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Greece will eventually restructure

Yesterday, I had the pleasure of talking on CNBC along with Marc Chandler of Brown Brothers Harriman about the European sovereign debt crisis. I also wrote a piece in the New York Times about the same issue, concentrated on Greece. While Marc and I differ somewhat in tone, we are both clear that eventually a restructuring of principal will happen.

Here’s the background to what we said:

  • Greece needs a strategic plan. At a minimum, a soft restructuring – that is to say, a voluntary reduction of interest rates and an extension of maturities – will happen sooner than later under the EFSF facility. While this is necessary, it will certainly not be enough. Eventually, principal reduction will occur.
  • Bank capital must be protected from immediate losses. Principal reduction has to be done with timing and in a way that considers the stress to Greek and foreign bank balance sheets. The problem with an involuntary default is that it would trigger immediate losses and panic. Europe’s banks are still undercapitalised; so such a default must be avoided at all costs.
  • It is unclear whether the move to principal reduction will be messy. An involuntary default would clearly be messy. I don’t see this scenario as likely, and it certainly won’t happen in 2011. Instead, I anticipate a soft restructuring followed by a certain amount of political dithering, which will create contagion that forces a hard restructuring (aka ‘soft default’) down the line. This will be “somewhat messy”.
  • Neither Marc nor I mentioned a euro zone break-up. My view is still that some combination of monetisation and a voluntary default, hard restructuring package is the most likely scenario for Europe. When I handicapped scenarios after the Irish stress tests in late March, I felt this way. I still do now. This means that when you look at the three options for the euro zone, monetisation, default, or break-up, I see break-up as by far the least likely. Again, a hard restructuring/soft default is much more likely.
  • Credit default swaps triggers can be avoided. My view is that a restructuring that involves maturity extension, interest rate and principal reduction via an exchange of bonds or a roll off of maturing issues does not necessarily have to involve a technical default that triggers credit default swap payments. If a strategic plan is properly conceived via bond exchanges, investors will lose money but actual default can be avoided. Obviously, a reduction of principal is still a loss of money for investors. But, it is key that this loss take place with as little unwanted negative consequences for other euro zone debtors and the banking system.

I wrote a follow on piece in the New York Times, detailing how to prevent the ‘somewhat messy’ situation we have now from becoming uncontrollable. Here are what I consider the hallmarks of a good plan:

  • Growth is key. Austerity decreases output, so immediate principal reductions are necessary to keep the debt burden manageable
  • Incentives must be built in for both investors and debtors to share in the upside of growth and recovery. The stick does not work without the carrot.
  • We want to see Greece with market access at reasonable rates as soon as possible. Therefore, any plan must offer credit enhancement because Greece has lost credibility with the market.
  • The banking system must be protected. See my second bullet point in the first section about European bank capitalisation. And note that investors like Felix Zulauf feel that Europe’s banks are winning the battle with regulators to allow them to remain undercapitalised.

Clearly, all of this contingency planning should be done in private right now. In the meantime, the present arrangement, or even a soft restructuring would aid Greece until a permanent solution is found like the one proposed by Evans and Allen.

Please read the full NYT piece on the Greek crisis here along with the opinions of other commentators.

CNBC Video below.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

14 Comments

  1. Anonymous says:

    I have to disagree. Protecting bank capital is just another bailout. Banks need to suffer the consequences of bad lending. If they get bailed out yet again what will stop them lending to bad risks? They will still collect their lending bonuses and when everything collapses get bailed out again. As for not restructuring it just kicks the can down the road till the next government takes over. Then there is the issue of the credit default  swaps. Any deals that are arranged in such a way that avoids a CDS hit means that there will be speculators who will trade in such deals driving up returns to the detriment of governments. 

    In order for the PIIGs to recover they need debt writeoffs, and significant writeoffs as well. Anything less will just delay the inevitable. Greece will need some reforms but its biggest problem is tax evasion. If it can deal with that then it should do well. Globally the CDS market is distorting government policy beyond belief. 

    • I am not talking about a bailout at all. I am talking about how to structure a default. The problem with Lehman’s default was not that it went bankrupt but that it did so in an uncontrolled way. A Greek default that had knock on effects for Europe’s banks would be catastrophic. It may sound good to talk about ‘giving it to them’. But the reality is the situation is more complex than that. 

      • Anonymous says:

        But such structured reductions in debt are not even on the table. All Germany wants is for Greece to send itself into the poor house just so that the german bankers get their money. Austerity never works yet that is what is being imposed on Greece. The debt burden will climb as their economy tanks yet the banks will continue to be bailed out. Europe’s banks are seriously undercapitalised yet governments will not say so because they are trying to con everyone that “everything is okay, and please invest in these banks.” This is not just a european problem. US banks are probably just as weak and if there were a sovereign default many US banks would fold as a result from CDS exposure. Ultimately the tax payers will have to pick up the bill but what will be the eventual bill. I suspect a lot more under a organised restructuring. 

        • As I said “I anticipate a soft restructuring followed by a certain amount of political dithering, which will create contagion that forces a hard restructuring (aka ‘soft default’) down the line. This will be “somewhat messy”.”

          A good plan would be a mix of immediate losses and losses phased in over time. One could make the case that all of the losses should fall on day one since that’s when the default happens. But you can structure a bond exchange offer which is a two- or three-step piece with only a portion of the losses recognized by principal reduction upfront.

          In any event, we are a long way from this. 

          • Anonymous says:

            Phased losses will end up in some playing the system to minimise their losses at the expense of other or the tax payer. Better to have a substantial write off if not even total writeoffs. Ireland will probably be able to grow straight away with it returning to fiscal surplus almost immediately. It could then start rebuilding its economy. Greece will also need total writeoffs but might be able to raise taxation from cutting avoidance, to cover expenditure without having to resort to austerity to balance its books. What is needed is a Swedish style bank restructuring. With the banks branch networks being split off into new good banks, and small depositors beong transferred over, saving small depositiors. All the bad debts and CDS are to stay with the bad banks and only once all losses have been resolved can shareholders get any money back. The problem from 2007 has been a lack of moral hazard and massive systemic risk which has been allowed to continue. One crazy week with a much brighter outlook is far better than a stagnant decade as banks play nations off against each other all while they collect bonuses. 

      • John Haskell says:

        I don’t know [clears throat] but the Lehman debt trading at 9 cents immediately after the BK might have been a problem too.  It’s really hard to go from par to 9 cents “in a controlled way” and the volumes involved (Enron x 3 or approx $150 billion) were astronomical – comparable to the AIG bailout – which after all, came in stages, not over 24 hours.

        Given that GR continues to run a large budget deficit, I strongly suspect that GR’s actual capacity to service debt, so long as they remain in the Eurozone, is near zero.  If “growth is key” – and I agree 100% on that – then isn’t exiting the Eurozone key?  How does a principal reduction cause Greek exporters to become more competitive?

        • It’s not about exports. Greece is not an exporter. It’s about having a debt load that is sustainable and can therefore be refinanced.

          From a credit market perspective, a Greek default would be analogous to a Lehman default because the  discount to par would be 50-80 percent. In a restructuring, you could get away with as little as 25 percent upfront.

          • John Haskell says:

            At 6 rubles to the dollar, Russia wasn’t an exporter either.

          • Anonymous says:

            How can Greece obtain growth? Domestic demand? Do they need to import for that disturbing trade balance and thus, more debt? Can they rely on tourism, which is rampant tax-dodging industry there? Will they get sustainable growth from privatisation, so the government is left with all non-producing, expensive liabilities found from their constitution? Can anyone be sure that companies privatised are not starting tax evasion as well?

            Still, about trade balance. If every single country would be like Germany i.e. heavy exporter where would these exports go eventually? If one country is net exporter somewhere must be a country of being net importer. I think this is mandatory role for Greece based on its level of education, investments and industry. The whole other question is it ok Greece being net importer and running constantly budget decifits, restructuring its debt from time to time.

  2. DavidLazarusUK says:

    I have to disagree. Protecting bank capital is just another bailout. Banks need to suffer the consequences of bad lending. If they get bailed out yet again what will stop them lending to bad risks? They will still collect their lending bonuses and when everything collapses get bailed out again. As for not restructuring it just kicks the can down the road till the next government takes over. Then there is the issue of the credit default  swaps. Any deals that are arranged in such a way that avoids a CDS hit means that there will be speculators who will trade in such deals driving up returns to the detriment of governments. 

    In order for the PIIGs to recover they need debt writeoffs, and significant writeoffs as well. Anything less will just delay the inevitable. Greece will need some reforms but its biggest problem is tax evasion. If it can deal with that then it should do well. Globally the CDS market is distorting government policy beyond belief. 

    • I am not talking about a bailout at all. I am talking about how to structure a default. The problem with Lehman’s default was not that it went bankrupt but that it did so in an uncontrolled way. A Greek default that had knock on effects for Europe’s banks would be catastrophic. It may sound good to talk about ‘giving it to them’. But the reality is the situation is more complex than that. 

      • DavidLazarusUK says:

        But such structured reductions in debt are not even on the table. All Germany wants is for Greece to send itself into the poor house just so that the german bankers get their money. Austerity never works yet that is what is being imposed on Greece. The debt burden will climb as their economy tanks yet the banks will continue to be bailed out. Europe’s banks are seriously undercapitalised yet governments will not say so because they are trying to con everyone that “everything is okay, and please invest in these banks.” This is not just a european problem. US banks are probably just as weak and if there were a sovereign default many US banks would fold as a result from CDS exposure. Ultimately the tax payers will have to pick up the bill but what will be the eventual bill. I suspect a lot more under a organised restructuring. 

        • As I said “I anticipate a soft restructuring followed by a certain amount of political dithering, which will create contagion that forces a hard restructuring (aka ‘soft default’) down the line. This will be “somewhat messy”.”

          A good plan would be a mix of immediate losses and losses phased in over time. One could make the case that all of the losses should fall on day one since that’s when the default happens. But you can structure a bond exchange offer which is a two- or three-step piece with only a portion of the losses recognized by principal reduction upfront.

          In any event, we are a long way from this. 

          • DavidLazarusUK says:

            Phased losses will end up in some playing the system to minimise their losses at the expense of other or the tax payer. Better to have a substantial write off if not even total writeoffs. Ireland will probably be able to grow straight away with it returning to fiscal surplus almost immediately. It could then start rebuilding its economy. Greece will also need total writeoffs but might be able to raise taxation from cutting avoidance, to cover expenditure without having to resort to austerity to balance its books. What is needed is a Swedish style bank restructuring. With the banks branch networks being split off into new good banks, and small depositors beong transferred over, saving small depositiors. All the bad debts and CDS are to stay with the bad banks and only once all losses have been resolved can shareholders get any money back. The problem from 2007 has been a lack of moral hazard and massive systemic risk which has been allowed to continue. One crazy week with a much brighter outlook is far better than a stagnant decade as banks play nations off against each other all while they collect bonuses. 

      • John Haskell says:

        I don’t know [clears throat] but the Lehman debt trading at 9 cents immediately after the BK might have been a problem too.  It’s really hard to go from par to 9 cents “in a controlled way” and the volumes involved (Enron x 3 or approx $150 billion) were astronomical – comparable to the AIG bailout – which after all, came in stages, not over 24 hours.

        Given that GR continues to run a large budget deficit, I strongly suspect that GR’s actual capacity to service debt, so long as they remain in the Eurozone, is near zero.  If “growth is key” – and I agree 100% on that – then isn’t exiting the Eurozone key?  How does a principal reduction cause Greek exporters to become more competitive?

        • It’s not about exports. Greece is not an exporter. It’s about having a debt load that is sustainable and can therefore be refinanced.

          From a credit market perspective, a Greek default would be analogous to a Lehman default because the  discount to par would be 50-80 percent. In a restructuring, you could get away with as little as 25 percent upfront.

          • John Haskell says:

            At 6 rubles to the dollar, Russia wasn’t an exporter either.

          • Anonymous says:

            How can Greece obtain growth? Domestic demand? Do they need to import for that disturbing trade balance and thus, more debt? Can they rely on tourism, which is rampant tax-dodging industry there? Will they get sustainable growth from privatisation, so the government is left with all non-producing, expensive liabilities found from their constitution? Can anyone be sure that companies privatised are not starting tax evasion as well?

            Still, about trade balance. If every single country would be like Germany i.e. heavy exporter where would these exports go eventually? If one country is net exporter somewhere must be a country of being net importer. I think this is mandatory role for Greece based on its level of education, investments and industry. The whole other question is it ok Greece being net importer and running constantly budget decifits, restructuring its debt from time to time.

  3. John Haskell says:

    I would like to see a fuller explanation of how Greece could impose a NPV hit to creditors and not trigger CDS payouts.  If it’s a “roll off of maturing issues,” fine, but that would imply someone standing by with a 300 billion Euro safety net which is hard to imagine.

    • Druce says:

      +1 

      Why pay for CDS protection, if you can take a haircut without the CDS kicking in?If you’re forced into an exchange where you’re not getting timely payment of interest and principal, how is that not a default?And why is it of economic importance and morally justified and who are the players providing protection who need and deserve to be shielded?When I read something like this, it makes me think CDS are very sketchy indeed, and wonder what purpose they serve, besides generating excellent flim-flam opportunities.

      • Greece or the EFSF has the ability to go into the market and buy up debt in the secondary market and exchange this debt for an offering through the EFSF.  That would effectively be a principal reduction. Would investors be willing to sell? And how much would the bonds rally if they were bought? The second option would then be to negotiate a transfer with the holders of individual bond issues much as we saw in Uruguay or Argentina. There would be some holdouts but if investors got 70 cents on the dollar, which is well above where the bonds are now trading, then you could get a lot of investors to trad in. The third option, of course is outright default, which would trigger CDS. And that is the stick used to make the exchange.

        • Druce says:

          Thanks Edward – interesting stuff. If I have bonds and CDS protection, what incentive do I have give up my bonds and take a haircut? Feels like the game is, when the price is high enough, give up all your bonds but 1 and force a default on the last one so you also get paid on your CDS. Becomes a helluva game of chicken. I don’t see how ultimately you avoid either a default, or a very sketchy cramdown which brings into question the whole sovereign CDS market. Which maybe is not such a bad thing, since they change the game in morally hazardous ways (ie manipulating a thin market, creating incentives to force a bankruptcy/default when it may be avoidable, or for the government to void private contracts).

  4. John Haskell says:

    I would like to see a fuller explanation of how Greece could impose a NPV hit to creditors and not trigger CDS payouts.  If it’s a “roll off of maturing issues,” fine, but that would imply someone standing by with a 300 billion Euro safety net which is hard to imagine.

    • Anonymous says:

      +1 

      Why pay for CDS protection, if you can take a haircut without the CDS kicking in?If you’re forced into an exchange where you’re not getting timely payment of interest and principal, how is that not a default?And why is it of economic importance and morally justified and who are the players providing protection who need and deserve to be shielded?When I read something like this, it makes me think CDS are very sketchy indeed, and wonder what purpose they serve, besides generating excellent flim-flam opportunities.

      • Greece or the EFSF has the ability to go into the market and buy up debt in the secondary market and exchange this debt for an offering through the EFSF.  That would effectively be a principal reduction. Would investors be willing to sell? And how much would the bonds rally if they were bought? The second option would then be to negotiate a transfer with the holders of individual bond issues much as we saw in Uruguay or Argentina. There would be some holdouts but if investors got 70 cents on the dollar, which is well above where the bonds are now trading, then you could get a lot of investors to trad in. The third option, of course is outright default, which would trigger CDS. And that is the stick used to make the exchange.

        • Anonymous says:

          Thanks Edward – interesting stuff. If I have bonds and CDS protection, what incentive do I have give up my bonds and take a haircut? Feels like the game is, when the price is high enough, give up all your bonds but 1 and force a default on the last one so you also get paid on your CDS. Becomes a helluva game of chicken. I don’t see how ultimately you avoid either a default, or a very sketchy cramdown which brings into question the whole sovereign CDS market. Which maybe is not such a bad thing, since they change the game in morally hazardous ways (ie manipulating a thin market, creating incentives to force a bankruptcy/default when it may be avoidable, or for the government to void private contracts).