Greece's selective default

After prolonged foot-dragging, the inevitable has happened. The Eurozone leaders approved the second bailout of Greece, one that bears clear signatures of a partial default. The €109 bn ($157 bn) bail-out of Greece will force private bondholders to take losses on their bonds through debt swaps, roll-overs and buy-backs. In return, the Eurozone economies collectively guarantee the repayment of Greece's debt principal.

Instead of significant "haircuts", bond holders will now have to accept smaller losses and agree for maturity extensions at lower interest rates. Private bondholders will be required over the next three years to swap or roll over debts for new 15-30 year bonds. Whatever its form, this will ensure that Greece becomes the first western developed world country to default in more than 60 years.

This bailout deal comes after consistent opposition among the main economies, especially Germany, against any form of selective or partial debt default by any Eurozone economy. In the circumstances, the preferred policy was to continuously keep rescheduling Greek debts by swapping it with longer-term bonds in the hope that austerity measures would restore growth and ease the debt burden. It was also argued that this would prevent a run on Greek debt and ensure that Greece and other PIIGS economies were not elbowed out of the nobd markets. However, these measures had failed to reassure the bond markets, especially in light of recent fears of a similar crisis in Italy.

In an attempt to limit contagion effects, the debt deal also contained provisions to enable the European rescue fund, the €440 bn European Financial Stability Facility (EFSF), to assist countries like Spain and Italy that have so far not received any assistance. All three bail-out countries – Ireland, Portugal and Greece – will see rates cut to about 3.5%, or about 100-200 basis points, and will not have to repay the loans for up to 30 years. The EFSF will now be able to buy government bonds (or alternatively lend to these economies) on the secondary market (presumably at a discount rate, compared to the high rates that each of the peripheral economies would have to pay) and to help recapitalize banks, moves long resisted by Germany.

Further, holders of short-term obligations would be able to swap their notes for debt with longer maturities and backed by high-rated bonds. It is expected that 90% of all Greek bonds will be exchanged. The terms of the aid package from Europe to Greece would be eased, with maturities lengthened to 15 years from 7.5 years, at very low 3.5% interest rate. Most encouragingly, the deal also includes a commitment from Europe’s leaders to support Greece until it is able to return to the financial markets – a potentially unlimited guarantee that could see European taxpayers fund Greece for years.

As the FT reports, bondholders will be given four options – three forms of debt exchange and one rollover plan – with different durations and interest rates. The first exchange plan and the rollover would flip existing paper into new 30-year bonds at par value and with interest rates beginning at 4% and rising in 0.5 percentage point increments during the first 10 years to 5.5%.

The other two exchange plans – one for 15 years and the other for 30 – would pay higher coupons of 5.9-6.8% as compensation for taking an upfront 20% "haircut" on the value of the bond. All plans would be backed by an obligation on Greece to reinvest a portion of receipts from the rolled-over or exchanged financing in European AAA bonds, which would act as collateral against default. These bondholder programmes, limited to Greece only, amount to a 21% reduction in the net present value of their current bondholdings, and amount to a selective default.

Though voluntary, it is estimated that upto 90% bond holders will participate. Most major investors and financial institutions have welcomed the plan. Accordingly, private bondholders are expected to contribute €54 bn from mid-2011 to mid-2014 and a total of €135 bn during the period to 2020. On top of all this, an additional €12.6 bn is expected to come in commitments from bond owners to sell their holdings at a reduced price as part of a bond buy-back programme.

The financial institutions that own Greek bonds would effectively contribute 54 billion euros through 2014, largely by accepting reduced interest payments, and will stretch their maturities to as long as 30 years. The plan does not immediately reduce the total Greek debt is 350 billion euros ($496 billion) which form nearly 150% of GDP by much. Greece will benefit by way of reduced interest burden, extended loan maturities, discounted rates for Greek bond repurchases by EFSF, and even some haircuts on debt principals. The benefits are conservatively estimated to shave off atleast €26 bn off the country’s €350 bn debt pile by 2014. Further, the maturity profile of Greek debts will increase from six to eleven years.

The selective default is also an admission of the failure of the fiscal austerity policies. Over the 12 months ending in March, the Greek economy shrank by 5.5%, while unemployment, at 12.2% when the country was first bailed out, rose to 15%. More importantly, it is the first step in acknowledging that the solution to Eurozone problems lies in a fiscal union. The bailout virtually involves fiscal transfers from the better off economies to the beleaguered ones. Further, the EFSF, with its explicit financial stabilization mandate, becomes an effective European Monetary Fund.