.

Of course don't call this a Credit Event yet, because it is a totally "voluntary" exchange. There is no default - just some bonds changing hands at 26 cents on the euro.

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The EIB now wants to be senior like the ECB; private bond holders don't stand a chance in subordination circus

One could potentially make a case for the ECB subordinating private bond holders of sovereign bonds. After all the central bank is not an investor, it buys bonds to implement its monetary policy. It's a weak case, but private investors could come to grips with it. But once that door is opened, another set of EU institutions will also quickly become "more equal than others". Out of the woodwork comes the European Investment Bank (EIB) with substantial Greek bond holdings. And that institution also wants to be senior to private bond holders.

Bloomberg: The EIB lends to major infrastructure projects in the EU and beyond. It has shareholder equity of about 41 billion euros and only about 0.1 percent of its loan book is impaired. It has traditionally held privileged creditor status, meaning it’s repaid before other lenders, according to Standard and Poor's.

The EIB owns more than 100 million euros and less than 1 billion euros of Greek bonds, said one of the regional officials, who declined to be identified because the deal to exempt the lender from losses on the notes isn’t public.

Of course, at this stage any institution that has an EU public affiliation and owns sovereign bonds will try to become pari passu with the ECB. Why not. It's free for all in subordinating private bond holders.

Bloomberg:  Investors are complaining that the European Investment Bank doesn’t deserve the same exemption from losses on its Greek bond holdings as the euro region’s central bank because it didn’t buy the notes to support monetary policy.
...
“They really are stretching it a bit, bailing out poor treasury management more than anything else,” said Brian Barry, a strategist at Investec Bank Plc in London. “There must be plenty of jealous treasury departments out there.”

Rainer Schlitt, a spokesman for the EIB in Luxembourg, didn’t immediately reply to an e-mail seeking comment.

And don't forget that Greece also issued some bonds in yen, the so called Samurai bonds. Of course there will be other "public" institutions holding the Samurai bonds who will not want to take losses as well.

Bloomberg:  Some holders of the nation’s yen-denominated Samurai bonds may also avoid losses in the debt restructuring, according to a statement from Shinsei Bank Ltd.

Sovereign bond investors don't stand a chance going forward. With ESM in place and numerous other public EU institutions buying this debt, the Eurozone debt is now basically a CDO with a senior and a junior tranche.

What makes this market particularly dysfunctional is the fact that nobody will know how "thick" the senior tranche is until a default occurs. There is no transparency with regard to which institutions holds which bonds and how much. There is also no rule of law to delineate who qualifies to be in the special club with the ECB.

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Greek CDS settlement auction is ‘lifeguards swim only’

The probability of the Greek CDS credit event (trigger) is now quite high. Once the ISDA committee makes their determination (and with CAC, they have to call it an event), the CDS settlement begins. Modern CDS are cash settled rather than via "physical". In the past the protection buyer often delivered the defaulted bond (usually could be any eligible pari passu bond from that name) in return for par payment from the protection seller. These days the settlement is done via auction of the defaulted bonds that is used to determine the bond "recovery value". That means if you hold a Greek bond and also hold protection you may still have some basis risk.

If your bond is worth say €30 and you also hold the CDS, you would expect the total value of the position to be around par. Suppose you want to hold on to your bonds (post-PSI) instead of delivering them into the auction. If the auction ends up with a recovery value of €32, the CDS will only pay you €68 (instead of 70), and now you end up with €98 instead of par. There is some basis risk between where your bond is marked and where the CDS recovery is established. That's why in preparation for the auction, some investors are using "recovery locks" - swaps that pay the difference between the expected and and the actual recovery levels once the auction is completed.

IFR has a great write-up on the topic:

Recovery locks only tend to trade in the run-up to a CDS auction. Some traders prefer to use these instruments to cover their residual risk in order to avoid volatility in the CDS market going into an auction. Five-year CDS on Greece has also pushed out over the last week by four points to 72 upfront to take into account the higher than expected haircut in the so-called private sector involvement programme that sees investors agreeing to swap existing bonds for new paper.

As discussed earlier, the markets are already pricing in the CDS trigger.

IFR: William Porter, head of credit strategy at Credit Suisse, said the market was already showing general signs of winding down. “The market is liquidating even now at the margin – the open interest is going down, and CDS is priced to an immediate event. You’re effectively conducting the early stages of the auction now,” he said.

Here is the expected timeline for the settlement. The bonds used in the auction to determine recovery will likely be the new, "post-PSI" Greek bonds.

IFR: ...the debt swap will take place on March 12, at which point the CACs will be exercised writing down bonds to 46.5% of face value, and CDS will be triggered. Domestic law bonds should therefore be exchanged for “new” Greek paper before a CDS auction is held, which have traditionally taken at least a week to organise following a credit event decision by the DC [ISDA committee]. As a result, these new bonds should be deliverable into the auction.

This settlement pertains to the Greek law bonds, while there is still uncertainty around €18.5bn of the UK law ("international") bonds. Other uncertainties remain as well, mostly associated with the actual process, given this unusual CDS settlement (vs. say corporate CDS whose settlement is commonplace.) By the time we get to Portugal or Ireland, everyone will be an expert.

IFR: “These auctions are not ‘adults swim only’, they’re ‘lifeguards swim only’ – the market is still learning as we go along. I think the Greek auction will be orderly, but the chance that something really strange might happen can never be entirely ruled out,” Porter said.

SoberLook.com

Certain European banks playing dangerous games with accounting rules

European banks are announcing new losses associated with the Greek bonds writedowns.

Bloomberg: RBS, Britain’s biggest government-owned lender, posted a wider-than-expected full-year loss after taking a sovereign-debt impairment of 1.1 billion pounds ($1.7 billion). Commerzbank, Germany’s second-biggest lender, booked a 700 million-euro ($1.1 billion) writedown on Greek debt in the fourth quarter. Credit Agricole, France’s third-largest bank, reported a quarterly loss after 220 million euros in impairments on Greek debt.

Dexia and the insurance firm Allianz also took losses. Greek bonds have been trading at some 25-30 cents on the euro for some time, so why are these banks taking losses now? It has to do with the wonderful international rules of “held to maturity” (HTM) accounting. Note that in spite of all the myths out there, this rule can be applied to bonds but not derivatives such as CDS. HTM bonds accrue interest (using what’s called Effective Interest Method) and are not marked to market. Impairment is supposed to take place when the value of the investment is deemed by the holder to be more than just temporary. That is if a bank believes it won’t be able to collect 100% of what is due to them under the contractual obligations, it should take a writedown on the bond. But some of these banks will now claim they didn't believe the impairment in Greek bonds is permanent, and that's why they didn't take the writedowns until the details of the Greek PSI have been announced.

Greek 5.2-7/34 government bond prices (Bloomberg)

Yes, this strange accounting rule gives European banks and other financial institutions a great deal of leeway. But for these banks to claim that Greek bonds were not impaired until the PSI deal was announced borders on accounting fraud. These writedows should have taken place months ago. What’s even more absurd is that Steven Hester who runs RBS (the UK “government agency”) is a former CFO of Credit Suisse First Boston (CSFB). He was in charge of, among other departments, product control and financial control, the groups responsible for portfolio valuation and accounting at CSFB. Having been a CFO through the Russian default crisis at CSFB should have made anyone an expert in bond "permanent impairment". Apparently Hester didn't learn his lessons. RBS must be as good with their accounting practices as they were with their risk management.

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Greek PSI outcomes tree: credit event probability at 93%

The CAC legislation has been put before the Greek Parliament.

Reuters: Greece said on Tuesday it would pass legislation that would allow it to enforce losses on bondholders who will not take part in a voluntary bond swap plan, also known as PSI, that forms part of its bailout plan.

The vote is set for tomorrow and is expected to pass. It will retroactively change the existing Greek bonds (only those under the Greek law, since a portion is under the UK law) and require two-thirds majority of the outstanding bonds to force the holdouts into taking a haircut (exchange for new bonds.) The ECB/NCBs will be excluded. Given this is an aggregate CAC (not issue by issue), the Greek banks and other "friends of Greece" holders should be able to form a two-thirds quorum (building a "blocking position" will be nearly impossible).

The BNP Paribas diagram below shows possible outcomes with the highlighted boxes representing the most likely scenario. This supports the view that the most likely outcome (as well as two others) will result in a CDS credit event (trigger) - as discussed earlier. Each final outcome on the tree has a precedent: Uruguay, Anglo Irish (bank), Northern Rock (UK lender), and finally Argentina. Only the "Uruguay scenario" does not end up triggering CDS.

Greek debt (PSI) event tree (source: BNP Paribas)

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Don't forget to add Bank of Greece TARGET2 liabilities to the overall government debt

Now that everyone has become an expert on Greek sovereign debt, here is one additional piece of information worth adding to that expertise. On top of the Greek government's indebtedness, which everyone is so focused on, the Greek central bank has also built up some liabilities. These are the so-called TARGET2 liabilities to the Eurozone.

EUR millions, Source: the Bank of Greece

That amount was around EUR 105bn in December. Normally these liabilities wouldn't be an issue because they are part of the overall payment system and would be consolidated by the ECB. The problem comes in if Greece were to exit the euro. There is no mechanism to separate a single central bank from the rest of the euro-system and would mean that the ECB as a whole would be on the hook for that amount. And unlike government bonds, there is no legal framework to go after the Bank of Greece for the money. If the ECB had trouble taking a loss on EUR 40bn of government debt they bought at a discount, it would be interesting to see how they deal with the Bank of Greece on a much larger amount. Here is the liability side of the central bank balance sheet:

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EFSF used to recapitalize the ECB on Greek debt loss

It looks like the ECB has caved in under the pressure to take a haircut on Greek debt. But only to a point. The central bank is not willing to take a loss, so it will transfer the bonds at cost to the EFSF.

WSJ: The idea is for the ECB, in effect, to exchange the Greek bonds it holds for bonds of the European Financial Stability Facility, the euro zone's temporary bailout fund. The ECB will hold the highly rated EFSF bonds on its balance sheet in place of the Greek bonds it bought as part of its Securities Market Program.

Apparently this exchange won't take place until the deal with the Greek bond holders is finalized. It means that the public sector is in fact taking a haircut, but rather than having the losses at the ECB, they are being taken at the EFSF (assuming the fund is not going to try subordinating the private holders.) The EFSF will not participate in the negotiations - it will be a passive participant in the bond exchange. In effect the EFSF is being used to recapitalize the ECB.

Update: Please see Comments below for an update/clarification from Blankfiend

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In Greek restructuring some institutions are more equal than others

It is understandable that the ECB would be sitting on the sidelines of the Greek restructuring process. But a simple statement from the central bank could go a long way in advancing the stalled negotiations. Draghi needs to agree that the ECB and other public holders of Greek debt must be treated the same way as the private bond holders. The pressure on the ECB to participate in the restructuring is now coming from both sides of the negotiations as well as from the IMF.

Reuters: Athens also wants public creditors like the ECB to take part in the bond swap deal, under which banks and insurers will take real losses of about 70 percent on the Greek debt they hold in a bid to ease Greece's debt burden by 100 billion euros.

Clearly that is not happening and the expectations from the ECB (and Germany who supports the central bank avoiding a haircut) seem to be that the €40bn of Greek debt it holds will have a priority claim. The Eurozone is beginning to sound like something out of Orwell's Animal Farm - all Eurozone institutions are equal "but some are more equal than others".

FT: “The balance between the participation of the private and the public sector is a concerning question,” Christine Lagarde said on a visit to Paris on Wednesday.

Back in the 90s Orange County California defaulted on its debt. All the public and the private holders were treated the same in the process. But imagine holding Orange County commercial paper and being told that a federal government agency who holds the same paper as you will be getting their money first, while you have to take a large loss. This is particularly ugly if you weren't told about this possibility when you bought the paper. (In fact there were rumors at the time that a pension fund may have a priority claim, but they turned out to be false.) Credit markets break down in these situations and that is what the Eurozone is now facing.

It is important to note that even though the ECB losses will be substantial, the central bank bought its Greek paper at a discount, mitigating some of the impact of the haircut. But it is unlikely that the ECB would be swayed by this fact:

Capital Economics: Draghi seems very likely to dismiss the idea, probably on the basis that the ECB’s purchases were designed to ensure the proper functioning of monetary policy - by lowering long-term interest rates - and not to relieve fiscal pressures on Greece or anyone else. What’s more, haircuts would presumably make the ECB even less inclined to buy other governments’ debt. 

All good points, but by avoiding a haircut the ECB will in fact end up raising long-term rates by undermining confidence in the credit markets. It may even end up having to purchase more Eurozone bonds in the future to maintain stability in sovereign debt because of this decision.

Greek default in and of itself is not going to have a dramatic effect on the Eurozone's financial system or the economy. The losses have largely been taken and the markets have adjusted accordingly. But it is the way the process is handled that will set precedence for sovereign credit markets going forward. There is little time left and a mistake at this juncture will have lasting implications for the Eurozone.

SoberLook.com

Der Spiegel hypes hedge funds' role in Greek restructuring - and gets the Hype Award

Mainstream media has been hyping up the hedge funds' role in the Greek restructuring process. The evil speculators are at it again, "holding out" on the voluntary exchange for new bonds. The argument goes that hedge funds bought bonds at a deep discounts and also bought the CDS protection. If there is a disorderly default or an involuntary restructuring, these funds would lose money on their bonds but more than make up for it on the CDS. Der Spiegel argues that these speculators are getting "free money" in this transaction.

Der Spiegel (Stefan Kaiser): Things look different for the hedge funds if an agreement breaks down. In this case, the threat of insolvency exists. The chance that the bondholders would get their money back would dramatically decrease. The bonds would have less value than before, and would no longer be worth €30 million, but say just €10 million. And the CDS guarantees would be due. The hedge funds would, depending on the arrangement of the CDS, receive up to 100 percent of the bonds' nominal value, or €100 million. Under this scenario, the hedge fund that invested €60 million would get €110 in return - a profit of almost 100 percent.

But let's check Der Spiegel's math. Evil Capital Hedge Fund buys a Greek bond at €30 (per Der Spiegel's comment) and a CDS protection that would cost them say €70. According to Der Spiegel the bond ends up worth €10 after the Greek default. The CDS will pay out par less the recovery amount or €100 - €10 = €90. So the trade makes them €20 on the CDS (from €70 to €90) and the bond loses them €20. Evil Capital is net flat on the trade, not up " almost 100 percent".

Some may argue that the shorter maturity CDS is cheaper than €70, closer to €60. But shorter term bonds are actually more expensive, closer to €40 (the 3/12 maturity bond is around €38). So the same math applies and Evil Capital still barely breaks even on the trade. Amazing. No free lunch here - the market is a bit more efficient than Der Spiegel gives it credit for. And Evil Capital may not be that smart after all.

Nevertheless hedge funds are still derailing the negotiations according Der Spiegel and the Greek Government won't stand for it.

Der Spiegel (Stefan Kaiser):  The Greek government, though, has threatened not to tolerate such freeloaders. If an agreement is reached with 80 percent of the bond holders, they want to force the remaining 20 percent to take part in the haircut. In that case, the existing bonds would later be so-called "Collective Action Clauses." The hedge funds could still cash in because in this case the debt repayment would not be voluntary, and it would be considered a payment default, making the CDS also come due, and the gamblers would profit.

But wait a minute here. What other bond holders may be holding out? The answer is that the other big holdout may in fact turn out be the ECB. With the support of the German government, the ECB does not want to participate in the voluntary exchange.

Bloomberg: While the ECB faces pressure to join private-sector investors in accepting losses on Greek debt, the central bank sees any participation as risking damaging confidence in the institution, two people familiar with the Governing Council’s stance said. The debt was acquired for monetary policy purposes and the ECB is firmly opposed to any restructuring, they said on condition of anonymity because the matter is confidential.

Therefore not only there is no free lunch in the Greek CDS-bond trade, but the holdouts may actually be dominated by the ECB, not hedge funds. For their focus on sensationalism rather than unbiased journalism, Der Spiegel and Stefan Kaiser get the Sober Look Hype Award. Congratulations.

And by the way, this Der Spiegel story opens with the following photo. Read the caption.

NYSE business "strained" by the Greece negotiations? And we wonder why the public is confused about financial markets.

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