-- The authors are a Reuters Breakingviews columnists. The opinions expressed are their own --
By Neil Unmack and George Hay
LONDON (Reuters Breakingviews) - When is a country in default? In Greece’s case, the answer depends on who you ask. Euro zone politicians want holders of the country’s bonds to help contribute to another bailout. However, they also want to avoid the wider market fallout that a default would bring. Getting accountants, rating agencies, derivative traders and the European Central Bank to agree will be hard. But not all opinions have equal weight.
A debt restructuring could take several forms. One option is to ask creditors to exchange Greek government paper into new, longer-dated bonds. The alternative is to persuade holders of maturing Greek debt to voluntarily roll over their holdings into new bonds. Different groups are likely to have differing opinions on whether this counts as a default.
For banks, the question is whether an exchange or extension forces lenders to recognise a loss on their bonds. That would have severe ramifications for Greek banks, which hold 48 billion euros of the country’s debt, and would also hurt French and German lenders. But banks may be able to avoid taking a hit.
Accounting rules are strict on obvious defaults. If the issuer of a bond cuts the coupon or refuses to pay back all of the principal amount then the bank must register a loss. But there is more leeway on milder “reprofilings”. If the issuer keeps up interest payments, pledges to repay the principal in full, and only extends the maturity, banks do not have to class the bond as impaired. True, the market value of the bond is lower, as the repayment date has been pushed out. But this only applies to bonds that are held in banks’ trading books, which are marked to market. Most banks now hold sovereign debt in their banking books, where accounting valuations rule.
Exchanging existing bonds for new ones could be harder to get past the auditors, because accounting rules technically deem this to be a sale -- which would crystallise losses -- rather than just an extension. But there are no explicit rules on the accounting treatment of such manoeuvres. It should therefore be possible for bank chief financial officers to argue that a bond exchange and a maturity extension should have the same treatment, as long as no change has been made to the coupon or principal.
Euro zone politicians also need to worry about the International Swaps and Derivatives Association, the derivatives industry body, which will decide whether or not an exchange or rollover triggers the country’s credit default swaps (CDS). If it does, that would trigger losses for institutions that have sold protection against a Greece default -- which have a net exposure of about $5 billion -- and a pay day for speculators. And it would be a public verdict of default. To dodge this bullet, the rollover or extension cannot be legally binding on all creditors, and will also have to avoid giving any creditors contractual seniority over other classes of debt.
The ECB is less worried about legal or accounting niceties. However, the central bank has so far objected to anything that changes the terms on existing bonds, because it fears this could spread panic throughout the euro zone. Politicians are understandably wary of overruling the central bank that provides the region’s lenders with liquidity and protects the single currency. However, there may be some middle ground: the ECB has recently given its blessing to a voluntary rollover of Greek debt. The ECB’s support is critical if Greek banks are to continue pledging government bonds as collateral with the central bank -- particularly if rating agencies take a hard line.
Even a voluntary rollover of Greek debt will be closely scrutinized by Moody‘s, Standard & Poor’s and Fitch. Whether they classify a restructuring as a default will depend on the terms offered to investors.
On paper, a voluntary exchange need not trigger a default. But any proposal that penalises investors who do not participate -- for example by threatening a hard default if the offer isn’t accepted, or by changing the residual bonds’ tax or legal status -- could prompt the ratings agencies to temporarily downgrade Greece to a selective or restricted default.
Even a voluntary rollover of debt may be viewed as akin to a default. Rolling over bonds at current market rates -- meaning a yield of about 15 percent on five-year bonds -- might be OK, as it would suggest that investors were entering into a commercial transaction rather than having their arms twisted. But Greece cannot afford to do that. An alternative is for Greece to sweeten the deal by offering collateral with the new bonds. But even then ratings agencies would frown on such an arrangement if they didn’t believe the deal was done on commercial terms.
So a default verdict from the rating agencies looks likely. But this may be temporary, and not too damaging, as investors who are forced to pay attention to ratings sold their Greek holdings when the country was downgraded to junk status. As long as the ECB is willing to keep on funding Greek banks, the fallout may be manageable. However, a Greek downgrade to default -- even if temporary -- could prompt downgrades of other peripheral government debt. Rating agencies might expect holders of Portuguese or Irish bonds to receive similar treatment in future. That could lead to downgrades for the euro zone periphery, and the risk of contagion.
Of all the opinions, the banks and the ECB are most important. So long as a rollover or extension doesn’t undermine the solvency of the banking system, and as long as the ECB continues to fund peripheral lenders, a systemic crisis should be averted. A rating agency default, or credit event on CDS, would have some knock-on effects, but these should be manageable. The longer-lasting impact would be the stigma that Greece was deemed to have defaulted on its debt. But that would only confirm something that most investors and analysts already believe is inevitable.
-- A voluntary rollover of Greek debt would likely be viewed by Moody’s as a default, the rating firm’s head of sovereign ratings, Bart Oosterveld, said on June 7. The ratings firm could classify a debt rollover as a default if it believed that bondholders had only taken part because they feared the consequences of not participating, according to Oosterveld.
-- “It’s hard to imagine in the current circumstances that people would voluntarily do this,” Oosterveld told reporters in Paris.
-- Greece needs to persuade private sector creditors to extend, exchange or roll over at least 30 billion euros of bonds maturing over the next three years to part-fund a new bailout package worth between 80-100 billion euros, Reuters reported June 7.
-- Greece needs a second bailout as it faces a funding shortfall in 2012 and 2013 after failing to return to markets and falling behind on its reforms under an EU/IMF programme.
Editing by Peter Thal Larsen and David Evans