Yet more drama for Greece’s debt deal

Protest signs on a wall in central Athens

Over the last 24 hours, a flurry of activity has taken place surrounding Greece’s €200bn debt restructuring, most of it expected but some of it potentially destabilising. Because the moves involve highly technical – but still significant – judgements by occasionally obscure groups, Brussels Blog thought it was time for another guide to what to watch for in the ensuing days.

The most eye-catching announcement was the one made last night by Standard & Poor’s declaring Greece to be in “selective default”. Luxembourg prime minister Jean-Claude Juncker, chair of the group of eurozone finance ministers, put out a statement saying the move was “duly anticipated” – and he’s right. S&P signalled this way back in June when the first talk of a Greek restructuring began.

Even though it was expected, it’s still worth reflecting on: It is the first time an advanced economy has been in default since West Germany in 1948. Practically, however, the most important knock-on effect to watch will be on Greece’s banks.

For much of the last two years, Greece’s banking sector has been reliant on the European Central Bank for funds to run its day-to-day business. With the country in such a precarious position, no private lender has been willing to provide the normal lines of liquidity that all banks need to keep their operations running.

But the ECB doesn’t just give that money away for free. In order for banks to get these loans, they have to put up collateral. And for most Greek banks, that collateral has been Greek sovereign bonds. Well, now that S&P has declared Greek sovereign bonds to be in default, they’re basically worthless, meaning the ECB can’t legally accept them as collateral any more.

Which is why the ECB announced this morning that they have “temporarily suspended” accepting Greek bonds as collateral. But the eurozone has prepared for this: as part of the new €130bn Greek bail-out, eurozone finance ministers signed off on an additional €35bn that will be set aside to temporarily serve as “credit enhancements” for Greek bonds. In other words, instead of being backed by the Greek state, they will be backed by a pool of cash raised by the eurozone rescue fund.

The problem is, national parliaments haven’t fully signed off on the bail-out yet (the German parliament approved it yesterday; the Finns are expected to vote today; the Dutch tomorrow). So for the time being, Greek banks have no access to liquidity. But if all goes according to plan, this will only last a few days.

And as S&P notes, once the debt restructuring is done, which is likely to be by mid-March, the “selective default” status will probably be lifted and eurozone governments can get their €35bn back. In the words of S&P:

If the exchange is consummated (which we understand is scheduled to occur on or about March 12, 2012), we will likely consider the selective default to be cured and raise the sovereign credit rating on Greece to the ‘CCC’ category, reflecting our forward-looking assessment of Greece’s creditworthiness.

Of potentially more drama will be a decision by an even more obscure group: the International Swaps and Derivatives Association. Last night, they announced that they, too, were opening an investigation into the Greek debt restructuring and would make a preliminary judgement by Wednesday evening.

The ISDA is important because they are the industry group which decides whether so-called credit default swaps – essentially insurance policies investors buy to protect them against a bond default – should be triggered. This is the “credit event” that European officials, particularly at the ECB and the French finance ministry, have been hoping to avoid.

The scary thing about CDSs is that nobody really knows who owns them. So if the ISDA rules they must be paid out, lots of financial institutions my suddenly find themselves with significant losses. It’s that kind of uncertainty that spooks the financial markets.

As fellow Brussels Blogger Alex Barker notes, the members of the ISDA’s “determination committee” are largely the same large financial institutions who negotiated the debt restructuring with Greece, which would lead you to think they wouldn’t upend the process by declaring a “credit event”.

But a deeper dive into the complaint reveals an intriguing wrinkle: unlike the S&P move, the ISDA inquiry isn’t only about the bond swap itself; it’s also about a deal struck between the ECB and the Greek government to protect the ECB’s own holdings of Greek bonds.

To boil it down to its essence, a couple weeks ago the Greek government agreed to trade the ECB’s €55bn in bond holdings for new bonds that contained new legal provisions protecting them from a default, even if one is forced on all other bondholders.

A forced default is still a real possibility. If less than 75 per cent of private bondholders agree to “voluntarily” participate, Greece is expected to activate new “collective action clauses” that have been retroactively inserted into all bonds governed by Greek law. That would force the deal on all non-volunteers. Except, with its fancy new bonds, the ECB would be excluded. The ISDA says it will look into whether this constitutes “a change in the ranking in priority of payment”, creating a new special class of bondholders that are treated differently than the rest. In the bond market world, that’s a no-no.

This part of the deal was not agreed with the financial institutions that negotiated the debt restructuring with Greece, which makes its outcome slightly more uncertain than S&P’s. And financial markets don’t like uncertainty. We should note here that the FT’s own reporting on this ECB move has been submitted as “supporting information” in the case.

In short, it’s going to be an interesting few days. The one thing that’s clear is the Greek drama that has engulfed the eurozone may still have a few acts left to play out.