Shouting Greek rollover, whispering Brady bonds

Posted by Joseph Cotterill on Jun 20 14:04.

In which FT Alphaville once again asks, what kind of fiscal transfer does Europe really want for Greece?

Since some way or other, a transfer it will have to be.

Monday’s answer from the Eurogroup sidestepped the issue, asking bondholders to roll over positions in a way that just appeases rating agencies (actually, the central bank that uses those ratings) enough to stop default. In reality the bondholders who will be most likely to ‘volunteer’, and have the most bonds to volunteer, are those most at risk from default themselves — Greek banks. They’ll also be rolling over into Greek bonds that are at high risk of a second credit event after 2013 or a plain disorderly default before then.

But why roll over into Greek bonds at all?

Because something funny did happen on the way to the rollover agreement. At some point over the weekend, someone in the German finance ministry went off-piste with a very surprising suggestion (via iMarketNews):

According to [Der Spiegel] magazine, citing an internal ministry plan, a “working group Greece” in the German finance ministry is proposing that Greece should get money from bonds issued by the European Financial Stability Facility (EFSF). These top-rated bonds would then be provided to Greek commercial banks through the Greek government, Der Spiegel wrote.

Specifically the bonds would replace Greek government paper as collateral for tender at the ECB. Except they won’t. The idea was quickly canned. It’s not surprising. Eurozone states’ guarantee (via the EFSF) for Greek banks is another fiscal transfer (although this version would keep the banks from failing) and it would require a further increase in guarantees for the Facility. Then again, if the alternative is more bailout loans…

Still – Nomura European rates analyst Laurent Bilke remained interested in a tweaked, roll-over version of EFSF collateral in a piece on Monday:

There are three schematic outcomes for European bond markets:

– (1) bond maturity extensions, which almost certainly would result in default or selective default as viewed by rating agencies (if not for CDS) and is thus a clearly negative outcome leading to contagion in the rest of the periphery and the banking system in Europe;

– (2) rollovers into GGBs (or any loan to Greece) negotiated with some of the largest GGB holders (so called “Vienna option”) which are a soft way of extending maturities, potentially avoiding a default as viewed by rating agencies and positive for the periphery in the short term to the extent that a default and the contagion effect are avoided for now;

– (3) voluntary rollovers into debt that has better credit than GGBs, ideally EFSF bonds (a European version of the Brady bonds) if not enhanced GGBs, which would be very positive because it is the closest thing to a durable solution to the problem (GGBs are removed from the circulation and the new debt is guaranteed by the rest of Europe) while it should considerably limit the risk of a default rating.

The first outcome seems to be no longer be an option since the press conference on Friday. The second is likely, but a form of guarantee/collateral on the new debt, as would be necessary in option 3, has not yet been openly debated and would need to be considered if avoiding [default/contagion] is the objective. If it is part of the package, it would be an important positive surprise for periphery bonds.

Indeed Nomura’s rates analysts have long looked at measures to credit-enhance Greece retiring its debt, arguing that substitution via EFSF bonds would not be a credit event. There is a long, long pedigree of collateralised sovereign debt to back Nomura up here. Not just the experience of Brady bonds in the 1980s (which were finely tweaked to banks’ accounting needs) but the broader drift towards making the EFSF into a big bucket of quality collateral. Already, when you buy EFSF bonds issued to cover the Irish or Portuguese bailouts, you’re buying wrapped Irish or Portuguese bonds, effectively.

Great. Except…

– Would it really stop contagion? If anything there might be even further impetus for the EFSF to provide collateral once the Greek dam is broken. Ireland’s banks have urgent funding problems.

– What happens when Greece properly restructures after 2013? Again the EFSF might have to collateralise bank exposures.

– Add both those problems and… you suddenly have quite a lot of extra contingent liabilities weighing on the states backing the fund. States like Spain, or Italy. You can see the problem here.

No wonder there are other collateralisation plans out there which don’t rely on national guarantees, such as Yanis Varoufakis’ and Stuart Campbell’s modest proposal for the ECB to issue bonds to substitute for state debts instead.

Of course this all seems a bit pie in the sky at the moment with a relatively simple rollover going forward anyway.

But since you’d have to be dropping acid to think that’s even going to do its job of buying time for the next few years, who knows?

Related links:
ESM / EFSF: An inverted capital structure – Self-Evident
Jean-Claude Trichet, the almost-Hamiltonian – FT Alphaville
+++Vienna Plus+++ – FT Alphaville
EFSF mission creep, a collateral story – FT Alphaville

This entry was posted by Joseph Cotterill on Monday, June 20th, 2011 at 14:04 and is filed under Capital markets. Tagged with , , , , , , .

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