On Greek PSI

Headlines And Reality

The Greek PSI is once again (still) hitting the headlines.Here is what I think the most likely scenario is (80% likelihood).

by Peter Tchir

Some form of an agreement will be announced.  The IIF will announce that the “creditor committee has agreed in principle to a plan.”  That plan will need to be “formalized” and final agreement from the individual institutions on the committee and those that weren’t part of the committee will need to be obtained.  The headline will sound good, but will leave a month or so for details to come out.  In the meantime every European and EU leader (or employee) with a  press contact will say what a great deal it is.  That it confirms that Europe is on the path of progress and that they are doing what they committed to at their summits.

That will be the hype that will drive the market higher.  They will do it because they have to.  They cannot afford an uncontrolled default, so they will have to push forward as though they have fixed something.

The reality of the situation is that the big European banks on the IIF committee will have agreed to the plan.  They will confirm it.  Other European banks will also agree.  They will be told that they will not have such easy access to the ECB or other programs if they don’t agree.  In the end, European banks will get fully on board.  That is the easy part.  What about hedge funds?

I believe hedge funds have 3 trades in Greece right now.  The “how much lower can it go”, the “basis package”, and the “let’s play chicken” trades.

How much lower can it go?

These funds bought longer dated bonds, often at a price of 40% of par or lower.  If they deal they get is profitable they may agree.  Maybe some side deals will be created.  Maybe a bank (on behalf of the EU or ECB) will pay 50% or something for these bonds.  It won’t be an economic trade for the bank/EU/ECB, but they are all about taking default off the table.  Once upon a time “Greenmail” was a strategy, so why not now.  How much would it cost to give the funds enough of a profit that they sell or to cut some side deal where they get a bit extra?  Remember, these are the same people who are talking about a retroactive Collective Action clause, so don’t put anything past them.  That would clear up this source of bonds.

The basis package?

Funds that own bonds and CDS will be the most stubborn, so take them out of the package at 104 or something.  That is more than they could hope to make from it, and monetizes it today rather than at some point in the future.  A form of “greenmail” but if default scares you so much, do this.

The “Chicken” Trade?

Some funds bought very short dated bonds, March and May of this year, with the hope that the TROIKA would just pay them par whether or not a full PSI had been reached.  These are trickier because the amount of potential profit is very high if they are paid at par, but the consequences of “defaulting” might still scare the EU.

Carrot and Stick

So the “greenmail” would be the carrot for funds to participate or sell positions.  At same time, during the month while things are “finalized” how many visits would it take from regulatory authorities to scare even an unregulated entity into action.  The governments could clearly threaten to scrutinize holdouts and make life harder for them.  This is likely more to be a nuisance threat, or threat of some regulations that will never get passed, but at some point accepting the carrot and avoiding the stick might be enough to get the funds on board.

What will we learn?

We will learn that the ECB’s holdings, including Secondary Market Programme purchases are treated senior to other holdings, 50% NPV doesn’t mean 50% haircut, banks will be do what governments want, governments will have crossed a threshold in what they are willing to say and do to hedge funds.  None of those are good, and although they are in the back of most people’s minds, confirmation of them will not be good.

The rating agencies will call it a DEFAULT, because it is.  ISDA won’t call it a Credit Event because it isn’t.  The EU leaders will call it a haircut or PSI, because they have an aversion to saying the word DEFAULT (and to the truth).  There will be some concern that calling it a DEFAULT by the rating agencies will trigger some actions.  It won’t.  The ECB will allow banks to overrule the declaration of the rating agencies.  They will say that Greece remains current on some bonds, that Greece will make payments on new bonds, so this DEFAULT situation is temporary and can be ignored for purposes of accounting, mark to market, collateral, etc..  It will avoid the chaos that would ensue, so they will go with the flow.

Then all talk will turn to Portugal.  Why should Portugal continue to pay on their existing debt, when Greece just cut a great deal?  And Ireland?  The reality that Greece will NOT be an isolated case, but will be the norm will hit, and we will see the market give back the gains and sink lower on the realization that the banks recognizing losses is just beginning.

Hard Default

Without the carrot and stick and coercion a hard default would be inevitable.  If they cannot bribe and blackmail and threaten their way into something they call PSI, then we will see Greece stop making payments, and then the markets will get very ugly in a hurry.  We saw how quickly an entity as small as MF Global impacted markets in unseen ways.  This will be much worse.  The fear of this happening is so strong that banks and governments will figure out a way to make it seem like they have a deal and then spend the next month ensuring it closes.