The Great Greek Swap Meet

Greece’s private-sector debt restructuring deal (officially dubbed “Private Sector Involvement,” or PSI) is in full swing, and EU officials are hotly awaiting the outcome. It’s the last big hurdle between Greece and Bailout 2.0, and Greece has till Thursday evening to secure participants.

The PSI isn’t the easiest sell. Banks are asked to help Greece axe around €100 billion from its outstanding debt by swapping existing Greek sovereign holdings for new 30-year Greek bonds and 2-year EFSF notes—each with a far lower face value. Respectively, the new debt will represent 31.5% and 15% of the old bonds’ face value—a 53.5% principal reduction in total. The interest paid will be 2.0% through 2015, 3.0% through 2021 and 4.3% thereafter. Participants will also receive detachable GDP-linked securities with a notional amount equal to the new bonds’ face value. Beginning 2015, these will provide annual payments up to 1% of the notional value if GDP exceeds a defined threshold and real Greek GDP growth exceeds targets (which aren’t yet determined).

The large haircut may seem unappetizing, but banks are pragmatic—they understand an orderly restructuring is preferable to a messy default, in which case they could be hit with even greater losses. Plus, the new bonds will be issued under English law, meaning the Greek government can’t retroactively change the terms—abating one of the risks banks would face by holding existing Greek sovereigns. In short, there's plenty of incentive to participate, and 12 large European banks have already reportedly signed up—banks with face-value Greek sovereign holdings of at least €40 billion as of year-end 2011.

That’s a good start, but Greece still needs more participants. If the participation rate is between 67% and 75% by March 8, Greece will automatically activate a retroactive Collective Action Clause (CAC), imposing the PSI on all private-sector Greek debt holders. If participation exceeds 75% but falls short of 90%, Greece and its European brethren may elect to activate the CACs. A 90% participation rate was factored into the second bailout’s €130 billion size, and lower participation may mean larger bailout contributions from the IMF and EU nations—something most nations would rather avoid. They may decide the fallout from triggering the CAC is preferable to doling out more money.

As to what shape potential fallout may take, the International Swaps and Derivatives Association has historically ruled the use of CACs constitutes a credit event, which would trigger credit default swap (CDS) payouts. And S&P placed Greece in “selective default” due to the CAC’s inclusion—if it triggers, the other raters likely follow suit. We’ve seen many headlines fretting these outcomes, and more will likely follow this week. But we suggest a more measured view, keeping two things in mind.

First, CDS payouts have been widely expected for some time—remember, markets typically move on surprises. Plus, the net notional value of all outstanding Greek CDS is a very small €3.2 billion.

Second, the ECB already adjusted collateral requirements to reflect S&P’s default label, so a follow-on move by Moody’s or Fitch shouldn’t much change things. Though the bank currently isn’t accepting Greek debt as collateral in primary lending facilities, that doesn’t automatically place funding strains on Greek banks. The ECB will accept the new bonds (issued under the swap) as collateral, rendering the default label’s technical impact extremely short-lived. And in the meantime, banks can still tap the ECB’s Emergency Liquidity Assistance program or seek funding from national central banks through TARGET2. In short, central banks have had ample time to prepare for an orderly Greek default, and backstops are in place.

In our view though, focusing on the what-ifs of CAC-triggering ignores a key fact: Officials and commercial banks have long expected at least a partial Greek default, and they’ve largely prepared accordingly. Whether Greek bonds are written down to roughly 30% of their net present value or Greece is forced into default shouldn’t much harm European financial system, thanks to the firewalls erected.