My Big Fat Greek Restructuring – The Week Ahead

The situation in Greece should create some big headlines this week.  The bond exchange “invitation” is set to expire at 3pm EST on Thursday March 8th.  This is the so-called Private Sector Involvement or PSI.  Greece has other steps to take during the week, and ultimately the Troika will determine how to proceed with the bailout, but not until the results of the PSI are known.

It could be a week of confusing, misleading, and market moving headlines.   Figuring out the “proper” reaction to each bit of news will require understanding the terms, and hoping the headlines are accurate – which given how confusing the situation is, cannot be fully counted on.  Remember, the original “invitation” from the Greek government was for an amortizing bond, which was then changed to a series of 20 “bullet” bonds, so the level of confusion remains high.

We are already seeing some headlines that PSI is slow to be adopted, but given the size of the document, even those with no choice will take some time, and those that plan to say no, will just do nothing until the expiration.

Types of Greek Debt

Total Hellenic Republic Debt according to Bloomberg is €354 billion (all debt outstanding amounts are based on data from Bloomberg).

Troika debt is the bilateral loans that have been made to Greece by the Troika as part of previous bailouts.  That is currently €76 billion.  The bulk of this matures in 2017 and 2018.  It is NOT subject to the exchange.  It is NOT subject to Collective Action Clauses (CAC’s).  This debt, although classified as “senior unsecured” has always been viewed as senior, structurally if not outright, to other debt.  The good news for American taxpayers, is the IMF loans are part of this pool, and are the most protected, regardless of the outcomes in Greece over this week and next.

Greek T-bills confuse me.  There are €15 billion outstanding, and they just issued €1 billion at 4.86% on February 7th.  The t-bills fall under special rules and are viewed basically as “money good” because of those rules and laws.   It looks like they paid of €2.3 billion last month and have €1.4 billion maturing Friday, which trade very close to par, again because of the special rules associated with “t-bills”.

Protected Entity debt is the debt that has been purchased by the ECB as part of their Secondary Market Programme (SMP), the European Investment Bank (EIB), national central banks (NCB’s) and possibly other “protected entities.  These are the bonds that were created recently so that these “protected” entities could exchange their existing bond holdings for ones that were not subject to collective action clauses and would not be “invited” for the PSI.  The legality of those exchanges has not been tested (the English Law bonds have a stronger case, in my opinion), so far now, have to assume that roughly €56 billion has been given this new status.  So far, I have not seen the outstanding amounts for these bonds, but am backing into it from total debt amounts outstanding, Trying to get details on a bond by bond basis.  In any case, the bonds are a separate class and are NOT being asked to participate in the PSI.

Individual holders.  There has been some discussion of protecting individual holders from having to participate (it may be in the 167 page invitation, but I haven’t read it that closely yet).  When it has been discussed, it was stated that holders would have had to own it for a while, so it is unlikely that we see a cottage industry develop in Greece where hedge funds find people to buy their bonds in small enough increments to qualify.  If somehow individuals are exempted, the size is fairly small, and no one seems to be offended by the attempt either (unlike what is going on with the ECB and other protected entities).

English law debt is the debt that was issued under English law.  Some of these bonds are denominated in currencies other than the Euro.  These bonds had stronger covenant packages than Greek Law Bonds (which is easy, since the Greek law bonds had none).  So these bonds have some rights that give them more protection in theory than Greek law bonds, and more importantly, any lawsuits could be decided outside of Greece.  With Greece’s willingness to change the law retroactively to suit themselves, this is a big advantage.  With only €18 billion of debt issued under English Law (and some of that part of the “protected entity” debt), this is a relatively minor class, but worth watching.  The distinction here is that you may see legal challenges based on bonds here, and not just CDS.  So far, there has been one attempt to determine if a CDS Credit Event has occurred, but have not seen any lawsuits under the bonds.

Greek law debt is the debt that was issued under Greek law.  It definitely has the weakest protections.  Not only were there virtually no covenants in the bonds themselves, but any lawsuit would have to be won in a Greek court and enforced in Greece.  There is a total of €237 billion of these bonds, though at least €40 billion is part of the “protected” class (just don’t know the details yet).  There are a couple of “inflation linked” bonds in here, so I am not sure exactly how the “principal” multiplier is accounted for, but that is a rounding error.

Short Dated Debt is of particular interest.  It looks like the private sector holds just under €10 billion of the March 20th, 2012 bonds, and about €5 billion of bonds maturing in May.  These bonds are mostly part of the Greek law debt pool, but are worth considering as a separate debt class as they have the most likelihood of getting paid out at par if they hold out.  Any holdouts in the March 20th pool will be the most interesting, because they will either have to be paid, CAC’d, or defaulted on in short notice.  Given the tendency for everything to drag on in Europe, this class has the highest chance  of being paid while the process is delayed, and they would rather keep options open.  With March bonds trading at 26 versus 22 and below for the rest of the bonds, there is some price built-in for that potential windfall, but not much.  So basically the market as a whole isn’t anticipating these bonds to get paid at par, but holdouts in these dates deserve special attention/notice.

PSI Strategies for different Bond Holders

The Troika and the ECB and some other entities have segregated their debt from the PSI.  They are protected and expect to be paid par at originally scheduled maturities (including T-bills).  Any concession from this group would help Greece in its efforts to restructure and would be a positive for the market – at least short-term.  Longer term it might raise questions by the sponsors about why they let the ECB and IMF and EFSF take risk where actual losses can occur (instead of the fantasy world where their positions are viewed as riskless).  I doubt we hear about any concessions from this group this week, but watch for it.

Banks are some of the largest holders, with Greek banks in particular having large, concentrated positions.  They will vote almost unanimously for PSI.  The Greek banks need to agree in order to get recapitalization money from the Troika.  Other banks might not “have” to agree, but even someone as politically naïve as myself, would have trouble dipping one hand into the LTRO cookie jar and then saying NO to the PSI.  I would be surprised if the bank participation rate was anything much less than 99%, though again, if some were silly enough to keep basis trades on, or own short dated bonds, they might decide to hold out.  Any bank that holds out would be an ideal short candidate.  Whatever money they potentially make would be at grave risk, as not only might they find themselves cut off from some of the ECB gift giving programs, but the regulators might actually take an interest and attempt to do their job for a change.

Insurance Companies and Pension Funds (other Regulated Entities) will likely agree to the PSI.  They aren’t really in the business of “rocking the boat” so their propensity is to play nice in the first place, and with so much government involvement in the process, fear of a regulatory backlash would add to their desire to go along with the crowd.  The worst part, and most distressing, is that everyone seems so scared of the word “default” that they haven’t tried to figure out if they could get a better deal by not going along.  So with no actual work done on the alternative, and no real incentive to part from the crowd, we should see a very high participation rate from this group.  Holdouts here would be interesting to watch and far less suicidal than a bank that chooses to hold out.

Hedge Funds are the most likely to hold out.  Those holding short dated bonds have their own reasons for playing the game.  Is there a participation rate that is high enough that they can get paid out at par, or at least get offered a better deal?  Funds that accumulated positions in the 20’s have far more ability to take their chances than other entities that paid close to par for their positions.  What would a post default recover look like?  Any worse than the PSI offer?  Without the threat of regulation, no access to cheap ECB money, and a potentially low-cost base, the problems with the PSI, if any, will come from the hedge funds.  Blocking positions in small issues, particularly English law bonds are another potential trade for hedge funds.  I don’t think we will hear much until the 8th or even the 9th.  They are in no rush.  They know the less time that the closer things get to the 20th, the more likely that someone in power will do something that benefits them.  They are effectively up against Greece and the Troika, and that deadline and the confusion amongst those parties plays into their hand.  It would be fun if we got news early in the week about hedge fund strategies, but I would recommend not saying anything (yes or no) until the deadline.  Finally there is the basis package holder, where an investor owns bonds and has bought protection (CDS) which deserves its own special section.

CDS Strategies (including the Basis)

There is a strong likelihood that we will get a Credit Event on CDS in the next 2 weeks.  The most obvious way is that the PSI participation comes in around 90% and Greece chooses to use the Collective Action Clauses to force all bond holders into the deal.  Using the Collective Action Clauses would be a Credit Event.  There has been some talk about using the Collective Action Clauses to pay holdouts even less than if they agreed.  This is an attempt to scare people into participating.  I think that argument is just wrong.  My understanding of the CAC is that it could be used to force a small group of bondholders (33% or less) into doing what the larger group was doing, but could not be used to force them into something entirely different.  If Greece wants to punish the holdouts (which would be my inclination) then they will have to default.  Offering worse PSI terms is unlikely to motivate someone who just said no, offering better terms rewards the holdouts, so the only way to try to force holdouts into a worse outcome is a default.  That would be a Credit Event (and I’m not 100% convinced that post default recovery couldn’t get a better deal than the PSI anyways).  If the acceptance rate was very low, they may not accept any PSI and default on all the debt.  It seems as though they would continue to pay the “protected entities” and the Troika the full amounts, but certainly paying the ECB par on their “new” bonds is more difficult if none of the other old bonds are paid or exchanged.  There is no way the market is prepared for Greek to default on ECB and IMF loans at this point.  In reality I can’t see how they would choose to default on IMF – they need the countries backing the IMF in any case, but treating the ECB’s SMP holdings like any other bond could be a different story, in spite of their current efforts to retroactively make them superior.

I think that CAC is most likely outcome, with actual default being the next most likely, but there is a chance the participation rate is high enough that Greece chooses to honor any remaining bondholders.  Unlikely, but possible, and what happens to CDS then.  If €200 billion participated in the PSI, the ECB gives back any coupons received, and accepts new debt based on their cost basis rather than par, and the IMF offers to reduce and extend, the value of CDS would drop dramatically.  I don’t see this as the most likely scenario, but if they can get extremely high participation and some other concession, their debt load will have been reduced, and with just coupons to be paid in the near term, the chance of a near term Credit Event would drop quickly.  I would think CDS could easily drop to under 40 points in that case (from over 70 right now).  A low probability, but If this round works, even though Greece might be back at the table within the year, the CDS should move a lot tighter.

Outright Short Greece via CDS seems like a very risky trade.  In all likelihood Greece will experience a Credit Event.  Most likely by using the CAC’s, but possibly by actual default.  At over 70 points up front, you are taking a risky bet on recovery.  Short CDS with a “recovery swap” on, makes it safer to short via CDS, but I wouldn’t consider that truly “naked”.  If you have lived this long without having to deal with “recovery swaps” you can probably continue to do so, but you should be aware that there are trades that have payouts based on actual recovery versus the “price” that the recovery swap was traded at, if, and only if there is a Credit Event.  If somehow Greece manages to pull this off without a Credit Event (super high PSI participation), then CDS will tighten a lot.  I don’t like this trade, and guess of the $3.2 billion of net CDS positions, most of the shorts are part of basis packages, rather than outright shorts.

Outright Long Greece via CDS seems slightly more reasonable than being short, though I suspect the only ones long this risk are weak banks and hedge funds.  For hedge funds, it will be those that put it on in the past 6 months to fund shorts in other countries.  At these prices, they may be keeping the long position in case the whole plan works out somehow, or that recovery is higher than where CDS is currently trading.  The weak banks will have ridden this position down from 20 bps or some other astronomically low spread.  They did it for carry, never marked it to market, and can only hope for the best.  They didn’t cut when it was down 10 points (just like AIG, it is very hard to cut at any loss when that loss dwarfed the maximum possible upside if everything went well).  They didn’t cut down 20, or 30, etc., so they are here hoping to somehow make it through another crisis moment and hope the mark gets a lot better.  Even then, they will likely be encouraged enough to try to ride it out to maturity.  In my opinion, the bulk of positions where someone sold CDS naked, resides in the weak banks – that is also where the potential contagion rumors will begin.

Basis Packages are when someone has bought credit protection (CDS) and owns the bond against it.  Of the $3.2 billion of net CDS outstanding, I believe virtually all of those short Greece via CDS have the basis package at this point, and almost all are held by hedge funds rather than banks.  Banks often have the basis package, as either a specific strategy, or as part of their market making role, but at this point they would be insane to have any meaningful basis trades on.  They do not control what happens to the bonds.  They cannot easily say no to PSI, so they have no way to force a trigger.  Running a basis trade with no control over one side is just not smart risk management.  Hedge funds on the other hand can hold out.  I think there will be at least $3 billion of holdouts, since that is the strategy anyone using the basis package HAS to employ.  Holdout and either get a Credit Event or get paid at par.  Right now someone with the basis package owns a bond worth 22 and a CDS worth 72, for a total of 94 (roughly).  If they holdout and a CAC occurs, there will be a Credit Event and they will get new bonds.  Those new bonds will be Deliverable Obligations and can be used to set the CDS recovery amount.  In fact, only the “cheapest to deliver” new bond will be used.  Therefore, after a CAC, you will get a package of new bonds, and a settlement equal to par minus trading price of cheapest of those bonds.  That package which is worth say 94, is worth a minimum of par.  But it is better than that, because you are getting 15% of your notional in EFSF bonds, some GDP kicker, and your interest paid out.  Assuming a cheapest to deliver bond of 20, an average price of new bonds of 25, the package could be worth 15 (EFSF) + 7.8 (31.25% * 25) + 80 (assuming no move in FX and hedged at today’s exchange rate, since the CDS is in $’s) = 102.8.  That places no value on the GDP kicker or the fact that you are getting paid full accrued, which is unusual in a restructuring. So potentially a holdout with a  basis package after a Credit Event related to a CAC would get above 100, and actually does better the lower the average price of new bonds, and in the difference in price between cheapest to deliver new bond and average price of new bonds.  Not bad for a position that costs 94 so in any case, a Credit Event from a CAC is good for the basis package holdouts.  A default is less clear.  The holdouts would have to fight for a recovery on their bonds, which might be 0, but in all likelihood is higher than that.  They would only get par – recovery on the CDS, so depending on where their existing bonds trade, they might not make money.  Though in a default scenario, expect the new PSI bonds to trade weaker than otherwise until the defaulted bonds are cleared up, so payout on CDS should be very high, but still the basis may not work out if there is a hard credit event after the voluntary PSI.  The worst situation is to agree to the PSI, and then have no Credit Event.  So you have bonds worth maybe 30, but the CDS should plummet – no private sector debt will be payable in the near term, and you can bet the ECB and IMF will be roll their debt when it is coming due, if it hurts CDS holders.  That could be a big loss.  To avoid the potential for a big loss, you need to hold out.

Noise around the Bailout

Separate from the PSI which has a deadline, there will be continued headlines around the bigger bailout.  Is Greece implementing the new programs fast enough?  Is Germany happy with Greece.  Is Greece happy with German presence?  Are other countries getting sick of the whole fiasco?  How do Portugal and Ireland react when they see their bailout buddies receive some nice big debt forgiveness?   This is far from over and we will likely see a mix of headlines, but without PSI, there will be no deal, so reacting appropriately to PSI related headlines will be a key over the next two weeks.  I think we will miss the simplicity of last week – when all anyone really had to think about was the size of LTRO2 and what it would mean.