Greek officials are optimistic that an unprecedented debt swap deal will be accepted by private bondholders, but are threatening to default on any that hold out.
Their optimism came as the Institute of International Finance (IIF), a bank lobby group that is negotiating the debt reduction effort with the Greek government, warned that a disorderly default would trigger €1-trillion ($1.3-trillion) in losses across the euro zone.
The deal is designed to lop more than €100-billion off the Greek national debt. Fears that it might fail or be delayed, combined with lower economic forecasts for China and confirmation that the euro zone economy contracted by 0.3 per cent in the last quarter from the previous period, contributed to a broad market selloff Tuesday.
Despite investor anxiety, some economist expect the deal to succeed. The deadline to accept or reject it is Thursday night. If it succeeds, private bondholders – largely banks – would swap their holdings of Greek sovereign debt for new bonds with longer maturities and lower interest rates. They will take a hit of 53.5 per cent on the swap.
On Tuesday, the main question was whether the bond exchange could go ahead without the messiness of so-called collective action clauses, or CACs, which Athens retroactively inserted and, if triggered, would force any holdouts to participate and change the terms of their payments.
"We expect the debt swap to get done and we'll likely see the CACs triggered," said ING Bank rates strategist Padhraic Garvey.
To go ahead with the bond swap, Greece wants 90 per cent of the bondholders to sign on. Finance Minister Evangelos Venizelos has said the government won't hesitate to unleash the CACs if the rate is lower. "Whoever thinks that they will hold out and be paid in full is mistaken," he told Reuters Monday. "We are ready to activate the CACs if needed."
On Tuesday, Greece's debt management agency issued its own threat. It said the government "does not contemplate the availability of funds to make payments to private sector creditors that decline to participate." The threat was aimed at the 14 per cent of private investors who own Greek bond issues under international law. The rest own bonds issued by Greek law, and might be hit with the collective action clauses.
But if the CACs are used, they could in turn trigger payments under credit default swap contracts, a form of insurance on bond defaults.
"The thinking here is that a voluntary deal would be deemed more tolerable than coercion, and would likely not trigger CDS," Mr. Garvey said. "Coercion would almost certainly trigger CDS."
The International Swaps and Derivatives Association, which is to determine whether the Greek deal will trigger the insurance, said last week that Greek CDS would not pay out because the bond swap did not constitute a "credit event." It also said that use of collective action clauses would lead it to reconsider its stance.
If the CDS were triggered, it appears the payout would not cause huge losses among the banks that wrote the insurance contracts. That's because the net amount of CDS held by investors –$3.25-billion (U.S.) – is small compared with the overall size of the Greek debt restructuring.
Greek government sources on Tuesday expressed confidence that the deal will go through, though they said predicting the participation rate two full days ahead of the deadline would be difficult. That's because many of the investors will not reveal their strategy until the last minute. One government source called the bond swap, which will come with sweeteners such as returns linked to Greek economic growth, "an attractive and unique deal that most will decide to go with."
On Monday, some of the biggest holders of the Greek debt said they would support the deal. The list of supporters includes BNP Paribas, Deutsche Bank, Allianz, National Bank of Greece, Greylock Capital Management and other banks, asset manager, insurers and hedge funds. On Tuesday, the Greek government said the country's six major banks had agreed to join in.
Most hedge funds, however, have not made their intentions clear. The Greek government considers them the wild card – they own as much as one-quarter of Greece's privately held bonds. But Tuesday's default threat might convince them to participate.
The confidential IIF report, from February but leaked earlier this week, said "there are some very important and damaging ramifications that would result from a disorderly default on Greek government debt. It is difficult to add all these contingent liabilities up with any degree of precision, although it is hard to see how they would not exceed €1-trillion."
Italy and Spain, the report said, would require €350-billion in financial support to protect them from the instant contagion of a disorderly Greek default. The European Central Bank would suffer substantial losses on its exposure to Greek debt, estimated at €177-billion, the IIF said.