Greece: Debt Rollover - Credit Event or Not?

Private sector participation

At the Eurogroup meeting on 19 June, finance ministers agreed that the second rescue package for Greece will be financed through both public and private sources and welcomed the pursuit of voluntary private sector involvement in the form of informal and voluntary rollovers of existing Greek debt at maturity, which should result in a substantial reduction of the required year-by-year funding within the official programme, while at the same time avoiding a selective default for Greece.

The avoidance of selective default is a demand from the ECB. At the press conference on 2 June Trichet said that they "exclude all concepts that are not purely voluntary or that have any element of compulsion" and "call for the avoidance of any credit events and selective defaults or default". This is probably the main reason why a maturity lengthening has been ruled out. A maturity lengthening (involving all investors) cannot be purely voluntarily and it will be a default event.

The big question is then how an informal and voluntary rollover – which is not a default event – can be achieved. Indeed, the extra time needed before presenting the rescue package will probably be used to solve this particular issue.

We foresee that an agreement on private sector participation will look like this:

A considerable number of major European investors in Greek government bonds (primarily banks) agree to 'voluntarily' buy new Greek government bonds (with a coupon around 5%) when their existing holdings mature. This outcome will be achieved after intensive meetings with authorities (central banks and governments). Investors will be persuaded by the argument that the alternative is much worse (substantial losses and possibly a European financial crisis). On a more positive note, authorities will help investors to solve a co-ordination problem. It is in investors' interests to keep exposure if they can be assured that a critical mass of other investors will then do the same thing.

The ECB is a special case as it is not allowed to purchase government bonds in the primary market, so it cannot simply roll over its existing debt at maturity into new bonds. What the ECB can do is to contribute by promising to 'restart' the SME programme and buy in the secondary amount for at least the same amount as matures from its bond holdings. This will not help Greece directly with its funding need, but it will help indirectly by contributing to calm markets.

Smaller investors will be free not to roll over their debt (purchase new Greek government bonds).

Credit event or not?

Since the smaller investors are free not to roll over their debt, they do not face any losses and cannot claim that it is a credit event. The major investors will not claim that it is a credit event either as they simply purchase new bonds (voluntarily) and no imminent loss in banking books has resulted from this move.

The rating agencies might nevertheless cry fault and downgrade Greece to default. Rating agencies are also likely to downgrade other peripheral countries in the event of 'voluntary' private sector participation in a rescue package for Greece.

But it is ISDA (and the wording of the CDS contract) that determines whether it is a credit event, which would trigger payment on the CDS contracts. Given that the existing maturities simply mature and the purchase of new bonds will be discretionary (there will not be a bond exchange binding all holders), it is our understanding that it would not be a credit event.

In any case, the CDS exposure does not seem to be very big relative to the Greek sovereign debt market. According to data from the Depository Trust & Clearing Corporation (DTCC), the gross issuance is USD77.5bn while the net notional (maximum bank exposure) registered by DTCC is just USD5.5bn, or less than 2% of outstanding debt. In addition to this, there is an unknown but possibly small amount of contracts not registered by DTCC. The exposure could potentially cause problems for some banks, but it does not seem to be a threat to the system. The CDS exposure is negligible compared with the CDS exposure on subprime loans that fuelled the financial crisis.

ECB will accept Greek bonds as collateral

If rating agencies downgrade Greek government bonds to default, the ECB may no longer accept them as collateral in its refinancing operations. On 16 June, ECB executive board member Lorenzo Bini Smaghi said that "asking the ECB, as has been the case recently, to extend the maturities of the government bonds it holds or to accept as collateral bonds from a state that is considered to have defaulted for the re-financing operations of the banking system, is a violation of the principle prohibiting the central bank from monetarily financing the treasury".

Nevertheless, we have previously seen the ECB show substantial flexibility with its collateral rules. Indeed, in January 2010, the ECB said that it would not soften its collateral policy for the sake of a single country, but a few months later it made a U-turn and did exactly that and eased its collateral rules to accommodate Greece's needs. And keep in mind that in March 2011 the ECB announced that "the Governing Council of the European Central Bank (ECB) has decided to suspend the application of the minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem's credit operations in the case of marketable debt instruments issued or guaranteed by the Irish government. The suspension applies to all outstanding and new marketable debt instruments. It will be maintained until further notice". In other words, the ECB can and will suspend the application of the minimum credit rating threshold when needed.

Despite the hard rhetoric today, we therefore think that the ECB will make another U-turn if necessary. Indeed, we believe that the ECB will take all euro area sovereign bonds as collateral as long as there is a euro area, though it might ask for a substantial haircut. So if rating agencies downgrade Greece to default, we think that the ECB will find a way to alter its collateral requirements to allow for this. If not, then other funding sources will most likely be provided from the European System of Central Banks (ESCB) to Greek banks and possibly also other holders of large amounts of Greek bonds. In conclusion, a downgrade from rating agencies will probably result in further spread widening for peripheral countries, but it will not be allowed to result in a chaotic situation where the Greek banks are left on their own.