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| Image Source: The Economist |
For weeks, the market was perfectly in tune with the news released about the Greek government and the Eurozone. If there was good news indicating a fix the Eurozone problems, the market was up and vice-versa. That game finally ran its course when news surfaced that the Greek government would need a second round of bailout funds by March 20th to avert a default on €14.5 billion worth of bonds coming due. Investors feared that a failure to obtain these funds could trigger another round of global financial meltdowns.
It’s important to recognize that
the Eurozone debt problems date back to late 2008, when the Eurozone agreed on
its first stimulus package of €200 billion. In April of 2009, the EU ordered
France, Spain, Ireland and Greece to reduce their budget deficits and then in
November, the EU, following the Dubai sovereign debt crisis, began
investigating the balance sheets of all of its members. Their exploration found
that Greece’s debt burdened amounted to 113% of GDP, nearly double the
allowable Eurozone limit of 60%. The following year (2010) can be characterized
as a year of bailouts. The Eurozone and the IMF gave Greece €22 billion
initially, but followed that up with another bailout package of €110 billion
later in the year after revised Greek deficit figures were worse than
originally reported. The EU and IMF then agreed to bail out Ireland with €85
billion. The bailouts were not finished. In 2011, €78 billion was given to
Portugal and ANOTHER €109 billion was given to Greece with the hopes of
resolving their crisis and preventing contagion among other European economies.
It would take pages to fully delve into the EU’s decisions over the past three
years, but at this point, the burden that Greece has put on the European and
global economy should be evident.
In return for another €130
billion in bailout funds, Greek MP’s passed a controversial package of
austerity measures on February 12, 2012. Riots ensued, but the
government ensured that this package would set the foundation for future
economic solidarity. The austerity measures included job and salary cuts for
government workers, pension reforms, public sector job cuts, and a lowering
of the minimum wage. Another part of the debt exchange meant private
bondholders were expected to take a hefty loss (a 53.5% write-down) as Greece
swaps out its existing debt for new, longer term bonds with lower interest
rates. The terms of the bill aim to not only decrease government spending in
general, but to decrease Greece’s debt from its current level of 160% of GDP to
120% by 2020.
At the forefront of Greece’s
effort to force private bondholders to accept sizeable haircuts is the actions’
relation to outstanding credit default swaps on Greek debt which were designed
to transfer the credit exposure of fixed income products between parties. The
purchaser of a swap receives credit protection while the seller guarantees the
credit worthiness of the debt security. In doing so, the default risk
associated with that debt security is transferred from the holder of the
security to the seller of the swap. A CDS is basically considered insurance
against non-payment, whereby “credit events” involving the underlying security
incur compensation from the CDS issuer to the buyer. The question of whether
this restructuring plan would be considered a Credit Event in the CDS market
was the main focus amongst Greek CDS holders.
On March 9, 2012, the ISDA
(International Swaps and Derivatives Association) announced that the recent
restructuring deal is in fact considered a Credit Event. The determining factor
of this decision was because the ISDA invoked the Collective Action Clause (CAC)
which forced all holders of Greek debt to accept the exchange and write-down
offer by the Greek government. The plan involves a “haircut” and is binding to
all holders and thus, is considered a Restructuring Credit Event. The current
CDS credit protection on Greek sovereign debt as of March 2nd was
approximately $3.2 billion. Although this is the largest sovereign CDS payment
on record, many believe this is an amount that the markets can easily handle.
All in all, considering the
healthy signal the CDS market provides coupled with the fact that CDS volume is
at normal levels, one can conclude that the negative effects of the Greek
restructuring on the CDS market and hopefully the global market as a whole have
so far been averted. However, Greek solvency still remains questionable and judging by the Greek response to austerity, there has been no sign of real economic improvement. The true question is whether the markets have priced in all the negative possibilities with Greece and contagion in the Euro correctly this time. Should debt 'fears' arise again this summer, it will decrease confidence in the effectiveness of monetary policy and liquidity pumping policies of central banks. Even now, credit markets are not buying the fragile facade of recovery as equity markets rallied. This summer, we may see that divergence correct, one way or the other.
by Ryan Porter
by Ryan Porter
