Hostages in the Debt Negotiations

January 13, 2012


Everybody knows that the Greek government has issued more debt than it can possibly repay, which explains why you can buy its government bonds at pennies on the dollar. Today's secondary markets are pricing Greek 10-year issues at prices that give buyers a jaw-dropping 35% yearly yield. By comparison, comparable Treasury securities issued by the U.S. government (which are NOT expected to default) are yielding less than 2%. Germany recently issued bonds at rates even lower than 2%.


The discounts on the Greek bonds have the certainty of default priced into them, and, indeed, the Bloomberg news organization reports that the Greek government has been quietly asking its creditors to accept a 60% reduction in interest payments--which would still keep rates around the 14% level. Meanwhile, the German and French governments have persuaded European banks to exchange their Greek bonds for new securities with longer maturities and lower coupon rates.


The effort to put the Greek debt crisis safely behind us has recently hit a snag, under circumstances that might interest the “Occupy Wall Street” crowd. According to the New York Times, a small group of hedge funds have been aggressively buying up Greek debt at pennies on the dollar, and now are refusing to negotiate any kind of a haircut. They're betting that the European governments will eventually have to pay them the full face value of the bonds they bought at huge discounts--giving them big windfall profits at a time when everybody else is accepting losses for the sake of long-term Euro stability.


It may work. If Greece is forced to break off negotiations, formally default and unilaterally impose the 60% haircut, that default legally becomes a so-called "credit event." A credit event would trigger the payment provisions of untold numbers of derivative contracts, which are basically private insurance policies called “credit default swaps”. The issuers of those contracts--chiefly those same European banks--would suddenly have to pay face value for the Greek bonds that everybody else is buying at a discount. But only if there is a credit event. 


Nobody outside the European Central Bank knows exactly how many of these derivatives are held by European lending institutions, but it is clear from the nature of the negotiations that all parties are carefully avoiding this trigger event. The hedge funds, by demanding either full payment or a credit event, seem to have figured out a way to hold the entire European banking system hostage to their demands for outsized profits.


The story offers a rare view inside the negotiating rooms where the European sovereign debt crisis is being managed, and suggests that responsible parties are, behind the scenes, working to resolve the European Sovereign debt crisis without a lot of the fanfare you see in breathless headlines. As the bank negotiations move forward, the "crisis" might not be as dire as the headlines make it out to be. There is even a chance that the hedge funds' greedy stand could backfire. The ECB is now inserting what are called "collective actions clauses" in their agreements with banks.  This would let the lenders impose the concessions they had to make on all bondholders, if a majority of holders agree to it. The hedge funds would either have to acquire a majority of Greek debt or lose their leverage--and most of their hoped-for windfall.



Edward J. Kohlhepp, CFP®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP®, MBA

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