Finally someone dares to go ahead and say what is on everyone's mind, namely that proclaiming a 60% "haircut" as voluntary is about the dumbest thing to ever come out of ISDA. As is well known, the ECB and the entire Eurozone are terrified of what may happen should Greek CDS be activated, and "contagion waterfall" ensue. The fear is not so much on what happens with Greece, where daily CDS variation margin has long since been satisfied so the only catalyst from a cash flow market perspective would be a formality. Where it won't be a formality, however, is for the ECB which has been avoiding reality, and which will have to remark its entire array of Greek bonds from par to 40 cents on the dollar, which as Alex Gloy indicated earlier, will render the central bank immediately insolvent all else equal. What it also will impact is treatment of all other banks and pledged collateral valuations which is effectively the only bridge in the chasm between Mark to Unicorn and reality. So here is Barclays with what can be the effective dealbreaker, because if a bank: an entity that owns the credit event determinations committee at ISDA, comes out with a contrarian statement to the conventional "stick your head in the sand" wisdom, then pretty soon everyone else will have to follow sui: "In our view, there is little doubt that a large notional haircut of c. 50-60% would be considered a credit event, consequently triggering CDS contracts." And here is why Wednesday's summit is now guaranteed to be a flop: "We consider that launching a hard restructuring without the adequate backstop could be too risky from a financial stability perspective, and we think the ECB would likely take this view." Since the summit will have to announce a decision on the Greek haircuts to be taken even remotely seriously, and since the ECB simply can not make one at this point, look for major disappointment, whether the summit is Wednesday, Thursday, next month, or next year, simply because the ECB will not be ready to pull the trigger for a long, long time.
What happens when a 50% Greek default is declared a "Credit Event"? Here is Barclays' Antonio Garcia Pascual with the explanation:
The FT is reporting today that "European negotiators" have asked the Greek government to impose a 60% notional haircut on sovereign bonds. The EU stance was apparently presented over the weekend by Vittorio Grilli (head of the Italian Treasury and lead European negotiator) to the IIF. Press reports over the past two days have also indicated that the IIF has warned against any haircuts above 40% as they would not be voluntary. The FT also reports that the ECB, France and the IMF remain concerned of the likely credit event and the trigger of CDS contracts. German and Greek newspapers argue that investors should brace for losses between 50% and 60% but they do not provide details as to whether this would imply notional haircuts or whether it would be done through drastic reductions of the coupon and/or extension of maturities. Ekathimerini indicates that Greek FM Venizelos had referred to a "radical haircut" that would not threaten the stability of the Greek economy.
Also, several Greek and international press reports have reported on a leaked draft debt-sustainability-analysis carried out by the IMF in the context of the 5th programme review. The report appears to indicate that a deeper PSI has a vital role in establishing sustainability of Greek debt. In order to reduce the debt below 110% of GDP by 2020, the report indicates that it would require a face value reduction of at least 60% of Greek debt and/or more concessional official sector financing terms.
Our views on a "hard" restructuring
In our view, there is little doubt that a large notional haircut of c. 50-60% would be considered a credit event, consequently triggering CDS contracts.
However, this would imply that the ECB would have given up its "resistance to a hard restructuring". In our view, that resistance has been motivated by concerns on the potential impact of CDS-triggers across the European financial institutions (FIs) and, more broadly, on concerns on financial stability, in particular on the potential trigger of a bank run in Greek institutions and the scope for contagion to other EMU countries. A hard restructuring would have its largest impact on Greek FIs, which hold more than EUR80bn of Greek debt, of which c.EUR45-50bn is held by banks (including bonds and T-bills).
We have argued in several research reports that the ECB could accept a hard restructuring (eg, 50-60% haircut) only after adequate safety-nets are in place. Specifically:
- EFSF has adequate financial resources and there is agreement on how to best deploy them, including in the form of a second programme for Greece;
- Italy and Spain have sufficient support from the EFSF and ECB and the countries are committed to deliver the needed adjustment policies (ie, Italy delivers pro-growth policies and reduces public debt-stock, including through privatisation; Spain completes the restructuring and recapitalisation of the cajas and contains regional deficits);
- ECB maintains its exceptional liquidity facilities, including the SMP programme for as long as is required;
- ECB provides full liquidity support for Greek banks even in the event of a sovereign restructuring (EFSF and IMF, in the context of the Greek programme, would provide funds to recapitalise Greek FIs)
We consider that launching a hard restructuring without the adequate backstop could be too risky from a financial stability perspective, and we think the ECB would likely take this view. Therefore, we would see scope for a possible delay in the announcement of a hard restructuring (ie, a specific size of the haircut) unless there is a substantive announcement on all the other fronts mentioned above.
Other likely implications of a hard restructuring, include:
- A 60% notional haircut would imply a similar reduction in the collateral available to banks using EGBs as collateral (however, collateral at the ECB should normally be MtM, so to the extent it is marked in the 40s, then a 50-60% haircut should not have a substantial impact).
- The ECB would need to authorise a larger use of ELA by Greek banks, which are already using EUR21bn.
- Euro area countries would need to decide how to treat ECB holdings of Greek debt under the SMP programme, c.EUR45bn. A possibility is for the ECB to be taken out of its exposure (possibly by the EFSF) before launching a hard restructuring.