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The lesser of two evils | ASHARQ AL-AWSAT English Archive 2005 -2017
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London, Asharq Al-Awsat- The Greek Ministry of Finance announced today that it had received consent from 85.8% of bondholders to participate in its debt swap. The Ministry of Finance also confirmed that it will apply the terms of the swap to all bondholders, including those not choosing to participate. The successful completion of the sovereign debt swap is a milestone in the implementation of the Greek rescue package: it reduces Greek sovereign debt by €105 billion and satisfies the precondition to the second EU and IMF rescue package of €130 billion. Most importantly, it has prevented a disorderly default by Greece. There are, however, negative aspects that merit consideration.

Under the terms of the debt swap, bondholders will receive 31.5% of the principal amount of their existing bonds in the form of new bonds issued by Greece with longer maturities (ranging from 10 to 30 years) and lower coupons (ranging from 2% to 4.3%). Bondholders will also receive 15% of the principal amount of their existing bonds in notes issued by the ESFS and GDP-linked securities issued by Greece. The debt swap will reduce the nominal value of the bondholders bonds by 53.5% and the economic value by 70% in net present value terms. Bondholders are taking a substantial loss on the economic value of their bonds, but the alternative is to risk a complete loss of their holdings in a disorderly default.

The impact of the Greek debt swap for European banks is unlikely to be significant. Banks which follow mark-to-market accounting for their bonds are unlikely to suffer any additional substantial writedowns as a result of the swap, as the market value of Greek debt has reflected a substantial writedown for some time and most banks have reflected this by writing down the value of Greek bonds and by strengthening their capital position. Banks which have not written down the value of their Greek bonds will now need to do so, but this would also have been the case in the event of a disorderly default in the absence of the debt swap.

While Greece claimed the debt swap to be voluntary, it was only voluntary to the extent that bondholders could initially decide whether to participate or not. However, by achieving a two-thirds level of participation, Greece was able to trigger “collective action clauses” (CACs) forcing the remaining bondholders to participate even though they had chosen not to participate. Collective action clauses are normally contractual provisions in bond documentation which permit the borrower to amend terms of the bonds with the consent of a supermajority of the bondholders. These clauses can therefore be instrumental in effecting a restructuring of debt by forcing the minority who chose not to participate to accept the restructuring. Such clauses are more typically found in bond documentation if the sovereign is borrowing in the international capital markets under a governing law other than its own instead of domestic issuance governed by local law.

90% of Greek sovereign debt had been issued locally, is governed by Greek law and does not contain contractual collective action clauses. Only a small proportion of the Greek debt had been issued in the international markets, is governed by English law and contains collective action clauses. Greece, however, in the legislation implementing the debt swap on 24 February 2012, retroactively and unilaterally imposed CACs on all of its local law governed bonds. The result was that if at least two-thirds of the eligible bondholders agreed to the terms of the swap, Greece could and did impose the same terms on the remaining bondholders even though they had chosen not to participate.

The use or threat of using collective action clauses is a means to prevent some investors from holding out for full payment and therefore benefiting unfairly from the losses that participating investors suffer in order to improve Greece’s financial position. Faced with a choice between risking the failure of the debt swap or exercising an element of coercion over bondholders through CACs, it is understandable that Greece has chosen the latter.

Nevertheless, this retroactive and unilateral amendment by Greece of the terms of its bonds could undermine investor confidence and make Greece’s return to the bond markets more difficult. It may also trigger arbitration and litigation under the terms of 40 bilateral investment treaties which Greece has entered into with other countries. Bill Gross, the co-Chief Investment Officer of PIMCO, one of the world’s largest bond investors, stated in an interview with Bloomberg that Greece’s action had diminished the “sanctity” of contracts. Some expect the debt swap to increase funding costs for all Eurozone countries.

The International Swap Dealers Association (ISDA), which determines whether “credit events” triggering credit default swaps (CDSs) have occurred, had initially ruled upon announcement of the Greek debt swap that it did not constitute a “restructuring credit event”, presumably because the CACs had not been applied. Today, upon application of the CACs, ISDA ruled that the Greek debt swap does constitute a restructuring credit event, and consequently payments on $3 billion of outstanding Greek sovereign CDSs will be triggered. This is undoubtedly the correct result, as investors that purchased protection from a Greek sovereign default through the CDS market will now be able to receive payments on their CDS contracts. Any other result would have undermined confidence in and the credibility of the sovereign CDS market.

The most troubling aspect of the debt swap is its potential to create a precedent. The underlying philosophy of the Greek bailout package is that Greece is a “special case,” and what applies to Greece should not be applied to other peripheral Eurozone debtor countries. This message should be communicated clearly and consistently. Notwithstanding its practical value in helping Greece restructure its debt and satisfy a precondition to receive its second bailout package, the Greek debt swap should be viewed as a very difficult and unpleasant choice by Greece in the face of extreme circumstances. It should not be viewed as a sensible debt management option, and under no circumstances should it be viewed as an option for other troubled Eurozone countries. Otherwise, the mere possibility of similar debt swaps by other the peripheral Eurozone sovereigns may create concern among investors and further undermine credibility and confidence in sovereign Eurozone debt markets.