It’s Still A Greek Haircut — Short Back and Sides

Here’s what’s going on with the European Debt Crisis, and particularly the Greek bond “haircut” negotiations; the fact that the barbershop closed over the long three-day weekend is of much more moment than the Standard & Poor’s downgrade of most Eurozone sovereign credits, which was widely anticipated by the financial markets (we should have guessed they would do it on Friday the 13th).

Here’s the deal:

Greece owes more money to its bondholders than it can ever afford to pay off, so the Eurozone “leaders” came to an agreement with the representatives of the major bank holders of Greek bonds back in December that the holders  would take a 50% haircut on the face value of their holdings in an exchange of those securities for new Greek bonds of considerably longer duration; but they deferred setting the  exact terms of exchange, including importantly the interest rate they would be paid on the new longer term debt  That rate — if set too low – would of course constitute an even deeper ‘haircut’ on the total value of their  holdings.

Most of the banking institutions holding  Greek sovereign debt can ill afford write-down on their balance sheet beyond 50%, which would put them in potential need for financial bailouts from their governments (the same governments S & P just downgraded, in part because of this very risk. But of course these governments would also have to pony- up more money to Greece if the interest rate is set so high on the new bonds that Greece can’t afford to pay the it off when due! It is this “balance of terror” that negotiators in December  felt would  lead to a rational, face-saving (as well as other-parts -of -the-anatomy-saving) deal on the interest rate that all parties could live with, by now.

Most of these bank holders bought the debt early on, but only some have the protection of hedges with credit default swaps, which would  theoretically (depending on the solvency of the counter-party) pay 100% of face value if Greece forced a haircut by legislation and thereby actually “defaulted”. The existing bonds are governed by Greek  law, which Greece could at least try to change to force harsher terms on the holders. Thus  the banks are  being “asked”   to choose between getting 50% or less of face value by “voluntary’ agreement, or, in a some but not all cases, take their chances on getting 100% through their CDS “insurance” under circumstances where the whole financial system might nonetheless collapse (a la Lehman) around them — and their insurers — because a forced conversion would likely foreshadow  a disorderly Greek default, which is exactly what most everyone has been trying to avoid! look like a voluntary haircut deal to me.

But now come some  hedge funds (the only lower form on the financial system’s Tree of Life apparently lower than Bain & Company in a Newt Gingrich taxonomy) that bought up Greek sovereign debt a the current market rate of t20-25% of face value, looking to cash in on the 50% haircut deal that they thought  would be a 100% windfall for themselves. And they have the Gaul (some of them may be French) to be so upset by the low interest rate Greece proposes to pay on their new bonds (with a push from the IMF,  Greece’s lender of last resort, which loves its own pocket book more than the hedge funds’ for sure) that they are threatening to walk away from any “voluntary” deal — I guess because just a 75% profit in a couple months isn’t enough). Greece being aware of this has threatened to change Greek law on the hedgies to force them to go along with a haircut deal struck with a majority of holders (the banks stuck, as described above,  between a rock and a hard place), knowing that this amounts to a default that could bring down the whole Euro house —  including Greece, as their Finance Minister well knows. The hedge funds seem tempted to bet that, rather than see that event happen, even the new Iron Lady of Europe, Frau Merkel, will come up with the  dough to let Greece pay a high enough  interest rate on the new bonds to keep the hedgies in hedge heaven.

Do we see any public spirited citizens in the room? This is not the first time the hedge funds or the Greeks  have played chicken with the world economy. My guess is that sometime in the next week Merkel will politely but firmly tell them  to stop the games or go to hell (namely, back to the drachma). This posture  worked in December with a slightly different cast of characters, and it worked with Berlusconi. But we may have a return to the wilder market days of last fall for a few moments this coming week or two before the dust settles. The effects of S&P’s downgrades can wait on this, because the too-easy ‘solution’ of letting Greece default is too much like the pre-Lehman “moral hazard’ talk that caused us all the trouble in the first place.Because if Greece is the new Lehman, then Italy, or Spain, or even France, is the next AIG, Merrill Lynch, or Bank of America, with or without further downgrades. But definitely without the lender of last resort that the Fed and the US Congress were able to be…unless the Iron Lady takes off the leash she holds on the ECB — dream on hedgies!

 

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