I appear to be in the minority here, and it may have to do with my not really having any money in the market (or elsewhere!), but for a long time I’ve found the news out of Europe very soothing. In part this is because I am a congenital optimist and so a sucker for can-kicking, but it is also in part because I realized that I didn’t need to pay any attention to it. There’s an evergreen quality to the euronews where you can ignore it for two months and come back and pick up right where you left off:
Euro finance chiefs left unanswered how they’ll fill a fresh hole in Greece’s balance sheet without tapping their own bailout-weary taxpayers for money after giving the country two extra years to trim its budget deficit. ...
Prospects of a funding deal at a hastily scheduled Nov. 20 meeting were clouded by objections from the International Monetary Fund, which took issue with the ministers’ decision to postpone the goal of getting Greece’s debt down to a “sustainable” level of 120 percent of gross domestic product by two years to 2022.
The highlights here - can-kicking, important questions left unanswered, disagreements between people at the same press conference1 - are perennials, and you’ll miss them if anything ever actually changes. I know I will.
This is my favorite though:
For now, [German FinMin Wolfgang] Schaeuble said the terms of the Greek package can be rejiggered by cutting the rates on bailout loans or giving Greece extra time to pay them back, without requiring creditors to put up more loans or write off parts of Greece’s official debt.
“Our assumption is that the program is working so that in the end, it’s a matter of guarantees and not benefits for Greece,” Schaeuble said.
Write-offs are a legal and political taboo for German Chancellor Angela Merkel, running for re-election in late 2013 with the argument that her anti-crisis prescriptions are working and unwilling to call on the German parliament to authorize more money.
Greece’s loan rates have been cut and maturities extended twice before. Schaeuble characterized the resulting cost to creditors as a reduction in profit. He said other, as yet undisclosed, steps can be taken to make the Greek fiscal math add up.
The interest rate margin on the euro zone bonds is 1.5%; Greece just issued one-month treasury bills with a yield of 3.95%, and those bills were sold to Greek banks who (1) kind of have to buy them and (2) don’t actually have to pay for them.2
So “reduction in profit” is a characterization all right, but you would not be crazy to seek other characterizations. I, for example, tend to think that extending a 5-year 5% bond into a 30-year 1% bond is basically the same as writing it down by 60-80% so y’know why not write it down by 60-80%? It’s just arithmetic. I mean, it’s not the arithmetic here - we’re talking smaller extensions and smaller rate cuts. A Goldman research report does the math and it is sobering; they can’t get to sustainability without a big reduction in actual debt amounts and they note re: rate reduction:
The interest rate margin for the bilateral loans handed out to Greece and worth EUR53bn was reduced to 150bp. A further reduction of the margin by 100bp would lead to annual savings in the interest rate bill worth about EUR0.5bn. The interest rates for EFSF loans are already close to EFSF funding costs and thus the scope for further reductions here are minimal. A reduction of interest rates on bilateral loans would involve a transfer of present value of debt from EMU states to Greece. It would also burden creditors such as Italy and Spain as they would lend to Greece at rates well below their own funding costs.
Still the engineer in me is intrigued by this notion that a highly value-destructive extension and interest rate roll-down of Greek debt is just a “reduction in profit.” You can see the same sort thinking in the U.S., of course, where the way-below-market bailout of AIG was highly profitable if you assume that all interest payments are profit, and not if you don’t. Financial arithmetic and government-sector arithmetic are very different.
Which means - by definition! - that one can arbitrage them. What if there were a way to reduce the nominal amount of Greek debt for Greece while keeping its nominal amount the same for its official creditors? Imagine this is a napkin on which I have sketched:
- Cancel eurozone nations’ loans to Greece and replace them with bonds issued by GreeDO LLC, which is a newly formed box that I have imagined.
- The GreeDO loans have the same nominal amount as the current loans to Greece, but have a  year longer maturity and a bps lower coupon.
- GreeDO purchases new Greek loans with the same maturity and coupon as the loans that are being cancelled,3 but with a lower principal amount.
- GreeDO uses the (higher) cash flows it receives on the new Greek loans to pay the (lower) cash flows on its bonds, and keeps the leftovers (and reinvests proceeds at the early maturity) to pay the higher repayment obligation at maturity
- Everybody wins: Germany et al. just have a “reduction in profit” with no principal write-off; Greece has a principal write-off.
I know I know this is just idle speculation and wouldn’t work for reasons legal and financial and arithmetic.4 It would be crazy to propose that Greece enter into an economically nonsensical derivative transaction with its official creditors just to optically reduce the principal amount of its debt outstanding. For one thing: it would only do that with Goldman. For another: isn't that kind of how it got here?
1.Here’s the FT:
In a rare breach, Mr Juncker told a post-meeting press conference the target would be moved to 2022, prompting Ms Lagarde to insist the IMF was sticking to the original timeline. When Mr Juncker again insisted it would be moved – “I’m not joking,” he said – Ms Lagarde appeared exasperated, rolling her eyes and shaking her head.
You and everyone else, Lagarde! I quibble with “rare breach” though; given enough time, you can get some Troikacrat to contradict everything said by any other Troikacrat. I guess it’s somewhat rare for it to be in the same press conference? Somewhat?
2.I see ISIN GR0006001847, first settle date 11/16/2012, maturity 12/14/2012, issue price of 99.694, YAS says 3.95%. Thereabouts.
3.Or shorter maturity and higher coupon, and an even lower principal amount! Really it’s just a napkin you can do whatever you want; optimize for whatever you want to optimize for.
4.For one thing, I sort of eyeball 2 years of maturity and 100bps of coupon paying for a ~10% principal reduction? That’s not going to make much of a dent.