Deutsche Bank on Greek debt restructuring

From Deutsche’s Mark Wall:

EU policy credibility: It would undermine EU policy credibility to extend the duration of its pari passu exposure to Greece from an average 3.5 years to 7.5 years one month and to start campaigning for restructuring the next. Having denied that restructurings will be a feature until after mid-2013 and having avoided (again) a sovereign default assumption in the EU bank stress tests, the U-turn could undermine policy credibility.

Bank exposure: First and foremost, an immediate outright restructuring would have an impact on the broader European financial sector. A key credibility failing of the first round of EU bank stress tests was the absence of a sovereign default assumption in the stress scenario. Banks’ exposure to Greek debt is declining, but the latest BIS numbers show that in Q3 2010, European banks were still carrying USD154bn of exposure to Greek entities (both sovereign and non-sovereign). This had fallen USD24bn from six months earlier, but the scale is still significant enough for politicians to think twice about creating a capital shortfall around the European banking system. More public recapitalization of banks will be politically unpalatable so close to elections. A perceived policy U-turn could go down negatively with markets and could unsettle progress in Ireland, Portugal and Spain. The willingness of private investors to recapitalize euro area banks — both periphery and core — could decline, thwarting efforts to build Basel III buffers and reinforcing contagion

Pari passu losses: Following the fourth disbursement in March, the EU has now made loans of EUR38.4bn to Greece under the joint EU-IMF loan programme. The IMF’s loans enjoy a preferred creditor status, but the EU’s loans are pari passu with existing government debt. If the international creditors decided to restructure the debt today, a rough 50% haircut would impose immediate losses on the EU of EUR19.2bn, over EUR5bn of which would be a cost to Germany3. Given the lengths Angela Merkel went to to alter and slow the pace of payment of paid-in capital into the ESM, even a EUR5bn loss would be taken very seriously in Berlin. The longer the EU delays a restructuring, the greater will be its pari passu exposure to Greece, but the exposure will be capped at about EUR101bn.

ECB recapitalization: Another element of the political cost would be the recapitalization of the ECB. Under the Securities Market Programme (SMP), the ECB has purchased outright EUR77bn of euro government bonds, said to be just bonds of Greece, Ireland and Portugal, with roughly half thought to be Greek bonds. The ECB did not purchase the bonds at face-value, but at an indicative 50% haircut there would still be losses on the EUR20bn of ECB holdings. The recapitalization requirement would fall on the euro area member states. To the extent that the ECB held shorter duration bonds, the longer the EU waits, the smaller the recapitalization need for the ECB.

ESM approval: Part of the collateral damage, entailing a political and economic/market cost, could be the passage of the ESM through national legislative channels. The ESM has been ‘adopted’ by the European Council, but to be enacted into law it needs approval at a national level. There is a risk that imposing the recapitalization and pari passu losses of an immediate outright restructuring could negatively impact the approval of the ESM. Unless the ESM is approved unanimously by the 27 EU member states, it will not come into effect in mid-2013 when the EFSF legally expires. Fear of the lack of a safety net, especially as even in mid-2013 the EU and IMF are still likely to be dealing with vulnerable euro area sovereigns, could impact negatively on markets and have some contagion risk.

While EFSF support for Greece is the most likely outcome, it may be complemented with ‘voluntary’ debt management initiatives. This fits with mounting commentary. Schaeuble talked about pre-2013 measures being ‘voluntary’. The German weekly Die Zeit this week quoted ‘EU sources’ claiming an EU working group has concluded that a haircut of 40-50% is required to make Greece sustainable, but that various options are being considered and “less radical” options were likely to be pursued, such as voluntary extension of maturities.

‘Voluntary’ initiatives echo with the European Commission’s last report on Greece. This referenced an “intense debate” on debt management operations, potentially covering “buy-backs, the roll-over of debt or the voluntary extension of maturities” (the idea of EFSFfunded buy-backs has been rejected since). The Commission said these operations could only be expected to provide a “modest” contribution to debt sustainability and do not supplant the need for fiscal consolidation, privatization and structural reform.

With domestic politics and the 2013 election in mind, Angela Merkel and her Finance Minister may be softening ground for maturity extension before 2013. But maturity extension could be costly. Banks could be forced to make market-to-market adjustments on their total Greek bond positions, not just the affected bonds. Caution might also encourage a similar adjustment to banks holdings of other periphery bonds. A ‘Vienna Initiative’-type approach to voluntarily encourage investors to roll their positions might be the preferable approach. This is consistent with sequencing of private sector participation in the ESM term sheet in any case.

Το blog των FT σε επόμενο ποστ περιπλέκει και τη Νέα Ευρώπη (που φαλήρισε πρώτη) με τις επιπτώσεις των ελληνικών τραπεζικών κτήσεων στη Βαλκανική