The Eurozone’s Wacky Plan for Non-Default Default

June 17, 2011

Things are really getting Alice in Wonderland in Europe now. Tragedy is rapidly morphing into farce.

The latest burst of optimism — born of a supposed get together between Merkel and Sarkozy — is exhibit A as to why “rational economic man” is a completely mythical creature.

How many times now have investors swallowed euro politicians’ promises that a “solution is imminent?” Half a dozen? More?

But this latest jab takes the cake, as France and Germany try to engineer a “voluntary” creditor participation, i.e. a default that doesn’t count as a default.

From the New York Times:

Germany backed away Friday from a confrontation with the European Central Bank over a new bailout package for Greece, agreeing under pressure from France not to force private investors to shoulder some of the burden.

…Chancellor Angela Merkel and the French president, Nicolas Sarkozy, announced their agreement after a two-hour meeting in Berlin.

“We would like to have a participation of private creditors on a voluntary basis,” Mrs. Merkel said at joint news conference with Mr. Sarkozy.

“This should be worked out jointly with the E.C.B.,” she added. “There shouldn’t be any dispute with the E.C.B. on this.”

So let me get this straight:

  • The new hope is for private creditor participation on a “voluntary” basis, i.e. a default without a default.
  • If private creditors “agree” to let the maturity of their Greek holdings be extended by X years or what have you, then the “D” word — default — can be avoided, and thus we get a restructuring without the nastiness of meltdown.

First, good luck convincing those creditors to go in for a “voluntary” haircut.

Second, were the eurozone to actually be successful in engineering a “default without a default,” what the hell happens to the CDS (credit default swap) market? Wouldn’t this move render the whole concept of CDS insurance pointless?

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Via Bloomberg Businessweek:

European Central Bank chiefs are determined to ensure any Greek debt restructuring won’t be deemed a credit event enabling buyers of protection to seek compensation from swaps sellers. It costs $2 million annually to insure against Greek default for five years, with Portuguese and Irish swaps also seeing all-time high prices.

A debt restructuring that doesn’t trigger swaps would be more damaging to the market as it would devalue contracts, according to analysts at JPMorgan Chase & Co. and Bank of America Merrill Lynch. Such a move would leave banks with unprotected, or unhedged, holdings, forcing them to sell bonds and ultimately drive sovereign borrowing costs higher.

So okay, summing up again:

  • The new ingenius plan of Sarkozy et al — with Merkel being hammerlocked into queasy semi-agreement — is to jury rig a “default without a default” so that the shiny happy charade can keep on.
  • But if they pull this off, the banks holding PIG liabilities are still screwed because investors are smart enough to figure out the “non-default default” is still an ACTUAL default — and now the banks’ disaster insurance (in the form of CDS) is possibly rendered worthless!

More from Bloomberg Businessweek:

“We have absolutely no experience as to what may happen if a member of a unique monetary union such as this one were to take such a step,” Juncker was quoted as saying. “The risks are so big that I can only warn of such a move.”

‘Holy Grail’

“The holy grail is to find a way in which to involve private sector participation, but without triggering a default,” said Harpreet Parhar, a strategist at Credit Agricole SA in London. “I don’t see how that’s possible.”

In other words, “There is pretty much no damn way to pull this off, and it might be like pouring kerosone on a fire, but hell, we’ve got nothing else to try…”

Yeah, way to go guys. And way to go Mr. Market for getting “optimistic” yet again (we’ll see how long it lasts).

The near ‘breakthrough’ hinted at by Sarkozy et al sounds more like a  Rube Goldberg contraption than an actual viable plan — it’s not a default, it’s a gentlemanly whoozawhatsit!

And even if the “non-default default” plan succeeds, it might actually make the situation WORSE by rendering CDS insurance worthless even as banks take huge de facto losses on their devalued and NO LONGER HEDGED (as CDS are moot) sovereign debt liabilities.

And never mind, of course, the monkey wrench of Greece itself (and the high possibility of the Greek populace refusing harsher austerity measures under any conditions)…

Or the high likelihood this whole thing could be repeated all over again with Portugal, or Ireland, or even Spain…

Or the odds of getting private creditors to go “voluntary” in the first place, a task akin to herding wet cats…

Yep, gonna be a fun week next week.


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7 Responses to The Eurozone’s Wacky Plan for Non-Default Default

  1. Michael McGillicutty on June 17, 2011 at 2:42 pm

    Lol…the market does believe it so far, look at the bounce since the announcement. Ridiculous.

  2. Jack Sparrow on June 17, 2011 at 4:09 pm

    Hail mary fulla grace, help me win this stock car race… it may just be a renewed sense of possibility that some kind of rabbit will get pulled out of a hat. Again.

    Ironically, the fact that the stakes are so high contributes to the notion (hope?) that "Geez, they gotta figure SOMEthing out"…

  3. brett on June 18, 2011 at 10:03 pm

    I remain amazed that its the GREEKs are rioting, when it should be the Germans screaming bloody murder.
    The Greeks remind me of your mouse, complaining that the milk you brought to go with the cookie you gave him isn't cold enough….
    as always, good stuff!

    • Jack Sparrow on June 19, 2011 at 12:05 am

      Greece is being forced to give up on entitlements, for which there is little sympathy, but Greek citizens are also being asked to endure recession or even depression like conditions. Under more normal circumstances, this is the part of the story where the country under pressure devalues and has an inflationary / reflationary event (a la Argentina). What Greek citizens see is deep fiscal pain asked to be endured for the sake of bankers.

      On the German side, Germany has built up a huge hidden advantage over many years via the lowered exchange rate of the euro. If not for the rest of the eurozone, Germany's DM would have been much stronger, cutting into profits for exporters.

      It is also German banks (along with French banks) in the firing line for holding huge amounts of peripheral sovereign debt, and Germany furthermore gained a euro advantage in being able to sell far more goods to fellow eurozone members than it would have otherwise (the euro encouraged deep trade deficits between Germany and the periphery countries).

      So it's not so cut and dried in reality. Also, Germans are upset but more so from a stance of fiscal conservatism and concern for the future — Greeks, in contrast, have lost their jobs, businesses and futures and are wondering how they will feed their families here and now.

      • Berliner on June 21, 2011 at 5:04 pm

        ALL countries entering EURO in the balance sheet have profited, not only german companies. Germany, as a nation, has mounted a huge amount of national debt which the citizens have to pay – either by higher taxes or inflation.
        What happened is this: germany gave credits to PIIGS, they bought german products in EURO with lended money from german taxpayers. They have the products, but can't pay back the credits. Thats above the line. Under the line: it is germany buying its own products without owning them.
        Fine for german companies but not for germany. The 90ies Mercedes Benz Cabrio Roadster was assembled in Finland, btw. Just an exemple what exporting means today:it is not necessarily for the benefit of the exporting countries workers. Daimler just enters the balance sheet in Germany. The creation of value and wealth takes place whereever.
        German workers suffer from a diminuishing salary since 10 years. Elderly poverty rate is spreading dramatically.
        It is again 1920s… Just five more years, believe me…it is the repetition of the eternal same (Nietzsche)

        • Berliner on June 21, 2011 at 5:09 pm

          I have a longterm eye on silver long and 10yrBund short.

  4. GoodBread on June 22, 2011 at 10:27 pm

    Satyajit Das just picked up on the CDS issue in today's FT (6/23) Looks like the ISDA will have the final say. I can't see them ruling this a credit event although that would probably be a good precedent to set.

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