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German Finance Minister Wolfgang Schauble (L) with Greek counterpart George Papaconstantinou (R) during an extraordinary euro zone finance ministers meeting at the EU Council in Brussels June 14, 2011, to discuss Greece's fiscal adjustment program. (THIERRY ROGE/REUTERS)
German Finance Minister Wolfgang Schauble (L) with Greek counterpart George Papaconstantinou (R) during an extraordinary euro zone finance ministers meeting at the EU Council in Brussels June 14, 2011, to discuss Greece's fiscal adjustment program. (THIERRY ROGE/REUTERS)

TAKING STOCK

Compromise puts Greece back in holding pattern Add to ...

For a fleeting moment last week, it looked as if German Chancellor Angela Merkel and her blunt-spoken sidekick, Finance Minister Wolfgang Schauble, might actually pull the plug on the latest - but certainly not the last - emergency loan package for insolvent Greece, unless bondholders shared some of the pain. The Germans have made similar noises in the past, only to back off. But they have become more insistent with each crushing defeat Ms. Merkel's Christian Democrats suffer in a state election - five out of five so far this year, despite an improving economy and falling unemployment.

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German taxpayers always hated the idea of bailing out the peripheral euro zone basket-cases. But the Merkel brain trust concluded that making the private sector absorb some losses and forcing more austerity on the shaky Greek government might make new loans a bit more palatable.

The very idea of even a modest haircut enraged the European Central Bank and French government, which warned darkly that the German demand for a seven-year extension of bond maturities or any other form of debt restructuring would threaten the existence of the ECB, severely damage the euro and put the future of the European Union itself at risk. They even raised the spectre of another global financial meltdown of the sort that followed the Lehman bankruptcy in 2008.

Their real fear was the potential of severe damage to the balance sheets of the ECB and the French and other European banks stuck with tens of billions of euros in toxic Greek debt. Extending maturities would not require the private-sector banks to absorb any immediate losses. But the ECB would instantly have to write down the value of Greek government bonds held as collateral for operating loans to Greek banks, causing huge losses. The Greek financial system, which itself is saddled with about one-third of Greek sovereign debt and depends on the ECB lifeline for survival, would undoubtedly be wiped out.

The dangerous game of brinkmanship ended when Berlin and Paris agreed to a compromise: Private creditors' participation in a debt rollover would be strictly voluntary (translation: largely symbolic and meaningless), and everyone could pretend there is no thought of any restructuring. And the Europeans, along with the International Monetary Fund, signalled they would fork over more money to a desperate Greek government, even if embattled Prime Minister George Papandreou can't muster the political support needed for even deeper budget cuts.

All of the political turmoil makes it hard for investors to bet on the outcome for Greek and other peripheral European debt, even for those who specialize in snapping up the junkiest of sovereign bonds.

"In this situation in Europe, you have a lot of different moving parts, a lot of politics," says Robert Smith, an intrepid speculator who made his name and fortune by going where most other investors feared to tread. "It's hard to really get a handle on what's going to happen. That's what I need. So we're not doing anything on this."

In his end of the business, "you have to be inside the tank, not outside," says Mr. Smith, managing director of Boston-based Turan Corp., which trades distressed sovereign credits and advises clients on high-risk bond investments. In other words, unless investors have a decent grasp of what a restructuring would look like and how much of a return they could expect, they should not be rushing into plays like Greek debt.

Still, the potential returns have to be tempting for those who can stomach the risk. The going interest rate on about €28-billion ($39-billion) worth of Greek sovereign bonds maturing this year runs between 14 and 20 per cent. And it jumps to between 25 and 28 per cent on 2013 bonds. Greece must redeem a €6.6-billion bond issue on Aug. 20, as well as the final payment on the coupon. But that's only the biggest of the immediate demands on the empty Greek treasury. Athens needs an average €1-billion a month just to finance its deficit and another €500-million to meet payments on bond coupons.

A gambler could load up on the 2013 bonds carrying a face value of €1-million for about €700,000 or less. "It's not like what you could earn on Canadian treasuries, my friend," Mr. Smith says, laughing. "But I don't see a lot of appetite for these [Greek]bonds at the moment."

Mr. Smith is convinced Greece will weather the latest storm and be able to make good on its maturing bonds over the next couple of years, because the European Union can't afford to let it go down the financial drain. But he warns that Athens will be back at the Brussels trough for more money in another six or seven months. What Greece is looking for, Mr. Smith says, is la quinta pata el perro, or the fifth paw of the dog. He first heard the expression in Argentina, a champion debt re-scheduler and defaulter, where it was used to describe the search for a solution that doesn't exist.

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