It is painfully clear now, that in spite of months of talk, headlines, and propaganda, very few people in the EU worked on any details. I thought, at the very least, they were working with traders, lawyers, and structurers and somehow were just getting the wrong answers. But now, it looks like asides from the IMF, no one else was figuring out anything, they were just saying what they thought the market wanted them to say.

IMF States that Greek Bonds Need to be Written down by at least 50%

The troika report, released on Friday was horrific. The situation in Greece was worse than anyone realized, again. The base case no longer puts Greece on a path to self-sufficiency, and the more dire cases, show it is beyond hopeless. The conclusion, which the ECB is still trying to fight, is that Greece requires write-downs of at least 50% of its existing private sector debt to have a chance. Even that level of write-downs doesn’t put Greece on a path to prosperity, but at least gives it a chance. Germany, and other countries seem to agree with this assessment. So, if they want a 50% write-down of Greek debt, let’s do it right.

The IIF should not be part of the write-down, they are glorified lobbyists who have lied from the start

Many argue that the lobbyists already have too much influence on public policy, but at least we still go through the motions of having the governments write the policy. The “Global Association of Financial Institutions” has the interests of their members at heart. They want to do as little as possible and receive the most benefit from doing so. They are not doing this for the “public” good, or what is best for sovereigns, they are doing this for what is best for “banks, globally active securities firms, and insurance companies.” All anyone has to do, is look at their July “21% haircut” proposal for a few minutes, and you can see that it is contrived to actually benefit the banks while sounding like it helps Greece.

The “21% Haircut” Proposal was a gift to banks, not from banks

The IIF plan had 4 options, but 2 were essentially the same, and show most clearly the games the IIF was playing. Banks could exchange existing Greek bonds for new Structured AAA Greek Bonds (“SAG”). The old Greek bonds would be exchange for an identical par amount of SAG bonds. The SAG bonds would have their principal protected by an EFSF zero coupon bond. An aggressive bank could do this switch without taking a write-down. The bank would argue that the principal amount hasn’t changed and the new note actually has the principal amount protected by a much higher rated entity, so they could do a par/par exchange and not have any accounting impact. It may seem bizarre, but most of the bank accounting rules focus on risk of principal and not risk of interest being received. The SAG and the entire IIF proposal was designed so that banks could try and swap out of old Greek debt for new Structured bonds without an accounting impact. Good for individual banks, but bad for the financial system as a whole.

The banks would be taking bonds worth about 40% of par, but marked at 100% of par, and would exchange them for new bonds, which they would also mark at par. No accounting write-down for the banks, but maybe there is a real economic write-down?

There is no Greek bond with over 9 months to maturity trading about 45% of par. Only a third of Greek debt has a coupon above 4.75% (and the 3 bonds with the highest coupons were issued in 1998, 1999, and 2000 where somehow 6.5% coupons were fine).

So, the IIF was going to “force” banks to exchange bonds where all of the exposure was to Greece and are trading at less than 45% of par, and make them take bonds where on day 1 they received a zero coupon AAA bond worth 35% of par, and received (in most cases) higher coupons than on their existing holdings? Yes, they did have to extend the maturity, but the SAG bonds put them in a much better risk position than the old normal Greek bonds. The value of the AAA zero is critical. If banks sold their Greek bonds in the market, they could barely afford to buy the zero, let alone have money left over to get a stream of income from Greece. In the exchange, they were basically getting the Greek flows for “free.” In fact, under any stressed scenario where Greece defaults, the banks that did the exchange were better off. Under any scenario where Greece survives and makes payments, most banks also do better as the coupon from SAG is higher than what they were earning directly. Scenarios where Greece would have made it to the maturity date of your holding and then defaulted are worse, but that is an exceptional case. The reality is that the banks dramatically increased their downside protection, and in most cases actually got some upside from the exchange.

So where did the 21% haircut everyone writes about come from?

The exchange gives the banks the ability to avoid recognizing an accounting loss, gives them higher recoveries in event of future default, and increases the current income for most banks, so clearly I’m missing something as EVERYONE KNOWS that the IIF plan was a 21% haircut?

The 21% number comes from the IIF discounting the EFSF zero at a certain rate, and the Greek coupon flows at another rate and showing that the combined NPV of the SAG bond is 79%. It is as simple as that. They run a calculation that determines the SAG bond is worth 79% and voila – the banks are taking a 21% haircut. But couldn’t you have run the NPV calculation using other yields and got a different answer? Yes. Doesn’t it seem that exchanging an asset with a market value of 40% into something with an NPV of 79% is considered a haircut? Yes.

What about residual bonds that don’t get exchanged? This is a real Problem

This is the real problem with a voluntary exchange. What bonds are covered? Are the bonds held by the Greek pension system covered? If not, then you can see why banks would be reluctant to do anything that changes their status when one of the biggest holders isn’t affected. What about bonds held by hedge funds? And yes, believe it or not, hedge funds do own Greek bonds at these prices. Those bonds would not be affected by any voluntary exchange. Even IIF members were only asked to do 90% of their bonds. In the end, there will be SAG bonds and residual Greek bonds. These residual Greek bonds create a lot of potential problems and conflicts of interest that not only are not being discussed, I now firmly believe, haven’t even been thought about.

Once the “voluntary exchange is done” what will happen to these residual bonds as they mature? Will Greece pay them back at par? If Greece is willing to pay them back at par, they will be rewarding those institutions outside of the IIF control (hedge funds in particular). It will also encourage the IIF members to exchange as few bonds as possible and to hold on to the shortest dated bonds in hopes that Greece will pay them in full. The deeper the “haircut” is (and the more real it is), the more IIF members have an incentive to find loopholes and keep as many residual bonds as possible. It is a weird system, where bonds that don’t “participate” are treated in a better fashion than those that do. In a typical corporate “pre-packaged” bankruptcy filing, there is an incentive to participate. Those bond holders who don’t participate, typically get less by waiting and fighting in the courts. This Greek exchange plan creates the opposite incentive, you are encouraged to avoid participating, as you will likely receive a higher payout later.

Couldn’t Greece default later to punish those who didn’t participate? Yes, they could, but so far the EU and everyone else has shown such an aversion to triggering a CDS Credit Event that they seem unlikely to default in the future. Their (irrational) fear of triggering a CDS Credit Event makes the problem of what to do with residual bonds, that much greater. Creating two classes of bonds is not a good solution, particularly when the methodology for creating the two classes is so subjective.

The wonderful world of CDS

Have the “authorities” asked the banks for all of their CDS trades? The regulators or EU by now must know who has net exposure to CDS and where the counterparty risk lies? It would seem to be a no brainer to have collected the data and know with certainty, who has what position, at least for regulated entities. Although it is a no brainer to me, I wonder if they have done this?

I have written about CDS and the benefits of triggering it before, so I will only mention them briefly. Banks that hold Greek debt and are being forced to take “voluntary write-downs” who bought CDS to hedge themselves are being punished. They are being taught a lesson that hedges, at least in regards to sovereign debt, are a bad idea. This is a big problem going forward that the EU is creating as it shows banks that managing risk through hedges is extremely risky when they can change the rules at any time. It is also ironic that the “basis trade” of owning bonds and being short CDS would work for hedge funds since they don’t have to agree to anything on their bonds if it is “voluntary” and run through the IIF. Even more perverse, it encourages the “dumb” banks, that selling protection (getting long credit via CDS) is better than buying bonds. A bank that bought €100 million of bonds, will be worse off than a bank that wrote $100 million of credit default swap protection? An ironic and frankly stupid outcome of this fear of CDS. The EU should be encouraging bond purchases, not leveraged CDS risk taking.

All DTCC evidence (which covers everything except some legacy trades and structured trades) shows that the Net exposure on Greek CDS is less than 1% of the bonds outstanding, and that across all sovereigns the Dealers (big banks) are net short credit via CDS. In fact across all sovereigns the DTCC data shows that dealers have bought $21 billion of credit protection, so are in fact net short. This fits the line that many bank CEO’s state they have minimal net exposure as they have bought hedges.

It is time for a real default

The IMF and other countries finally realize real losses need to be taken and recognized on Greek debt. For once, they can step back, break away from their existing thinking – the IIF’s PSI proposal – and do something that will actually work.

Greece needs to say it is not paying back debt and stop paying back debt. It should offer to exchange old bonds for a series of maturity staggered new bonds, with an exchange rate of 40% of par. After the exchange period, Greece should not pay any of the residual bonds and fight tooth and nail to give the lowest possible recovery – zero.

This will ensure that all bonds are covered. You do not want two classes of bonds, and you do not want the option in the hands of the bondholders, it has to be controlled by the issuer. The likelihood of getting a higher recovery in the future by not accepting the initial exchange, has to be low (and it should be since the reality is sovereign debt holders have very few rights in the event of default).

The CDS will trigger and in the end payments will be made and there will be no calamity directly from the CDS market. If there is any calamity, it will come from those who hold bonds and were not prepared. If the market can handle a CDS Credit Event on Greece, and I think it will, that would be a big positive for the market. It also means that banks don’t have to sell other PIIGS debt because they know their hedges are good. Avoiding a CDS Credit Event leaves question marks, and hopefully after 18 months of this, the EU and IMF are finally realizing that closure can be better than kicking the can.

A real default is the only good and fair way to ensure the write-downs occur and the system can move beyond Greece. Realizing that the problems in Ireland and Portugal and Italy and Spain are similar to but not correlated with Greece, may also help.

Copyright © 2011 · Peter Tchir

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