Over the past two weeks, Greece has begun the process of asking its private lenders to forgive more than half the outstanding debt they hold. Today its euro area partners also released a 30 billion euro chunk of a 130 billion euro ($170bn) loan that finances the process.
The Institute of International Finance, which represents the majority of private lenders, has declared that “if successfully concluded, the debt exchange will be the largest ever sovereign debt restructuring and could lead to a reduction in the debt stock of approximately €107 billion for Greece,” equal to half its GDP last year.
Here is a brief explanation of where we are in Greece’s second bailout, and what lies ahead:
1. Where are we in the process of Private Sector Involvement (PSI), as the debt forgiveness exercise Greece negotiated with private lenders is known?
• Standard & Poor's (and earlier Fitch's) rating agency on Tuesday declared Greece in temporary selective default. This was partly because a week ago Greece voted a framework law on Collective Action Clauses, which prepares the ground to coerce some private lenders to accept the discount, or writedown, of 53.5 percent to the principal of their existing Greek bonds. But it is mostly because Greece issued Letters of Invitation to those private lenders to participate voluntarily in a bond exchange programme, which will be the means of that debt forgiveness. Those lenders hold some 206 billion euro ($277bn) of Greece’s estimated outstanding debt of 350 billion euro ($470bn).
• The declaration of Greece in selective default (because it will default on a part of its debt) in turn triggered the European Central Bank's statement last week that it can no longer extend liquidity to Greek banks. This stems from ECB rules and is automatically invoked. Like the selective default status, it is temporary and should be revoked with Greece’s securing the 30 billion euro advance on its loan.
• A third consequence of Greece's passing Collective Action Clauses and officially asking for debt forgiveness is that the International Swaps and Derivatives Association was asked to rule on whether a credit event had occurred. It is under intense pressure from hedge funds and other buyers of default insurance to say yes, triggering payment. At present it has ruled in the negative. The main criterion for its decision is whether the debt reduction is being carried out voluntarily. Lenders had until today to declare themselves. Greece needs until next Friday to gauge what proportion of its private lenders will participate, possibly longer, but it is unlikely to be 100 percent. Greece is hoping for at least 90 percent, but has legislated that it may invoke the Collective Action Clauses if it has a minimum participation of 66 percent. That will be the controversial part of the process. The ISDA will again be called upon to rule on whether a credit event has taken place. Its press releases hitherto suggest that Greece fulfils many of the criteria for a positive ruling if those criteria are combined with a form of coercion. Another potential hiccup is that lenders may legally challenge the CACs, though they will have to do so in Greek court. Legal challenges do not overturn the entire Private Sector Involvement, however. They are adjudicated on a case-by-case basis.
• The ISDA's declaration of a credit event does not upend the entire PSI process either, but it would be a victory for the derivatives and swaps markets, and could create more market pressure on the euro.
2. How will it take the debt restructuring to be carried out?
• Willing lenders will surrender their existing bonds. In return, they will receive a basket of new Greek bonds worth 46.5 percent of what the old ones were worth at face value. So if your old bonds were worth $100, your new ones are worth $46.50. But even that is not the full extent of your loss as an investor. That is just what you lose on the principal you lent the government.
• Bonds also carry an interest coupon, which represents the investor’s profit. That, too, is being cut. Most of the new bonds mature between 11 and 30 years from now and carry interest of just two percent for the first three years, three percent for the following five years, and 4.3 percent for the following 22 years. The weighting is clearly designed to encourage investors to hold onto these bonds for at least a decade, rather than turning around and dumping them, which would duplicate the problem that exists with the old bonds. This is why the IIF says that while the reduction to Greek outstanding debt today is in the order of 107 billion euro ($144bn), the real loss to investors over 20 years is closer to 150 billion euro ($202bn).
• It took tough negotiations to force the private sector to accept a three-quarter loss on its long-term earnings. IIF negotiators were forced to accept a loss 3.5 percent deeper than previously agreed during a 15-hour Eurogroup meeting on 21February. To get an idea of why it took months of negotiations to nail down the interest coupon of the new bonds consider this: In 2009, a year before it entered eurozone life support, Greece was still able to borrow from markets at 4.3 percent. That rose rapidly as the country’s political system showed itself unable to rapidly cut a 15.5 percent budget deficit. Greece sold its last multiple-year bonds in March the following year at interest of 6.25 percent. Its first eurozone bailout came two months later.
• As a sweetener, 15 percent of the 46.5 percent of face value investors get to hold onto will be in the form of two-year, short-term bonds, essentially cash, backed by the European Financial Stability Fund.
• A second sweetener is that Greek banks, which have such a high exposure to Greek debt that their very existence is threatened by the writedown, will be prevented from collapsing and affecting the eurozone financial system through refinancing funds from the government.
• There is a third, rather aspirational sweetener for long-term investors. They will receive extra interest equivalent to one percent of their new bonds’ face value from 2015 onwards if Greece has returned to growth exceeding “a defined threshold”.
• The ultimate goal of the debt forgiveness exercise is to reduce Greek debt to 120.5 percent of GDP by 2020 the maximum level deemed by the International Monetary Fund to be sustainable by Greece.
3. Will Greece complete the process by March 20, when two maturing bonds worth 14.5 billion euro ($19.5bn) threaten to bankrupt it?
• Greece will attempt to effect the bond exchange with Greek banks, whose participation is taken as a given, immediately thereafter, on Monday 12 March, and with banks overseas later on. Along the way it will aim to incorporate the holders of the March 20 bonds.