Today is supposedly the day. The initial deadline for Greek PSI will occur later today (unless of course it is extended somehow - but will be released here [10]) and while CAC activation (and hence 90% participation) is the consensus most likely outcome for bonds under Greek law (but not for all bonds under English law) - which the market appears to be very comfortable with given overnight trading - there are still risks, as BofA notes, that a number of low risk but high impact events unfold with extremely negative connotations. Clarifying expectations and market implications, it does seem that while BofA is a little more sanguine than us on this initial deadline, that the market's complacency is extremely high.
BofA: PSI participation
The Greek PSI participation is supposed to be announced tomorrow, at 8am Athens time, on greekbonds.gr [10]. Summarizing views that we have discussed in recent reports:
- The most likely scenario is activation of Collective Action Clauses (CACs) for all bonds under Greek law – about 87% of the total. We expect that PSI consent for these bonds to be above the 66% threshold required to activate CACs. Assuming total PSI participation is below 90%, we do not expect the IMF-ECB-EU Troika to increase the total size of the new Greek package in order to avoid activating CACs. Note that CACs will be activated for all bonds under Greek law together, as the activation threshold does not have to be reached separately for each bond.
- However, CACs may not be activated for all bonds under British law – about 10% of the total. Activation of CACs in this case will be decided on a bond by bond basis, during bond-holder meetings for each bond at the end of March and early April. As PSI participation for some of these bonds may not reach the threshold to activate bond-specific CACs (in some cases as high as 75%), some of them may be repaid in full.
- A small PSI participation for the bonds under British law is not a problem for the success of the PSI, even in the case that CACs cannot be activated for some of these bonds. Activation of CACs for the bonds under Greek law and a small participation for the bonds under British should be enough to bring the overall PSI participation to the target of above 90%.
- About 3% of the PSI eligible bonds are bonds issued by state owned enterprises, which although have no CACs, are within Greece and are expected to participate.
- The only PSI scenario in which CACs are not activated is if participation in the bonds under Greek law is almost full, bringing total PSI participation close to 87%, and participation in the bonds under British law is more than 50%, bringing total PSI participation to above 90%, on a voluntary basis. In this case, activation of CACs for bonds under Greek law would not bring any large savings, while it may not be possible to activate CACs for most of the bonds under British law. Any holdouts will be repaid in full, assuming there is not another debt restructuring in the future. Such a “free-riding” may be politically unpopular, but we believe that the Eurozone authorities may still prefer to avoid a credit event in a member country if they have a choice.
- The worst case scenario is if consent to activate the CACs on the bonds under Greek law is less than 66%. This is a low probability event, in our view, as consent to activate CACs is likely to be well above the voluntary PSI participation. To activate CACs, Greece needs the consent of 66% of those who reply to the exchange offer, provided those who reply are more than 50% of the total debt-holders. Those who tender their bonds – participate in the PSI – give their consent automatically. Those who don't tender their bonds will most likely also consent to activate CACs, because they should still prefer the PSI haircut from what could be a larger haircut outside the PSI. Those who don't reply to the offer don't count, but will be subject to the same haircut if CACs are activated.
Market implications
In our view, an orderly default in Greece should be already priced in. An orderly default includes triggering of CDS contracts and enforcement of the PSI scheme to all debt-holders for bonds under Greek law and some for bonds under British law, within an IMF program, funded by the new aid package. In contrast, a disorderly default would take place if the March 20 debt maturity is missed, or the new program with the Troika is not approved. CDS spreads in Greece have increased sharply to record levels following the country’s recent downgrade to selective default, suggesting a very high probability of a credit event (Chart 1). Although CDS spreads in the rest of the region are also increasing, they seem to move independently from Greek CDS spreads.
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Activation of CACs and triggering of CDS in Greece could even have a positive market impact, at least in the short term. Although we do not believe that PSI the scheme ensures debt sustainability in Greece, it buys time and removes the risk of a disorderly default, at least before the elections in early May.
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Some have argued that triggering CDS in Greece could support sovereign markets in the rest of the periphery, but we don’t consider this to be an important channel. In theory, a credible insurance mechanism should help reduce sovereign borrowing costs. If Greece was to restructure its debt without triggering CDS, it is unlikely than any other advanced economy would ever trigger CDS, with the exception of a disorderly default. This could cause a sell off of sovereign bonds in the rest of the periphery. However, net CDS protection is surprising small for the countries in the region (Chart 2), and it does not seem to be correlated with sovereign risks.
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A number of developments could still affect markets negatively, at least in the short term, but we see them as having a low probability or a small impact:
- Gross CDS exposures in Greece are still sizable (Chart 3). Concerns about counterparty risk and blind spots could trigger some market turbulence following the triggering of CDS.
- Some bond-holders may take legal action against Greece. Such cases could take years to resolve, particularly in Greek courts, but related headlines could raise concerns.
- The decision to activate or not CACs could be delayed, causing market uncertainty. The Greek authorities now seem adamant to activate CACs, but this is expected as they try to maximize PSI participation. All related PSI legal documents make the activation of CACs subject to a government approval, following consultations with the Troika. Such language could suggest that there is not an agreement yet on the PSI participation that is really needed to avoid activating CACs. We also note that the recent Eurogroup decision makes the total size of official funding conditional on PSI participation (see Eurogroup early morning hours). The Greek authorities plan to finalize everything by the end of the weekend, but this may not be possible.
- The participation deadline could be extended. One week could prove to be a short period to allow some investors to get internal approval for participating in the PSI, including from the boards, and to coordinate with their risk management units. “Arm twisting” of some debt holders may also require more time, for example in the case of some Greek pension funds that are not willing to participate in the PSI. Indeed, in the first PSI that was planned for last summer and was never implemented, bondholders were given almost a month to decide, while press reports suggested an increasing participation during this time.
- Consent for the CACs could be below the threshold. As we argued above, this is the worst case scenario, but has a low probability, in our view. In this case, the PSI scheme will have to be abandoned for a forced debt restructuring scheme. It could prove difficult to design a credible new plan given the limited time and the number or parties involved. Moreover, legal challenges to any such plan would be a substantial risk. The failure of the PSI after more than half a year preparations could fuel market concerns about the overall ability of the Eurozone to deal effectively with the crisis, even beyond Greece.