Remember when we said that "stagflation" would be the word of 2011? We were only kidding. The true word of the year can only be one. Er three. And all credit goes to Goldman Sachs. The firm which always finds a way to call a spade an excavator, has released a note on the Greek "liability management exercise" - yes: restructuring is now such an ugly word it is to be henceforth omitted when discussing what insolvent European vassal states are about to do. In the note - Francesco Garzarelli also confirms another thing about Goldman: why use another three words, namely "we don't know", instead of 10+ long paragraphs which have effectively the same effect. So cutting to the chase, here is Goldman's summary on why a Greek restructuring, pardon, "liability management exercise" would be good, no bad... no good, or unknown: "any transaction would need to be designed extremely carefully and give consideration to the impact on domestic institutions, with the ECB fully on board continuing to extend funding assistance. Further uncertainties relate to ‘second round effects’ and potential exposure of non-bank financials (estimated to amount up to EUR50bn). Funds diverted from repaying foreign creditors in full and on time, be it through debt exchanges or haircuts, could be used to further bolster the capital base of the Greek institutions." So anyway, Goldman also provides another somewhat factual note which lays out the total risk exposure to Greece, and of PIIGS in general: not surprisingly, the countries most exposed (in addition to Greece itself of course), would be Germany, France and Benelux. Here's to hoping banks in these countries have enough excess capital to absorb the massive MTM losses to come.
Summary view from Goldman's Garzarelli:
What’s All This Talk of Greek Debt ‘Restructuring’?
It has been our view for a while that Greece, in agreement with its EMU partners, would attempt to undertake a liability management exercise on its sovereign debt, most likely involving a ‘voluntary’ maturity extension of at least part of the medium and long-term bonds coming due in 2012-15 (cumulatively amounting to some EUR250bn). Here we spend a few lines reviewing our thoughts on the matter, and try to understand what could have recently led to an escalation of talk on the occurrence of such an event.
On the assumption that the severe fiscal adjustments agreed with the EC and the IMF are fully delivered, and that EUR5.5bn worth of privatizations receipts are collected, Greece is projected to have a debt-to-GDP ratio of around 160% by end-2012. The sustainability of such a high debt stock is understandably the subject of an intense debate. But the economy’s medium term growth trajectory – a key factor in any sustainability assessment – is hard to know based on today’s information (the IMF assumes a figure in the ball park of 2.5% in real terms).
In March, the full repayment of funds provided through bi-lateral loans was extended and the interest reduced. This makes it less burdensome for the country to generate enough savings to pay back its EMU partners, which rank pari passu with existing bondholders. However, the adjustment program currently envisages that, already next year, Greece will have to return to the market and raise around EUR40bn in order to roll over 76% of maturing bonds, and meet coupon payments. Crucially, around two-thirds of these disbursements will end up in the hands of foreign creditors, mostly financial institutions in the Euro area.
The IMF’s third ‘program review’ (released in March) highlights this as a ‘notable risk’ – it may prove difficult for the Greek government to re-access markets before the economy and debt dynamics have turned the corner. The price action over the past week (2-yr Greek bonds trade at 75c, or a 20% yield) suggests that such a risk may already have become reality. This argues in favor of at least buying Greece more time to show it can deliver.
Topping up the EUR110bn pool of official fund is an option. But by the end of next year, we calculate that 42% of the overall Greek debt will already be in the hands of the EU, IMF or the ECB (the percentage is higher considering only medium and long term marketable securities). Increasing this share further may have the adverse effect of reducing price disclosure, further disengaging potential bond holders, and ultimately complicating an eventual return to the market. This suggests that a solution involving the private sector may be preferable.
We have not been specific about timing, but have indicated action of any sort would probably come next year, when the Greek primary fiscal balance will probably have swung into surplus, the economy may have stabilized and external conditions further improved. The intensification of talk of an adjustment, including (crucially) statements in this direction from German officials, could be indicative of the fact that some form of burden sharing has become politically palatable both from the Greek side (as the authorities prepare to push more measures through Parliament), and for some EMU members (in which the question of why tax-payers’ money should be used to make financial institutions whole on their past investments is being more frequently asked). Finally, the new round of bank stress tests this June could offer regulators the opportunity to encourage financial institutions to enter into liability management negotiations.
Admittedly, carrying out a liability management exercise is a complex matter and carries several risks. The legal intricacies have been discussed by Mitu Gulati and Lee Buchheit (see: Duke Law working paper no. 47, 2010). More generally, there is the question of how to minimize any ‘contagion’ effects to other program countries and beyond (we have emphasized that Greece is in a league of its own in Euroland and that Ireland and Portugal would not be impaired). And if NPV ‘haircuts’ are contemplated, rather than the re-profiling of a portion of existing bonds as we have in mind, the question is how to calibrate the exercise so that the market agrees that this represents a resolution to the issue of concerns over debt sustainability, and not the start of a sequence of adjustments.
An important contribution to the restructuring debate is offered by a note published earlier today by our colleagues in the European Bank Research team (see: European Bank Exposure to Greece Revisited). Roughly EUR100bn, or 40% of Greek bonds outstanding, are held by Eurozone banks, and the amount is about equally distributed between the Greek banks and those domiciled in the ‘core’ countries. In an aggressive scenario of a 60% notional ‘haircut’, they calculate that Euro zone system-wide losses would amount to around EUR41bn (broken down as EUR24.7bn in Greece, EUR3.8bn in France and EUR7.5bn in Germany), corresponding to at most 3% of aggregate ‘Tier 1’ capital of all European banks.
They estimate that the impact would be manageable for banking institutions in Germany and France (representing 5% of Tier 1 capital in the former, concentrated in a few institutions some of which are backed by the government, and around 2% in the latter), and thus not represent a threat to the stability of the financial system. Clearly the hit on the Greek banks based on such a large restructuring assumption would be commensurately big (wiping out 80% of Tier 1 capital or equivalent to 160% of current market cap).
This indicates that any transaction would need to be designed extremely carefully and give consideration to the impact on domestic institutions, with the ECB fully on board continuing to extend funding assistance. Further uncertainties relate to ‘second round effects’ and potential exposure of non-bank financials (estimated to amount up to EUR50bn). Funds diverted from repaying foreign creditors in full and on time, be it through debt exchanges or haircuts, could be used to further bolster the capital base of the Greek institutions.
So now that that's all clear, here are the facts. And they are not pretty.