It will come as no surprise to anyone (other than Dallara and Venizelos perhaps) that all is not rosy in the Greek Public Sector Involvement (PSI) discussions. Whether it is the Kyle-Bass-Based discussions of the need for non-Troika haircuts to be 100% for any meaningful debt reduction, or the CDS-market-based precedent that is set from chasing after a purely voluntary, non-triggering, agreement, the entire process remains mired in a reality that Greece needs much broader acceptance of this haircut (or debt reduction) than is possible given the diverse audience of bondholders (especially given the sub-25 price on most GGBs now). As Goldman points out in a note today, the current PSI structure does not encourage high participation (due to the considerable 'voluntary' NPV losses), leaves effective debt-relief at a measly EUR30-35bln after bank recaps etc., and as we have pointed out in the past leaves the door open for a meaningful overall reduction in risk exposure to European sovereigns should the CDS market be bypassed entirely (as the second-best protection for risk-averse investors would be an outright reduction in holdings). The GGB Basis (the package of Greek bond plus CDS protection) has been bid up notably in the last month or two suggesting that the banks (who are stuck with this GGB waste on their books) are still willing to sell them as 'cheap' basis packages to hedge funds. This risk transfer only exacerbates the unlikely PSI agreement completion since hedgies who are holding the basis package have no incentive to participate at all.
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The Greek bond - CDS basis package price has risen notably in the last month or two as banks offload GGBs to hedge fund basis packagers. While this may help reduce risk exposure on the bank's balance sheets, it further diversifies the ownership of Greek bonds and dilutes the likelihood of any broad agreement to a PSI at all (given basis package holders have zero incentive).
Goldman Sachs: Greek PSI: What To Watch
- Large PSI participation is necessary in order for economic benefits to be meaningful.
- However, the current PSI structure does not encourage high participation.
- Downside risks could persuade investors to participate.
- But in the event that an involuntary solution is chosen, the way that the restructuring deal is imposed will set a number of important precedents for Euro area bonds.
- We discuss a non-exhaustive list of the relevant dilemmas.
Recent press reports suggest that Greek and Euro area officials may be close to an agreement with the IIF on the structure of the Private Sector Involvement (PSI) plan, which is meant to reduce the debt burden for Greece on a voluntary participation basis. The reports suggest that an agreement may be reached by next week. After the agreement is reached, the application of the PSI will commence. In today’s Daily, we discuss the risks involved in the PSI application and the key issues to watch.
Why Large-Scale PSI Participation is Necessary
The key issue in the Greek PSI is the large dispersion of bondholders and the need for a high participation rate in order for the whole operation to be meaningful economically. As we published in a recent note, using Bank of Greece, EBA, and ECB data, we estimate that out of the nearly EUR360bn of Greek debt at the end of 2011, about EUR210bn are held by markets. The rest of the debt represents official loans and bonds held by the Bank of Greece or the ECB.
Out of the EUR210bn of marketable debt, a bit more than EUR85bn is held by Greek banks, mutual funds, and pension funds, about EUR55bn lie with Euro area banks, and the rest with other foreign entities. Of the officially held debt, EUR50bn of bonds have been bought by the ECB as part of the SMP programme.
Assuming that only Greek entities and Euro area banks participate (a large portion of which are represented by the IIF), then a total of about EUR140bn gets restructured. However, for some of the debt that is written off within Greece, the government will need to borrow anew in order to recapitalize local credit institutions. Therefore, from a 50% debt stock reduction in EUR140bn of bonds, the effective debt relief could potentially be as low as EUR30-35bn (there is a significant margin of error in these calculations depending on the way in which that part of the domestic losses will be replenished/distributed).
The true economic gain for Greek debt sustainability stems from external debt reduction. If for example the ECB and the rest of the private sector (ex Greece and ex Euro area banks) were to participate in full, then the effective debt relief could be as high as EUR100bn (about 50% of GDP, or 28% of debt stock reduction).
While in terms of funding needs for the next aid package a more limited participation could work (the assumptions of participation in the 2012 Greek budget are not extreme), in terms of actual sustainability, even a EUR100bn reduction in marketable debt may not suffice to stabilize debt dynamics; an additional reduction in interest payments for official loans may be required. Of course, smaller reductions in marketable debt would further reduce the effectiveness of the restructuring operation.
Structure of PSI Does Not Encourage High Participation
Again as we have discussed in past research, the starting point of 50% face value reduction makes it quite hard for private investors to opt in enthusiastically. This is because with a slightly lower coupon and a maturity extension, NPV losses could be about 70-75% depending on the discount factor, the collateral for the new bond, and the maturity of the original bond.
Such losses touch historical recovery rates in past restructuring episodes in other countries and are close to or even below market pricing in certain circumstances. Furthermore, the hit to front-end bonds could be larger.
As we have suggested in the past, the structure of the PSI could be altered and geared more towards coupon cuts than face value reduction in order to offer more upside for investors to opt in. But that does not seem to be the structure of choice for policy makers at the moment. Thus, without much upside offered to them, investors would participate either if they assessed that there is meaningful downside to opting out or if the restructuring were to occur in a forced manner.
Precedents that PSI Implementation May Set
The threat of a disorderly default, involving minimal recovery rates for near-term bonds and intense pressures on the Greek banking system, could be enough to encourage investors to opt in. However, in the event that participation is poor regardless of the disorderly default threat, and the restructuring becomes involuntary, then the way that investors are treated will set a precedent that will affect the premia and the micro-structure of several Euro area bond markets. To name a few of the key issues to watch:
- How will ECB held bonds be treated? In the event of an involuntary restructuring episode, exclusion of ECB bonds or a separate more favorable treatment could create significant disputes with private investors holding bonds of the same legal statute. More importantly, it could create the impression that under extreme and arguably low-probability circumstances, private sector investors would become de facto subordinated to ECB holdings. The larger the ECB holdings, the larger the losses to the private sector under the same line of reasoning. That could create an adverse connotation to the SMP purchases.
- How extreme will local law be employed in order to enforce certain outcomes? News reports have highlighted the possibility of retroactive imposition of collective action clauses (CACs) on Greek bonds allowing a large majority of bondholders to opt into an exchange that is binding for the rest of the debt owners. This would require a change in Greek legislation. Tweaks of local law to accommodate debt restructuring outcomes could create a broader market segmentation between bonds issued under local law and those issued under UK and law issued bonds in other markets’ law, with investors opting for the safety of bonds issued under foreign law.
- Will CDS be triggered? A CDS triggering event is by no means a desired outcome. However, trying to completely bypass CDS in the event of less than voluntary restructuring would cancel out the validity of the insurance market for sovereign risk. Without credible insurance for sovereign bond holdings, the second-best protection for risk-averse investors would be an outright reduction of these holdings.
Euro area policy makers have been very outspoken in making the point that Greece is a completely different case from other Euro area countries. However, in the absence of a credible commitment to no restructuring in the Euro area outside Greece, markets will continue to price spreads in Euro area bonds in a risk-averse way, factoring in the remote possibility of extreme outcomes occurring elsewhere too.