collective action clauses: Greece’s deus ex machina

Greek sovereign debt restructuring under way

Greece is in the final stages of restructuring €270 billion in government debt.  Its deadline for holders to “voluntarily” exchange their bonds for new debt that’s worth only a little more, on a present value basis, than a quarter of what creditors were originally promised, is today at 8pm London time.

For the past few months, EU governments have been engaged in high stakes behind the scenes duel with their major commercial banks, which hold a majority of the Greek securities, over whether the financial institutions would agree to the Greek offer.  During the past couple of days, the banks have all been falling in line and saying they’ll take the Greek deal.  I don’t think the banks ever seriously considered doing anything else.  The discussion has all been, I think, about what quid pro quo they would receive in return.

That leaves private holders  …who don’t stay up at nights worrying that the bank examiners will be unusually thorough this year or that their applications to open new branches might be denied.  So both the threat of future bureaucratic ill will and the call to make a patriotic sacrifice of their (own and their clients’) capital fall on deaf ears. That’s where collective action clauses come in.

collective action clauses

A collective action clause is a stipulation in a bond indenture saying that if holders of a certain majority percentage of the issue agree to a given proposal by the issuer, then the rest can be forced to go along with the decision of the majority.

About one outstanding Greek government bond in seven was issued under English law and have had collective action clauses in the indentures from the outset.

The rest were issued under Greek law.  Being subject only to local law isn’t the norm for emerging markets debt, but I guess buyers weren’t concerned because Greece is part of the Eurozone.  Until a few days ago, those bonds had no collective action clauses.  Then the Greek parliament passed a new law to retroactively include them in its government bond indentures.

Not only that, but the lawmakers conveniently set a low threshold of around 60% acceptance (usually, it’s 75%) as the point at which the clauses can be invoked.  EU banks who have been arm-twisted into agreeing to the restructuring will doubtless lift Greece past that mark.  So, like it or not, private holders will be forced to accept the huge haircut Greece is proposing.  The maneuver is all perfectly legal.  The move isn’t a surprise to the bond market, no matter what you hear in the news.  It has been anticipated by bond pundits for at least a couple of years.

the English-law bonds

The case of the English-law bonds is more interesting.  From what I’ve read, their collective action clauses are set at 75% acceptance.  Early betting is that Greece won’t come close to that amount.

But Greece has already announced that if holders don’t tender in lat least large enough amounts to allow it to exercise the collective action clauses, it simply won’t pay anything.  The holders can see Greece in court.  Tomorrow we’ll see how much of this is bluff–and how successful the tactic has been.

rating agencies have already declared a Greek default

Major credit rating agencies have already declared that Greece has defaulted on its bonds.  So far, the body that decides whether credit default swaps (effectively, insurance policies against default) must be paid off is saying that no default has yet occurred.  That’s because the language of the swap agreements that describes what a default is contains an accidental loophole.  The government-inspired “voluntary” restructuring doesn’t qualify, even though holders are losing almost three-quarters of their money.   If Greece invokes collective action clauses and forces bondholders to take the new securities, however, that may change.

not many Greek CDSs?

Reports I’ve read say that Greek CDSs amount to a relatively small €3+ billion.  If that figure is correct, it’s hard to see why the EU has put so much effort into arranging a “voluntary” restructuring that avoids triggering them.  Maybe bank issuance of CDSs on Spanish and Italian debt is immense and contagion is the worry  …or the official figures may substantially understate bank exposure.

This time tomorrow we’ ll have more answers.

Europe’s deal on Greek debt

the Greek sovereign debt deal

Europe appears to have reached another milestone in its circuitous journey toward resolution of its twin debt crises–Greece and its banks’ unknown, but presumably very large, exposure to sub-prime mortgage debt.

Yesterday’s development is that commercial banks in the EU have agreed to “voluntarily” agree to forgive half the amount the Greek government owes them and write down the value of their Greek sovereign debt by 50%.

Although sharply higher stock prices in Asia, Europe and in pre-market trading in the US signal investor relief, I don’t think it’s particularly surprising that the banks would accede to the wishes of their governments to do so.  For one thing, defying your central bankers is never a good idea.  But in this case agreement brings tangible advantages to the banks as well.

Press reports have made it clear that, earning once again their reputation as the world’s ultimate “dumb money,” the big EU commercial banks had enabled hedge funds to bet heavily on a Greek default by taking the other side of hundreds of billions of euros of credit default swaps.  So the banks would be facing mammoth losses if Greece defaulted and they had to pay off.

But the EU has found what it considers a loophole in the language of the CDS contracts. Technically speaking, it argues, if creditors “voluntarily” forgive a portion of Greece’s debt–which they have just agreed to do–that action doesn’t count as a default; the CDS payoffs aren’t triggered.

Maybe this interpretation is sound, maybe not.  But it’s what the EU is going to do.  National regulators will certainly order their banks not to pay any CDS claims.  Hedge funds can sue.  Litigation would doubtless be long and expensive, however.  And it would provoke the ire of EU politicians, who might find ways to make litigants’ lives more difficult in other areas.

So the bank agreement appears to make the threat to bank solvency of their CDS exposure go away.

what I make of the EU situation

To my mind, resolution to the EU financial crisis has three possible outcomes:

1.  The Greece et al sovereign debt crisis spins out of control–causing the failure of one or more major banks, a run on the euro and a collapse of the EU political structure.  While this is going on, we discover that one of the now-defunct institutions has a crucial, but hitherto unappreciated, role in world commerce.  So the global economy comes to a screeching halt, just like it did after the Lehman bankruptcy.

There’s no evidence there’s an EU Lehman and it’s hard to believe the world would shoot itself in the foot a second time.  On the other hand, the EU has shown itself particularly ill-suited to deal with a financial crisis.  recent trading show clearly that global equity investors have been worried about this possibility, but I regard Lehman II as about as unlikely as you can get.  It’s even less likely today.

2.  Same as #1, except no Lehman.  That is to say, a big banking failure paralyzes the EU.  Most of the economic damage is domestic.  There are ripple effects elsewhere, but they’re not gigantic.

It seems to me that today’s news is also the start of taking this worry off the table.

how important is the EU?

Sizing the problem in the most simple-minded way (all I’m capable of), the world economy is divided about 50-50 into emerging and developed markets.  Half the developed part is the US and another 5% is the UK.  That leaves 20% for Euroland.

Suppose banking failure(s) caused a severe recession in the euro area.  Real output drops by 5%.  That would reduce total world output by 1% (5% x .2), and developed world output by 2%, in the year following the blowup.  factoring in ripple effects, the developed world would stagnate; the developing world would power along, but a bit more slowly.  The whole world would grow at, say, 2.5% next year instead of 3.5%-4.0%, if the blowup happened now.

…something you’d like to avoid, but not such a big deal.

As surprising as this thought may be to Americans with cultural roots in Europe, Euroland is no longer big enough to matter that much to overall world growth, except in extreme circumstances.

True, Europe has a lot of accumulated wealth–which we’ve seen on display, I think, in the periodic panic selling that has marked the past few months.  But it’s too wrapped up in what looks to an outsider like petty regional politics to focus on getting GDP to expand.  And much of the rest of the world is passing it by.

3.  The financial crisis is addressed, the banks recapitalize and the EU begins to heal its wounds, following the general trajectory of the US economy with a three-year lag.  Dreary as it sounds, I think this is both the most favorable and most likely case.

equity implications

Not much different from what I’ve been writing for a long time.  In cases #1 and #2, equity investors would be better off not holding EU-listed securities and should shade their other holdings away from companies with a large percentage of their business in the EU.

In case 3, it’s safe to dip a toe in the water.  But growth outside the EU will likely be much better than growth inside.  So the relative winners will be EU-listed firms with large exposure to foreign markets.  In a non-recessionary EU, these stocks stand to be winners on the world equity stage as well, since EU investors will likely concentrate heavily on them.