Partying on the Edge of the Eurozone Volcano

The latest proposal in the Greek debt rollover saga is intended to achieve two inconsistent objectives. The first is for eurozone governments to ensure that private sector banks contribute to a bail-out (at Germany's behest). The second is to ensure that participation in the plan is seen as voluntary by the rating agencies, thereby avoiding a declaration of default. The outcome, however, is a default in all but name writes Wolfgang Münchau at the Financial Times:

If you own a Greek bond that matures by June 2014, you keep 30 per cent of the redemption as cash, and roll over 70 per cent into a 30-year Greek government bond. The Greeks will have to pay an annual coupon, or interest rate, of between 5.5 per cent and 8 per cent. The precise rate will depend on future economic growth. 

Of the money received, Greece will lend on 30 per cent to a special purpose vehicle, another well-known construction from the subprime mortgage crisis. The SPV invests into AAA-rated government or agency bonds, and issues a 30-year zero coupon bond. The purpose of this is to guarantee the principal of the 30-year Greek government bond that you just bought. 

With this construction, the downside to your losses is limited. Depending on how some of the parameters of this agreement evolve, you will probably make a small loss, relative to the par value of your holding. If you are lucky, you might come out positive. You will probably not be lucky. But you will still be better off than if you sold today, or if Greece were to default. More important, the accounting rules allow you to pretend that you are not making any losses at all.
If this was any other field of human activity, you would go to jail if you accepted, let alone made such an indecent offer. 

It is also inevitable that Greece will default on its coupon payment at some point. The interest will be 8 per cent under a benign growth scenario, and 5.5 per cent under a not so benign one. Either way, Greece cannot pay such a high level of interest. 

As Jeffrey Sachs pointed out last week in the Financial Times, if you really wanted to achieve Greek debt sustainability, you would need to reduce the interest rate to about 3 per cent. This is what Germany pays for 10-year bonds. And even then would you have to extend the maturity of those bonds as well. Neither is, unfortunately, on offer. All there is, is this dirty little con-trick. The complexity of the scheme is due to the need to persuade the rating agencies not to attach a default rating to Greek bonds. 

The rollover agreement represents, from an economic point of view, nothing but a collateralised bond. It subordinates all other bondholders. The rating agencies would normally not hesitate to attach a default rating to Greek government debt. So the solution is to create a complex structure, and claim that it is technically not a collateralised bond, but something that defies definition. 

Unfortunately, S&P has already called the bluff, saying the leading proposal under consideration would bring the country into default. Even if the finance ministers eventually succeed with their contraption and the rating agencies withhold their judgement Münchau writes that "the politics of crisis resolution in Greece [are highly likely] to become even more difficult, and accident-prone. We are not just “kicking” any old “can down the road” any more. This is a can of explosives."