Investors are prone to responding swiftly to questions about whether Greece will need to restructure its sovereign debt. ‘Of course, just a matter of time,’ is the most common comment.
It seems everyone other than the Greek government is convinced it will need a haircut. Mystifyingly, this week it launched a probe into rumours that restructuring discussions are underway. A cynic would argue the source of the rumours is clear: namely the European Commission, which wants to privately talk Athens into an orderly solution, rather than see it bumped into one by the markets.
Yet given the fact that most think a default by a developed European nation is now ‘almost inevitable’ it is surprising just how little analysis has been produced about what its impact is likely to be.
Economists and strategists are not rushing to answer this question. The reasons are clear. The outcomes are, in the words of one senior economist who did not want to comment publicly ‘non linear’ and ‘almost without precedent’.
While Greece can be compared to nations like Argentina this is not really fair. One was an emerging growth market in a classic bubble with plenty of growth but poor access to funding. The other is
a developed nation which blossomed with easy access to capital yet delivered low returns on economic activity owing to institutional weakness.
So what happens the day after Greece announces that government bond investors are being forced to take a 20% hair cut?
Mike Lenhoff, the chief strategist at Brewin Dolphin, points out that day two of the post-default world is the easiest period to call.
‘I would have thought that the market would react pretty sharply and that would be reflected in particular in the banking sector. The view would then be what’s next? Could it be Portugal? The sentiment would spread and it would not just be the European banks but the UK and the US banks too. We would be back to the risk off/risk on trade.’
Lenhoff argues that the market would realise fairly quickly that such a restructuring was mostly in the price.
Except that this begs the question: what specifically is in the price? There are many different outcomes that could unfold in this situation. Greece could insist existing bondholders swap their current bond for one of a longer maturity and lower yield, but without compromising the value at maturity. That would be markedly different to simply telling them they were getting back 60p in the pound.
Should the first outcome materialise, it would immediately raises the question of whether the credit default swaps (CDS) on the debt would be triggered. Should the second materialise it would be apparent that the CDSs would be triggered but would beg the question of how much confidence investors have that banks have already mark all of their debt to market effectively?
Perhaps more importantly, would the restructuring happen in an emergency because either the European Financial Stability Fund or the European Central Bank somehow failed to keep the country afloat? Or would it come as a result of a long drawn-out process in which the European policymakers stress-tested banks to establish they could cope with a haircut before foisting it on them only in 2014? That would leave plenty of time for it to quietly go into the price of banking shares.
Andrew Milligan, chief strategist at Standard Life Investments, argues there is broad confidence that banks have transmitted accurately their exposure to Greek debt. ‘We have chatted to our European bond team and banking analysts and they have said that as far as banks have been reporting honestly and openly, the news is to some extent in the price.
‘That is not to say that there are not going to be surprises depending on the institution, the timing and the nature of the change that is made.’
Perhaps the most lingering fear for veterans of the credit crunch surrounds the CDS issue. Just how far does the exposure run? How many times multiplied does exposure turn out to be? Just how nasty will the legal battles between holders and issuers become if it is not a clear-cut pay-out?
Fundamentally, if the European policymakers achieve some form of orderly restructuring where the value at maturity is not compromised, will the CDSs pay out? Milligan said: ‘Clearly the CDS is another mechanism to transmit the shock.’
We all know what confusion about credit default swaps can do to markets.
However much optimists retort a restructuring is ‘in the price’, it must be acknowledged that there are many unanswered questions.