The Greek Debt Swap: Is it a Default, or isn't it?

While you were watching imported Chinese fireworks yesterday, the Europeans were shooting off some home-grown ones.
The euro has been trading down for most of the last 24 hours, as S&P and Fitch announced that they would consider the French-led rollover plan for Greek debt a “selective” default.
What’s really going on is that a negotiation is taking place over what should be the credit rating of Greece as an issuer, and of its particular debt issues. (Wouldn’t it be nice if you could negotiate with ratings agencies over your credit rating, next time you have to borrow money?)
Greece has to “roll over” its existing debt (meaning, reissue it as it matures) without getting slaughtered on the interest rate or even failing to find lenders at all. And of course, they’re running a budget deficit that’s in the high single digits (ours is even higher, at about 11%), so they need to keep issuing brand new debt on top of the rolls.


Sarkozy has been trying to arrange for existing lenders to Greece (mostly large French and German banks, too big to fail) to accept rollovers of debt maturing over the next three years, in the form of 30-year Greek bonds backed by strong collateral, or five-year notes backed by nothing.
So if you were a TBTF bank, what would induce you to accept new debt issued by an obviously bankrupt country without demanding a crushing interest rate?

That’s pretty easy. You’d do it if you had a guarantee that someone would stand up and accept your Greek debt as repo collateral, no matter what. And that someone is, of course, the ECB.

The problem at the ECB, however, is its president, Jean-Claude Trichet. He’s eager to protect the value of the euro, which of course is his job. So against nearly everyone else in Europe, he’s been holding out on the default question. He won’t (can’t, really) guarantee that any new Greek paper will be accepted at the ECB’s discount window unless at least one of the ratings agencies declares that the debt swap does not constitute a default.

The “Austrian alternative” (debt swap) plan is being presented as something that Greece’s lenders would accept on a voluntary basis, and hence not really a default. But the truth is that their only alternative is to accept a real default. The terms of the indebtedness are changing materially, in a way not favorable to the lenders. For this reason, the ratings agencies have started saying that they have to consider the swap to be a default of some kind, and that’s what stirred up the markets yesterday.


So now, the agencies, the political authorities (acting on behalf of the banks), and Trichet are negotiating over language that will allow Trichet to consider the “default” a short-term, technical one, rather than a permanent breach of covenants. So far, they’re talking about putting the Greek government itself on a “selective-default” rating, down from its current CCC/Caa1, and not changing the rating of existing securities at all. The selective-default rating would be lifted as soon as the upcoming rollover is completed.

What Trichet has to decide is whether he can accept this rating language, and continue to offer a “money good” pledge to accept Greek paper at the ECB’s discount window.

If they can’t get past this hump, Greece becomes this year’s Lehman Brothers, and the world replays the autumn of 2008.

Because this outcome would suck, you know they’re going to figure something out. But I’d forgive you for considering that the credibility of the euro is now showing some huge cracks. The Europeans are praying that this charade ends with Greece. If Spain or Italy have to negotiate phony debt guarantees as Greece is doing, the dikes won’t hold.


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