With an enormous €14.5 billion bond maturing on March 20th, Greece continues to negotiate with its private sector investors on the reduction of approximately €100 billion of its total €350 billion of debt. Agreement with these investors is intended to reduce the country’s debt from 160% of GDP to 120% of GDP by 2020 and is required in order for Greece to secure from the European Union and International Monetary Fund the second installment of bailout funds, approximately €130 billion, necessary for the country to avoid default. However, the negotiations have been complicated and, perhaps, compromised, not only by Greece’s economic deterioration, but also, at least to some extent, by the involvement of smaller private investors who have purchased Greek debt—and, in some cases, credit default swap (“CDS”) protection on Greece—since the deal was announced in October 2011. At that time, the expectation was that approximately 90% of debt holders would voluntarily agree to the terms of the restructuring, which generally entailed an exchange of existing debt for new, longer-dated bonds. There is now concern that, as currently contemplated, significantly fewer debt holders will voluntarily agree to the proposed terms of the restructuring. One reason for this appears to be the purchase (at a deep discount) of large amounts of Greek debt from banks by funds and others more insulated from political and other pressures to accept a restructuring. This has resulted not only in a decline in debt holders willing to participate in an exchange of debt, but also in the tougher negotiation of terms for the new debt.
The main sticking point in the discussions with private investors has been the coupon of the new debt. In a meeting in Brussels on January 23rd, the euro zone finance ministers rejected the private investors’ proposal that the new debt bear an average coupon of 4%. The Institute of International Finance, which represents the private investor banks and funds, had previously indicated that the 4% offer reflected the investors’ limit for an acceptable restructuring, as investors effectively were being asked to accept a real loss of approximately 70% on their debt (i.e., a reduction of some 50% of the face amount of debt, coupled with a lower coupon, longer maturity and other terms).[1] Even with such a deep haircut, certain observers (including Standard & Poor’s, which rates Greece at “CC”) remain skeptical as to whether a deal with private investors would constitute sufficient debt relief in light of the outlook for the country’s GDP, absent the much larger public sector of investors also taking a haircut.[2]
If Greece is unable to negotiate terms with private investors that are acceptable both to those investors as well as the euro zone ministers authorizing the release of bailout funds (and, of course, actually implement additional austerity measures reflecting several billions of euros in savings),[3] Greece likely will be unable to repay maturing debt as early as March 20th.[4] This would trigger a credit event under CDS contracts, and possibly precipitate Greece’s exit from the euro. Although the net uncollateralized payments that would be owed on Greek CDS are highly unlikely, in and of themselves, to present systemic risk, there is concern that a Greek default would severely shake financial markets.
Even if a deal is reached with private investors and the bailout funds are released, Greece appears to have inched closer to potentially triggering a credit event under CDS contracts. One reason for this is that the holdouts will have to be paid in full, gobbling vast amounts of liquidity and making a hard credit event in the future more likely. Alternatively, Greece could force all holders to accept a restructuring of debt by imposing (since Greek law governs most of the existing bonds) a retroactive collective action clause,[5] which would bind all holders to the decisions of some supermajority. The imposition of a collective action clause would be difficult for debt holders to challenge through a lawsuit, as such an action would likely have to be brought in Greece. However, that alternative is far from ideal, as use of such a clause would almost certainly result in a Restructuring credit event being triggered under the 2003 ISDA Credit Derivatives Definitions.
Until now, the Greek debt restructuring has been intentionally and carefully structured in a way that would not result in the triggering of a credit event under CDS transactions. Specifically, a Restructuring credit event (whether due to a reduction of coupon, extension of maturity or other specified change) is not triggered unless the event “occurs in a form that binds all holders” (emphasis added).[6] Certain market participants have argued that, formalities notwithstanding, the CDS product is simply not providing the contemplated protection, as the market expectation was that such a comprehensive restructuring would indeed trigger protection payments.[7] There have been market calls for revisiting the Restructuring credit event or, perhaps, adding a “soft” restructuring event that could be triggered in similar situations in the future. Nevertheless, any future credit derivatives market changes would not impact outstanding transactions, which are bound by existing terms.
[1] However, debt holders may be eligible for an enhanced payout in the event of an economic recovery. An offer of billions of dollars in short-dated bonds from the euro zone’s temporary rescue mechanism (known as the European Financial Stability Facility) has also been discussed as a potential “sweetener” for private investors.
[2] On a related note, the European Central Bank (the “ECB”) has indicated a willingness to forgo profits on its €40 billion Greek bond portfolio, which was expected to pay €55 billion at maturity, hence further reducing the Greece’s debt burden. The ECB is not able to take losses on its bonds, as this would be viewed as providing monetary financing of Greek government debt, which may be impermissible under relevant treaties.
[3] On February 9th, Greek leaders announced that the major parties had reached a deal on reforms and austerity measures (including budget cuts worth an estimated €3.3 billion) needed to obtain the bailout funds. This follows the February 6th announcement of the lay-off of 15,000 civil service workers.
[4] Note, however, that concern has been raised that the bond maturing on March 20th has a seven-day grace period, during which CDS protection may expire.
[5] Note that, beginning January 2013, it appears that euro zone governments will be required to include collective action clauses into new government bond issues having a maturity greater than one year pursuant to the terms of the permanent €500 billion bailout fund agreed to at an EU summit on January 30th.
[6] Note that parties to virtually all CDS contracts are bound to the decisions of the regional Determinations Committee as to whether a “credit event” has occurred (among other things), hence minimizing the potential for legitimate individual action by disaffected market participants.
[7] Despite this insecurity, based on the results of its most recent quarterly survey of European fixed-income investors, Fitch Ratings announced on February 8th that most investors continue to view sovereign CDS as a useful hedging tool.