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Table of ca

Part I: Fundamentals

Fundamentals of ___ _

sovereign debt Eugenio A Bruno TIG Americas, Garridc :..:.···

Part II: The governments the markets, the IMF and the rating agencies

The sovereign stress situati Rashique Rahman Morgan Stanley

The Greek sovereign __ _

debt restructuring Alexander Metallinos Karatzas & Partners

Behind the 2012 Greek __ · default and restructuring

Arturo C Porzecanski American University

Part III: Sovereign debt liti

Debt restructuring cases _ against sovereigns and the US Foreign Sovereign Immunities Act

Oliver Armas Thomas Hall Chadbourne & Parke LE

Behind the 2012 Greek default and restructuring

Aituro C Porzecanski American University

In March 2012, the government of Greece defaulted on approximately €200 billion (about $265 billion) of its bonded debt, the largest sovereign default in recorded history and the first by an advanced country boasting an annual income per capita exceeding $25,000 and membership of the very wealthy European Union.'

The default was precipitated by persistently negative attitudes being displayed by the authorities in Berlin which ultimately destroyed the confidence of the credit rating agencies and fixed-income investors which had been funding the Greek government. The subsequent debt restructuring, which imposed ali-in losses on bond holders in excess of 70% on a net-present-value (NPV) basis, placed Greece in the same company with Argentina and Ecuador- serial defaulters which had likewise inflicted up-front losses of a similar magnitude on their creditors.2

In each of these three cases (to a greater or lesser extent), the sovereign debt workout was driven largely by considerations of a non-economic nature, with creditor rights and the rule of law being trampled.' Moreover, we argue that the scale of the losses imposed by the government of Greece under pressure from its eurozone partners and the International Monetary Fund (IMP) was based on questionable estimates and judgments. It is no wonder that the Greek default and restructuring set a troubling precedent that has been worrying investors involved in other vulnerable countries around Europe's periphery ever since.

Greece had previously defaulted in 1932, as other countries in Europe and most in Latin America had done in the midst of the Great Depression. See Carmen Yf Reinhart and Kenneth S Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, XJ: Princeton Univ Press, 2009), p 96. The world's second-largest default was staged by Argentina beginning in late 2001, and it involved about $80 billion of bond holder debt plus several billion more in obligations to official and various other private sector creditors.

2 Juan J Cruces and Christoph Trebesch. "Sovereign Defaults: The Price of Haircuts", draft, March 2012, p 36. The authors summarise various alternative calculations of investor ;\!PV losses generated by them and other experts, finding that they average 7 .fo/o for Argentina and 68% for Ecuador. The Greek restructuring involved a 53.5% reduction in the nominal face value of existing government bonds held by private investors, but considering the payment terms of the new bonds issued to investors after this 'haircut' was applied and pre,·ailing market conditions, the debt exchange imposed an :-;pv loss of over 70%. See Credit Suisse, "Greece's Debt Exchange", February 27 2012, which estimated a 74% NPV loss, and Morgan Stanley, "On the Greek Debt Restructuring, Part I", February 22 2012, which estimated a 73%-78% C\"P\' haircut.

3 For more on Argentina, see Arturo C Porzecanski, "From Rogue Creditors to Rogue Debtors: Implications of Argentina's Default", Chicago [oumal of Intemational Law, Summer 2005. For more on Ecuador, see Arturo C Porzecanski, "When Bad Things Happen to Good Sovereign Debt Contracts: The Case of Ecuador", Law & Contemporary Problems, Fall2010.

33

Behind the 2012 Greek default and restructuring

1.

1.1

4

6

34

The Greek tragedy

Act I

The pedestrian version of the story of the Greek financial crisis and default is that the

country was fiscally mismanaged for a long time and failed to carry out needed

structural reforms that could have improved economic grovvth prospects and

enhanced the country's creditworthiness. A default and debt restructuring were

therefore inevitable sooner or later- and certainly so once the financial markets were

informed, as happened in October 2009, that prior governments had underestimated

their budget deficit and public debt figures. This prosaic tale of the supposed

inevitability of the Greek tragedy has been endorsed, for example, by a prominent

economic historian: "Since independence in the 1830s, Greece has been in a state of

default about SO% of the time. Does that tell you something?""

In reality, Greece's road to default and debt restructuring in 2012 was not at all

straightforward - and there was no historical inevitability about it either. Consider

some of the facts. In the last five decades, successive governments in Greece managed

its public finances without a hitch, including servicing a very high level of public

debt that averaged the equivalent of nearly 100% of GDP from 1990 until 2009. 5 In

2009, the public debt was structured very favourably: the average interest rate on the

debt was a low 4.2% per annum, and its weighted-average residual maturity '"'as

eight years, the second-longest among advanced economies (after the United

Kingdom). 6 It is difficult to argue that this exceedingly benign debt structure in

Greece was the poisoned fruit of moral hazard; after all, the European Union

enshrined a well-known prohibition on bailing out its members, designed to protect

it from shouldering the cost of fiscal indiscipline in any one country, thereby

encouraging bond holders to assess and bear the risk of any potential default and

restructuring. 7

It is true that Greece raised eyebrows in October 2009, when an incoming

government announced that the fiscal deficit for 2008 had been revised from the

equivalent of 5% to 7.7% of GDP, and that because of an election-related drop in tax

11Q&A: Carmen Reinhart on Greece, US Debt and Other 1Scary Scenarios/ 1' \Vall Street Jounzal Blugs, February 5 2010. Greece was in default throughout much of the 19th century. The flippant Yiew expressed is reminiscent of sceptical attitudes among academics toward Mexico's financial crises at the end of seemingly eYery six-year presidential term- at least until a dozen years ago, that is, when .'.1exico 'outgrew' them. IMF, Historical Public Debt Database, September 2011. The precise two-decade average was 99'Yo of GDP. The government of Greece defaulted on its obligations during the Great Depression, as preYiousl,- noted. and so did some 30 other governments around the world, more than a fifth of total sovereign issuers.The Greek default was finally cured in 1964. See Standard & Poor's, "Sovereign Defaults at 26-Year low, to Show little Change in 2007", September 18 2006. Average implicit interest rate calculated by the author from Eurostat, Govemment Finance Statistics, Summary Tables 1996-2010, December 2011, p 13; maturity data from IMF, Fiscal .\fonitor, :\m-ember 2010, pp 27-32. Article 125 of the Treaty on the Functioning of the European Union, often referred to as the 'no-bailout clause' of the Maastricht Treaty ratified in 1992, states that the EU and am- of its member states "shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed bv public law, or public undertakings of another member state, without prejudice to mutual financial guarantees for the joint execution of a specific project". European Union, "Consolidated Version of the Treaty on the Functioning of the European Cnion". Official Joumal of the European Union, C-83/99, March 30 2010.

8

revenues :':~: .:. :" 12.5% ra;:"_c:: ;-__ :

were 6.5°: ~=--:

minister p:- ~ ~--- , : iilll both COnYi:-_:::-: ~

Howev·e: --::-::"::Je

member cc::.:- ::- ,- :II

2007 and ::': - <:<I

fiscal deficit- ::,- -!'ll!l

position of ;:-_c: c __:_-::a

2009 budget: :::: _ --.

Figure 1: Sele::t·: ::.

Fiscal balan c c ~- ::::C·4

Eurozone

Belgium

Italy

Greece

Government De':"': Eurozone

Belgium

Italy

Greece

Government De:C:

Belgium

Italy

Greece

Government Debt

Belgium

Italy

Greece

Source: Eurostat and _;:_

And largely bec~­

ratio of governmem :

of the eurozone bet\\--

Unless otherwise stated c calculations from Euroste~

'::"-~=-- ~: ~: :~isis and default is that the =-:: :_:-_ :_ ~.:.~led to carry out needed

-:-: : :-_ : =-:-: growth prospects and ::: :_ __ : ~=--=- debt restructuring were

:: ::-_::::he financial markets were :- :: --::::-::::c.ents had underestimated

-::--_.-_: ;:::s1ic tale of the supposed

::::::. :::example, by a prominent

~ ' : : ; ~:eece has been in a state of - ~: ~- ::::_--_:_:-_g?n.;

:::'::::-:.:~..:::::1g in 2012 was not at all ~ --_: .o:: ::: :o: about it either. Consider

:·:::; :---=~=--:::1ents in Greece managed -=:--_::_:-_;.:.wry high level of public

:: ::::::_:::':om 1990 until2009.' In

:.:: _ -- ::-.:: :.·.-erage interest rate on the

:-.:-:-:.-.'.~-~~::.ge residual maturity was

::::.::. :::::::omies (after the United

:::-:::.:.:-.;;'.- 8enign debt structure in

.'.:':::~ a.lL the European Union

: _: .:: =.e::::bers, designed to protect · _ _.-_:: .:: ::.::,- one country, thereby

__ , ,: : ~ my potential default and

: =~: :::: _:,X19, when an incoming

:: .: :•: ~ ::-_::.d been revised from the

...:~ :: ~=-- :::ection-related drop in tax

: "~-"-' cs. --· l·Vall Street Journal Blogs, __ _ o : 0 :~_ century. The flippant view __ _ -- -.;.::. ~.:e-xico's financial crises at the -=-=- : :: :e~- -.-c::s ago, that is, when Mexico

~o: :c - :<o:l~e average was 99o/o of GDP. .: -_- c :-:e:: ::·~::cession, as previously noted, :··c ----~-: ~-~~-cf total sovereign issuers. The .:- _ - --·ece:~ Defaults at 26-Year Low, to

·: =- ~ _: :::.'.: :Cc;wrmnent Finance Statistics, - :_ -~ :::: = ::,:r. Fiscal Monitor, November

__ : ':e:: referred to as the 'no-bailout :.-, ~-- :~_: :::x of its member states "shall :-,-:-.::-cc." o<o£ional, local or other public _ .:. : o-:,_;~::<s of another member state, ~- ~--, ~ _ =.: ~- ::a specific project". European .:.: : :_·_o ::·"::;Jean Union", OffidalJournal 8

Arturo C Porzecanski

revenues and a splurge in fiscal spending, the deficit for 2009 would end up closer to

12.5% rather than 3.7% of GDP. (In the event, the actual figures for 2008 to 2009

were 6.5% and 15.8% of GDP respectively.) It is also the case that the incoming prime minister promised at the time to impose austerity measures, but that he was short on both convincing detail and political support.

However, Greece was the rule rather than the exception: every one of the 17

member countries of the eurozone experienced a major fiscal deterioration between 2007 and 2009 as a consequence of Europe's economic downturn. While Greece's

fiscal deficit widened by 9.3 percentage points of GDP during the two years, the fiscal

position of the eurozone as a whole widened 5.7 percentage points. Britain's own 2009 budget deficit was equivalent to 11.3% of GDP.•

Figure 1: Selected fiscal indicators (percentages)

2007 2009 Change Fiscal balance/GDP Eurozone -0.7 -6.4 -5.7 Belgium -0.3 -5.8 -5.5 Italy -1.6 -5.4 -3.8 Greece -6.5 -15.8 -9.3

Government Debt/GDP

Eurozone 66.3 79.8 13.5 Belgium 84.1 95.9 11.8 Italy 103.1 105.8 2.7 Greece 107.4 113.0 5.6

Government Debt/Eurozone GDP

Belgium 3.1 3.7 0.6 Italy 17.7 19.7 2.0 Greece 2.6 3.4 0.8

------- ---- --- - -

Government Debt/Eurozone Government Debt Belgium 4.7

Italy 26.7

Greece 4.0

Source: Eurostat and author's calculations.

4.6

24.7

4.2

-0.1

-2.0

0.2

And largely because of the added fiscal cost of various bank bailout plans, the

ratio of government debt to GDP increased by 13.5 percentage points in the whole

of the eurozone betvveen 2007 and 2009, and a more limited 5.6 percentage points

Unless othernise stated, all fiscal data cited here and appearing in the Table reflects the author's calculations from Eurostat, Government Finance Statistics, Summary Tables 1996--2010.

35

Behind the 2012 Greek default and restructuring

9 10

11

12

36

in Greece. (In the United Kingdom, meanwhile, it jumped by more than 25 percentage points of GDP.) Among other heavily indebted countries in the eurozone, the ratio of debt to GDP went up as much as 11.8 percentage points in Belgium and as little as 2.7 percentage points in Italy. The eurozone average debt-to-GDP ratio exceeded 87% in 2011, having measured 66% in 2007.'

The news that the 2009 fiscal deficit in Greece would be much larger than previously projected actually did not lead to a measurable loss of investor confidence in Greece's ability to refinance its debt and access new funds to cover ongoing deficits. Yields on Greek two-year and five-year benchmark government bonds were slightly lower in the five working days after, than in the five days prior to the October 20 announcement by George Papaconstantinou, then finance minister in the new Socialist government, that the budget deficit would be far higher than estimates provided by the former Conservative administration.10

The erosion of investor confidence that would take place later on could have been prevented if Greece's eurozone partners had seized the initiative and worked constructively with the new government in Athens to come up with a preemptive plan to introduce fiscal austerity and implement structural reforms that was backed by Europe and the IMF. After all, the public debt of Greece was minuscule by eurozone standards: it represented as of end-2009 a mere 3.4% of eurozone GDP, or 4.2% of total eurozone government debt.

Early on then, Greece could have been stabilised- and for a fraction of what it has so far cost.

Instead, initial hesitation in Athens on the part of Prime Minister George Papandreou, combined with inertia and indecision that gripped the eurozone in assembling a stabilisation program for Greece until six months later, would plant the seed of doubt among the credit-rating agencies, market analysts, and investors - and not just about Greece's fate, but also about the vulnerabilities of other countries sharing the single European currency. This is why a few months after Greece was provided with official funding, Portugal and Ireland also had to be supported by the EU and the IMF.11

In essence, Greece unwittingly played the role of the child in Hans Christian Andersen's famous tale, pointing out that the eurozone "Emperor" was stark naked. 12

The slide in investor confidence in Greece began in December 2009, when all three of the leading rating agencies downgraded the sovereign (Fitch and Standard &

Poor's from A- to BBB+ and Moody's from A1 to A2, all with a negative outlook). That fanned concerns that Greek government bonds would be excluded from ECB

Eurostat, Newsrelease 62/2012, April 23 2012, and Newsrelease 20/2012, February 6 2012. Greek bond yield data courtesy of Bloomberg. "The news, delivered at a meeting of European Union finance ministers, was unpleasant but not unexpected for Greece's 15 eurozone partners. They had suspected that the financial crisis would have a more serious impact on Greece's deficit and debt than had been admitted in Athens." See Tony Barber, "Greeks Aim to Cut Deficit", Financial Times, October 21 2009. Domenico Lombardi, "The Euro-Area Crisis: Weighing Policy Options and the Scope for US Leverage", US Senate Subcommittee on Sewrity and Intemational Trade and Finance Hearing, September 22 2011, p 2. This is a reference to serious flaws in the eurozone's governance structure that have become obvious during the past few years as a result of the handling of the European banking and sovereign crises - and not only to the hesitant leadership of German chancellor Angela Merkel. For an incisive analysis, see Matthias Matthijs and Mark Blyth, "Why Only Germany Can Fix the euro", Foreign Affairs Snapshots, November 17 2011.

1.2

13 14

(European Central B returned to pre-crisis mid-January when F change its collateral ~ the ECB would annou rules into 2011, and i: did not become inel Standard & Poor's.) Yl in early December 20 to around 5.5% later

Investor confiden between Greece and t - on an economic Union-IMP financin government bonds ir before dropping belo1 and news that the E

attempt yet to end tl Facility (EFSF) was bo capital of €440 billior

Another investor with Standard & Pc government bond rat greater, albeit, low ris; from 7.5% to 10% p: additional, temporar; market calmed dovvn effort to rein in its fis, by mid-October.

Act II What turned out to b began on October 18 Sarkozy met in Deam­to future European S<

meaning that bond payment terms on th< permanent bailout fu1 system of state-funde( the bond market.

The financial rna yields jumped from -;

ECB press conference, Jan~ Moody's Investors Service.

:.:__:; ~: ·:.:mped by more than 25 :_::-_::.:;~::;: ~o:mtries in the eurozone,

~ :::·~:::;::.::.ge points in Belgium and '.:..:::: =--~ =.-.-erage debt-to-GDP ratio

:=·o-::; -.-::·.;.:d be much larger than '.l.C·..:.: =.':: :~ :.Jss of investor confidence

:::.'::' =---=~·: funds to cover ongoing :>:::-.:::.=-_=.:~government bonds were :::::=.:-_ :_::-_ :.':le five days prior to the -~_-::-.::-.:·.:. then finance minister in : ::':':::: ~·:Duld be far higher than

r_:__:: :-'-;·_-:: p:ace later on could have <.::. :-:::::-::: :.':le initiative and worked

::me up with a preemptive -::-::-_:-::-.::}:reforms that was backed ::.-:::- :~ .J:eece was minuscule by .: =. :.::-.-:::-:: 3.-±% of eurozone GDP, or

:.:;o-::. - .J.::::.: for a fraction of what it

:': ::: ~ ::: Prime Minister George >:: ::_ ::-. .o: gripped the eurozone in =- :~--- :::::.:::ths later, would plant the ::"":' -::: _o_:-_:.lysts, and investors - and :-:::=.: ::.:::.::s .Jf other countries sharing : _:-_ ::-_: _o_-':-::: Greece was provided with >0 • .::::::: :::-:~d by the EU and the IMF.11

.:: :: ::-_-:: child in Hans Christian : : : :-. = ~--=---;:: eror" was stark naked.12

:.:-::=.:: :_::-_ =:Jecember 2009, when all ::-_-::: :·:-::::::g::11Fitch and Standard &

C.: -'--- ··.::::-. 1 negative outlook). That ::..: - ·:·.::: '::le excluded from ECB

.;., : :: ~= :=o·:ruary 6 2012. :, __ - c:e-:. :o: , meeting of European Union

· :-:~:e • ~ < o·Jrozone partners. They had _ _:::: :o :-: : :_ -~:eece's defidt and debt than __ : _:: o:':c:i:", Financial Times, October

::- : ~:. : ::.• o:::C: :he Scope for US Leverage", -_ -_,_'=·,.:"":?:;.September 22 2011, p 2.

::: __ - _' ::: c :-::-~:e that have become obvious _ __:: :•o.:. :o:_;;'_,g and sovereign crises- and

<c:;:o:. i'or an indsive analysis, see :.:.:-· : ~·- :c.o "-~r2'', Foreign Affairs Snapshots,

1.2

13 14

Arturo C Porzecanski

(European Central Bank) market operations when collateral credit-quality rules returned to pre-crisis levels at the end of 2010 - concerns that were aggravated in mid-January when President Jean-Claude Trichet said that the bank would not change its collateral policy for the sake of "any particular country"." (In the event, the ECB would announce in late March that it was extending its emergency collateral rules into 2011, and in May it dropped all restrictions on Greek bonds to ensure they did not become ineligible after the country was downgraded to 'junk' level by Standard & Poor's.) Yields on two-year Greek government bonds rose from below 2% in early December 2009 to a peak of 6.5% in early February 2010, before subsiding to around 5.5% later that month.

Investor confidence was undermined again in April2010 ahead of an agreement between Greece and the IMF, ECB, and European Commission- the so-called 'Troika' - on an economic stabilisation and reform plan backed by a joint European Union-IMF financing package worth €110 billion. Yields on two-year Greek government bonds increased from 4.5% in late March to above 18% in early May before dropping below 7% by mid-May, on the heels of both the financing package and news that the ECB would buy government and private debt in the biggest attempt yet to end the European financial crisis. The European Financial Stability Facility (EFSF) was born, the region's 'temporary' bailout mechanism, with an initial capital of €440 billion.

Another investor scare took place in mid-June 2010, when Moody's concurred with Standard & Poor's move in late April in likewise downgrading Greece's government bond ratings to 'junk' (to Ba1 from A3), a level "which incorporates a greater, albeit, low risk of default". 14 Yields on two-year Greek government bonds rose from 7.5% to 10% prior to easing down to 9.5% in early July. There followed an additional, temporary loss of investor nerve in mid-August, but then the bond market calmed down, partly owing to praise from the IMF for Greece's continuing effort to rein in its fiscal deficit. Yields on the two-year bonds fell to as low as 7.25% by mid-October.

Act II What turned out to be the destruction of investor confidence on a permanent basis began on October 18 2010, when German Chancellor Merkel and French President Sarkozy met in Deauville (France) and agreed that private investors must 'contribute' to future European sovereign bailouts - a demand that was rightly interpreted as meaning that bond holders would have to accept adverse modifications to the payment terms on their securities. This would be the price of a deal to set up a larger, permanent bailout fund to replace the EFSF, because according to Merkel the current system of state-funded rescues had allowed for too much moral hazard to creep into the bond market.

The financial markets were understandably roiled. In Greece, two-year bond yields jumped from 7.25% back up above 10%. On November 4, the ECB's Trichet

ECB press conference, january 14 2010. Moody's Investors Service, "Moody's Downgrades Greece to Bal from A3, Stable Outlook", June 14 2010.

37

Behind the 2012 Greek default and restructuring

15

16

38

expressed public concern that forcing bond holders to take losses would drive up

borrowing costs. On November 12, seeking to calm the financial markets, the finance

ministers of Europe's five largest countries issued a statement clarifying that any

private sector involvement (PSI) would not apply to any outstanding debt, and

would only come into effect from 2013. However, irreparable damage to confidence

was done.

The following :vfarch (20ll), Moody's became the first of the major rating

agencies to slash Greece down to single-B status, citing in part "the lack of certainty surrounding the precise nature and conditions of support that will be available to

Greece after 2013, and its implications for bond holders". 15 It was followed by

Standard & Poor's and Fitch two months later, after the top European finance

ministers gathered in Luxembourg (in May) to discuss further aid for Greece - but on

condition that it would be accompanied by "sacrifices" made by private creditors.

The ECB's Trichet walked out, refusing to participate in any meeting that discussed

such "haircuts" .16

Figure 2: Greek government bond yields (percentage per annum)

250~--------------------------------------------------------~

... -------- ~

0 0 0 N N

0 0 0 0 0 0 0 0 0 0 0 0 0 (::' ~ (::' (::' (::' N N

~ ~ (::' ro '2 "' "- ~ "<?; "' 23 (::' (::'

"' (::' 0; a N "' "-

(::' 2 N N a (::'

0J

- 2-year bonds · ~ ~ · 5-year bonds

Source: Bloomberg and author's calculations.

Later that May, European finance ministers for the first time floated the idea of

talks with bond holders to extend Greece's debt repayment schedule. Two weeks later,

Moody's downgraded Greece to Caal, consistent with a 50% probability of default, in

Moody's Investors Service, "Moody's Downgrades Greece to Bl from Ba1, ~egative Outlook". :\larch 7 2011. Asked about the likelihood of a potential Greek default, Trichet said, "It is not in the cards." Stephen Castle and Landon Thomas Jr, "Ministers Meet to Study Fixes on Greek Debt", New York Times, C,fay 6 2011.

1.3

17 18 19

20 21 22

part because of t;,c .:· ~­

assistance to Gree: c

which private sec:: :::: In early June, :S::: __ :-:

years. Within da;.·s ~ :.::

citing that "the ::•·

significantly", anc :: . .:: 30% to 50% of ·:.:::o·

president of the EC:

the costs outweig:-. ::.:: ·

As the IMF woe::. .:. . in Europe over this ... _

bond yields ever hie.:: rating downgrades

necessitating bants ::

Systemic banking s::::•

aggravating the cou:: ::--

Negotiations be~.·;::­

represented by the :·:•:.· on a bond exchange :·_.:.

20ll to mid-2014, c.:.:.

Brady Plan vintage .=: ~ bonds for par and c'•: : reduced coupons or :::: collateralised and cc.::

instruments were to ·::-::

rating agencies respo:.::: to Ca, S&P to CC, an:: ::

Act III

The ink was barely dr:. questioned. The glooc .:

August 2011 caused rr . .:.:

Greece) in a direction ::

the cost of purchasing :

voluntary participatio::

Moody's Investors Service, · '.: :· Standard & Poor1S1 uLong-Te::.-::-::-_ Stephen Castle, uMaria Drc.i~~ 14 2011. IMF, "Greece: Fourth Revie,·: _ IIF, "IIF Financing Offer", ]u::. It was originally estimated t':-cc to buy the AAA bonds nee-3c intervening global rally in "..c: would now need to borrov: c: Losses from Greek Bonds!J 1 ~\-~--

,::::~: ~: ~.=.:.;:;:losses would drive up

= -_-_:: :'.::-. .:.::-~;::ial markets, the finance

~= ;. '~::.:::::lent clarifying that any

~: .:.:::y outstanding debt, and :: _-:-:::: ::.:::.:::le damage to confidence

:.:.:=:: :::--.:: :i:st of the major rating :::::::;::_:-_?art "the lack of certainty

:: : .: :::: : ~ that will be available to ::::: :-.:::::::s"." It was followed by :: ::..-'--:::: :::e top European finance

~·=-' • :' ..::::::e: aid for Greece -but on ,.:."::--=:::::; :r~ade by private creditors.

:::.:. ::: ~=- .:.::--_ y meeting that discussed

~::::a;:c per annum)

---"' "' 0 5 0 - :::; >:::' ~ ~ " "' - s ~ - -

':: :.-.:: :'.:s: time floated the idea of

:::;.·.-::::.::::--.:schedule. Two weeks later,

•···- :.-. .:. ~ _.- probability of default, in

:. :c:= :Oc: C\egative Outlook'", March 7

c:. ::..: :: c; :-.ctin the cards.'" Stephen Castle -~. -- ',",-... lark Times, May 6 2011.

1.3

17 18 19

20 21 22

Arturo C Porzecanski

part because of the likelihood that the Troika would "make the provision of financial

assistance to Greece over the medium term conditional on a debt restructuring, in

which private sector creditors would absorb some economic losses" .17

In early June, Berlin proposed extending the maturities on Greek bonds by seven

years. Within days, Standard & Poor's responded by downgrading Greece to CCC,

citing that "the risk of default . . . within the next 12 months has increased

significantly", and that in the event of a default, bond holders would recover only

30% to SOo/o of what they were owed." For his part, Mario Draghi, incoming

president of the ECB, warned against forcing private investors to take part: "All in all,

the costs outweigh the benefits", he said during his confirmation hearings.19

As the IMF would admit in a July 2011 report, the very protracted public debate

in Europe over this issue would take a heavy toll on Greece, not only by propelling

bond yields ever higher, but by encouraging an exodus of bank deposits and also, via

rating downgrades, by decreasing the value of Greek collateral with the ECB,

necessitating banks to post additional collateral when they could least afford it.

Systemic banking stress, in tum, was causing a major credit contraction and

aggravating the country's deepening recession.20

Negotiations between Troika officials and some 40 mainly European banks

represented by the Institute of International Finance (IIF) finally reached agreement

on a bond exchange that would deliver financing to Greece of €54 billion from mid-

2011 to mid-2014, and a total of €135 billion from mid-2011 to end-2020. It was a

Brady Plan vintage 2011, involving the voluntary exchange of outstanding Greek

bonds for par and discount bonds entailing an extension of maturities and either

reduced coupons or principal forgiveness. Bonds maturing in 2030 would be fully

collateralised and one maturing in 2015 would be partially collateralised. All

instruments were to be priced to impose an NPV loss of 21%.21 Needless to say, the

rating agencies responded promptly by cutting their assessments yet again (Moody's to Ca, S&P to CC, and Fitch to CCC).

Act III

The ink was barely dry on this debt restructuring deal when its adequacy began to be questioned. The gloom about the future of the eurozone that became pervasive from

August 2011 caused many officials to revise their economic forecasts (including for

Greece) in a direction that suggested the debt relief on offer would be insufficient,

the cost of purchasing collateral to back the new bonds would be too high, and the

voluntary participation rate of creditors insufficient.'' This led to a hardening of

).-foody's Investors Service, ").foody's Downgrades Greece to Caa1 from B1, C\egative Outlook'", June 1 2011. Standard & Poor's, "Long-Term Sovereign Rating on Greece Cut to 'CCC'; Outlook Negative'", June 13 2011. Stephen Castle, ").1ario Draghi Holds ECB Line against Restructuring for Greece'", New York Times, June 14 2011. IMF, "Greece: Fourth Review under the Stand-By Arrangement'", July 4 2011. IIF, "IIF Financing Offer", July 21 2011. It was originally estimated that Greece would have to borrow €35 billion from eurozone member states to buy the AA/1. bonds needed to back the new securities to be created for the debt swap, but the intervening global rally in high-quality debt had made the intended bonds pricier, such that Greece would now need to borrow an extra €12 billion. See Landon Thomas Jr, "European Banks Face Huge Losses from Greek Bonds", :\'ew York Times, October 4 2011.

39

Behind the 2012 Greek default and restructuring

23 24

25

26

40

official attitudes and to an October demand that private creditors agree to a new plan entailing the forgiveness of at least half of what they were owed, with lowered coupons and no collateral backing. One of the (circular) arguments put forth was that since the prices of Greek bonds had plunged to about 36o/o of face value from 7 5o/o since the forging of the deal in July, the terms of the original deal were now too generous to bond holders.23

There followed several months of negotiations between the Troika, Greece, and creditor representatives, but most time was taken up by various Troika-Greece economic and political issues. A confrontation between European leaders and Greek Prime Minister Papandreou over his desire to submit the latest austerity and financing plan to a national referendum elicited an ultimatum from EU leaders (on November 2). Papandreou decided to step aside to give way to a new unity government headed by Lucas Papademos, a former ECB vice president.

The gloom in official circles about Greece's incapacity to pay the bulk of its obligations falling due in 2012 and beyond became more pervasive with the realisation that the economy was shrinking faster and deeper than anticipated, government revenues were falling short of target, and the public debt was growing more burdensome than expected. In late 2010, the IMF had forecast that Greece's GDP would drop 3o/o in 2011, but by early 2012 it was clear that it had contracted nearly 7o/o and that it would keep shrinking in 2012 - as in fact it has done at that rate of decline. The unemployment rate had been expected to peak at 15o/o in 2012, up from 7.25o/o in mid-2008, yet it had reached nearly 21 o/o already by the end of 2011. It

would keep soaring to almost 25o/o during the third quarter of 2012. Government revenues had been anticipated to hit an all-time high of €97 billion in 2011, but by early 2012 it was evident that they had actually come in below the prior year, at €88 billion. The public debt was supposed to expand to no more than €347 billion in 2011, the equivalent of 152o/o of projected GDP. In the event, the year closed with the debt stock at €356 billion, representing 165o/o of a much-reduced GDP.24

Negotiations with creditors resumed in February (2012) and a new debt relief plan was finally agreed on February 21, reportedly prompted by the impression conveyed to creditor representatives that the eurozone leadership might countenance a unilateral default on Greece's part." Investors were 'invited' to forgive 53.5o/o of what they were owed under 135 series of bonds, and to exchange 31.5o/o of their remaining principal for new, low-coupon Greek bonds with maturities of 11 to 30 years, and the rest (15o/o) for two-year notes issued by the EFSF." It was part of a

Ibid.

Projected figures for 2011 from IMF, "Greece: Second Review Under the Stand-By Arrangement", December 6 2010, pp 41-3; actual figures from Hellenic Statistical Authority, The Greek Economy, December 14 2012, pp 11-33. "The Greek bailout appeared to hang in the balance when rumors circulated that Germany's Finance Minister, Wolfgang Schauble, was willing to contemplate a Greek default." See Stephen Castle, "Europe Agrees on New Bailout to Help Greece Avoid Default", New York Times, February 20 2012. Holdings of Greek Treasury bills were excluded. The coupon on the new bonds was set at 2% until February 2015, 3% for the follov.ing five years, and 4.3% until 2042. See IIF, "Press Release: Greek Debt Exchange", February 28 2012. Creditors were also offered GDP-linked bonds that will pay interest if the economy grows by more than 2% per annum during 2020-2041, and faster than 2.25-2.90% before that (depending on the specific year). The complete details were provided to investors in The Hellenic Republic's Invitation Memorandum dated 24 February 2012.

27 28 29 30

31

new Troika programn public finances and t~ for safeguarding finar

The resulting deb; all-in NPV losses tot: 75o/o, depending on t{ was part and parcel o: to in return for a ne•· were requested by th extended into April. i

worth of Greek goYe 96.9o/o of the €205.5 t creditors - the target :

The debt restructu sector holders of app: bonds.29 However, it>\

• First, most of European balli respective go dependent for participate.

• Second, the G: 'collective act::t governed by G:

bond holder " applicable to a: bonds represer: remaining €25 introduction o:' has never happ; It is no wonder to English law:

• Third, the Gre. exchange sho1: investors in Fra stated that the availability of f: to participate··.

Eurogroup, "Eurogroup Staro Hellenic Republic MinistrY : Hellenic Republic Ministry : Under the Greek Bond holci bonds vote and two-thirds exchange offer - it becomes Hellenic Republic Ministry :

;-:-··::.:-::~:editors agree to a new plan :...:: ::-.-:::-- were owed, with lowered

~-.:-:-..::::::- :uguments put forth was ~= :: ::.~ :·..:t 36% of face value from ::...' :: :::-.:: -:-riginal deal were now too

C.' :-:::-.. :::-:::1 the Troika, Greece, and :..•:::. ·..:;- oy various Troika-Greece e:-:··::-:::: :::·.::opean leaders and Greek : ;-_: ::...::: the latest austerity and ~-=-- -=.:::::.atum from EU leaders (on

c:-:: :: ;i•:e way to a new unity :-::: ::..:: ::: ·.ice president.

:.:-.::o.;-::.:::y to pay the bulk of its ·:-=-::o.:=.-:: :nore pervasive with the .s:-::: :o.:-.2 jeeper than anticipated, : -'---.::: ::-::: :;mblic debt was growing : =:'-~ :-_::.: :'orecast that Greece's GDP ' :.-::::.: :::.~t :thad contracted nearly :.o :_:-_ :::.:: : t has done at that rate of :t: :: ;- :::::i-; at 15% in 2012, up from

:O.:::::o.:y by the end of 2011. It

:::-...:::: :·.::::.:ter of 2012. Government :-.. ;:-. : f ~ :- billion in 2011, but by :::::.:: :.:-. ·:.::ow the prior year, at €88 : :: :-.: :::.me than €347 billion in : ::-_:: -::·:;;::t. the year closed with the '=:.:.::-_-:;;:uced GDP.24

- o-. .: : ~=. and a new debt relief ~-:-:::._· ;::::::.pted by the impression -:.:-.-= -=·.::::zone leadership might - :_:-_-.-::;::•:s 11·ere 'invited' to forgive ::' :-::::.; and to exchange 31.5% of :-::-::, :: :-_ :::s 11ith maturities of 11 to ;:·.:.-::::: :::: t:-_e EFSF.26 It was part of a

. . ·_-:::'t: ::OE Stand-By Arrangement", ::cc-:::-::::0.: _c.-~±ority, The Greek Economy,

~ -= · :·: ::-.:c::-~:e:ed that Germany's Finance :-:,..,:- :c"o·.:.::. See Stephen Castle, "Europe ' -- - · ,_- ?e':::t:ary 20 2012. :- - - :.·. e :. e'·; ':JOnds was set at 2% until ::::.. : ~: :e= ::F. --Press Release: Greek Debt :: · _::_ .. ;, : ~: ::.:'s that will pay interest if the :..,: c::-.: "os:t: :.'lan 2.25-2.90% before that =~" ::::-_:';,:' :: :nvestors in The Hellenic

27 28 29 30

31

Arturo C Porzecanski

new Troika programme which provided "a comprehensive blueprint for putting the public finances and the economy of Greece back on a sustainable footing and hence for safeguarding financial stability in Greece and in the euro area as a whole".27

The resulting debt relief was equivalent to about half of Greece's 2011 GDP, and ali-in NPV losses to investors were mostly estimated to have been between 70% and 75%, depending on the discount rate applied (9%-12%). The restructuring proposal was part and parcel of a €130 billion loan program that Europe and the IMF agreed to in return for a new round of Greek austerity and reform measures. Acceptances were requested by the close of business on March 8, but the deadline was later extended into April. In the end, €199 billion (the equivalent of about $263 billion) worth of Greek government debt was written off and restructured, representing 96.9% of the €205.5 billion face amount of government debt held by private sector creditors - the target of the selective default."

The debt restructuring was billed as a "voluntary transaction" involving private sector holders of approximately €206 billion (face amount) of Greek government bonds." However, it was not to be really voluntary in various respects .

First, most of the bonds were held by Greek banks, or else by dozens of European banks and insurers, all of whom operate under the thumb of their respective government regulators - and most of whom have become dependent for funding on the ECB. Realistically, they had no choice but to participate.

• Second, the Greek parliament hastily passed a law retroactively introducing 'collective action clauses' (CACs) into the €177 billion of targeted bonds governed by Greek law, specifying that by tendering into the exchange, every bond holder was automatically voting to make the terms of the exchange applicable to all other bonds.30 Therefore, once the consent of €152 billion of bonds representing almost 86% of holders was received, the terms of the remaining €25 billion were amended as if they too had consented. The introduction of CACs in sovereign bonds is no novelty, but to our knowledge has never happened retroactively- a clear violation of the sanctity of contracts. It is no wonder that the new bonds arising from the debt exchange are subject to English law; otherwise, their indentures would have no credibility. Third, the Greek authorities made it plain that non-participants into the exchange should not expect any payments. At a March 5 meeting with investors in Frankfurt, the head of Greece's Public Debt Management Agency stated that the country's economic program "does not contemplate the availability of funds to make payments to private sector creditors that decline to participate". 31

Eurogroup, "Eurogroup Statement", February 21 2012. Hellenic Republic Ministry of Finance, Press Release, April 25 2012. Hellenic Republic Mfnistry of Finance, "PSI Launch Press Release", February 21 2012. Under the Greek Bond holder Act (Law 4050/2012), if holders of at least 50% of outstanding Greek-law bonds vote and two-thirds of them are in favour of a proposed amendment - in this case, the debt exchange offer - it becomes binding on all bond holders. Hellenic Republic Ministry of Finance, "Public Debt Management Agency Press Release", March 6 2012.

41

Behind the 2012 Greek default and restructuring

32

33

42

The message was presumably intended for investors in the €29 billion of bonds

issued under foreign law, or by state-owned enterprises under government

guarantees, whose terms could not be amended unilaterally. As of the first due date,

€20 billion (69%) of these bonds were tendered into the exchange, since many of

them already included CACs, but even after an extension, an untendered remainder

of €5.5 billion worth of government or government-guaranteed bonds was left in the

hands of holdout investors. Thus, the question arose as to what the Greek authorities

would do: refuse to pay the holdouts, as Argentina has done for a dozen years now

despite many court judgments ordering it to pay what it owes or behave honourably and pay up. A first answer was provided on May 15, when Greece announced that it

had made a €436 million bond payment to the hold-out investors who owned it.

Two other such payments were due in September and December (2012), although for lesser amounts, and they are presumed to have been paid."

It is noteworthy that the €206 billion in government bonds subject to debt

forgiveness and restructuring accounted for less than 60% of the Greek public debt,

which as mentioned earlier totalled €356 billion as of end-2011. Treasury bills, which

the authorities excluded in order not to taint this short-term segment of the market, represented a mere €15 billion of that. Loans from the European Union and the IMF

accounted for €7 4 billion, and it is understandable that these creditors, who were

providing new funding under debtor-in-possession circumstances - especially the traditionally senior IMF - would likewise have been excluded. That left some €61

billion that was potentially up for grabs.33

However, most of that figure (an estimated €50 billion) involved ECB holdings of Greek government bonds purchased through the Securities Market Program (SMP),

the ECB's window to support the secondary market for eurozone sovereign bonds.

The working assumption among many observers had been that the ECB, or possibly

individual national central banks, would find a way to contribute to Greece's debt­

relief exercise by exchanging their existing bonds for new ones paying, for instance, lower interest rates.

As it turned out, in mid-February the ECB did swap its stock of Greek government

bonds for new ones- but it did so on identical terms (same face value and coupons) with a separate ISIN (International Securities Identification Number) from that of

other Greek government bonds, thereby setting its holdings apart from and above all

other bonds. The swap did not include bonds held by individual eurozone central

banks. All that eurozone finance ministers subsequently agreed was that future

profits made by the ECB from Greek government bonds would be distributed

"What's news is where most of that money went. Almost 90% was delivered to the coffers of Dart Management, a secretive investment fund based in the Cayman Islands, according to people with direct knowledge of the transaction. Dart is one of the best known of the so-called vulture funds, which have a track record of buying the distressed bonds of nearly bankrupt countries - and if they do not get paid, suing the governments for the money. Dart and another big vulture fund, Elliott Associates, perfected that strategy during the various Latin American debt crises in years past." Landon Thomas Jr, "Bet on Greek Bonds Paid Off for 'Vulture Fund"', New York Times, May 15 2012. On the bond redemptions scheduled for September 13 and December 21 for €184 million and €250 million, respectively, see Zsolt Darvas, "The Greek Debt Trap: An Escape Plan", Bruegel Policy Contribution, November 2012, p 15. Data from Hellenic Republic Ministry of Finance, "Public Debt Bulletin", December 2011; and from I~F, "Greece: Request for Extended Arrangement under the Extended Fund Facility", March 9 2012.

2.

2.1

34 35

36

37

38

alongside c::-_-o: :-n-:11 by Member ~:::~-:c 11

As Stan-=.::~~ c: I Greek gow:-:-_-:_ o.-- l

were thus r:::::-o:-~ other bond ::-::- : ~~-: i

The ECE : :· .:r

creditor ~: : ·, ~~ Mechani_c··~- :·oo developn:;-:: 'U

current/1 ·, _-, -m

and cou:.; -.- .. ,, markets.'' Moody's:

of the outsta::-.::.:--:;

private sector ::-:- .:..-:c existing supp: :-: ;:-:

Morem·er. :::-. ~ ::;

principal or :::-.:~::-;

government t: :-. :.: done - and lit~- .-.:.-o

by private ere::.::::-: end-investor - ::::-. ~

eurozone's erne: :7:-J understandab::: :: = ECB's when -~~­

different.38

Critique

Bank recapitalh:<ti

It is notable thi:.: :.:-_

of at least tvw '·.: ~;

decision to rece.;:::: do so very gene::--

Eurogroup, "Eurogr:·c; Standard & Poor's. :' = February 24 2012. Moody's Investor So:-·. Holdings", Februar;; :­The EIB has confim:o: were exchanged for :: ~ · their documentatioL. ~= available upon reques: exchange doesn't ge:-. oc. John Glover and Es:o': Investors", Bloomber; ·.·,

-. ~::: :; ~=-- :he €29 billion of bonds : c::-.:2::xises under government .:.::-_::~:~:::y. As of the first due date,

_:-_: : ::-:.2 exchange, since many of r:~:-.::::-. an untendered remainder :::-.:-z-_:~:~::teed bonds was left in the ·: , -= :o :: , .. -hat the Greek authorities .:-.: :--.~; :~:1e for a dozen years now

_-_: · :: :-~·:es or behave honourably ~ := - -.-:--.~=-- Greece announced that it : _-_: _ :-: ·.:t im·estors who owned it. ::.:-.:: :::- ~~2mber (2012), although for

~: --~:-:.::-.c:nt bonds subject to debt --,- - of the Greek public debt,

~ :: ~:-.:-2011. Treasury bills, which s , _-_: :-:-::c:-::n segment of the market, c:::. ::-:.~ ::-_:::,pean Union and the IMF l::- -~ :::--.~: :hese creditors, who were >: : :-. ::: :-.Jmstances - especially the :--::-~=-- ~:c.:::·.:ded. That left some €61

~: :::.::~::-. involved ECB holdings of ~~ : ~ :-.:::':ies :\farket Program (SMP), ;.:,~: ::: c:.Irozone sovereign bonds.

' :--.~::. =-~~n that the ECB, or possibly ·. ·::.·· :: :on tribute to Greece's debt­:_;:::=---=~·: ones paying, for instance,

: ,.. ·::.:;: ::s stock of Greek government ;~:::c face value and coupons)

:~:-.::.:':~~':ion Number) from that of :-::; ::-.:: ::::gs apart from and above all :-:=:: ·::: ::1dividual eurozone central ::: ;~ :::·.:~::tly agreed was that future =~=--: :Oonds would be distributed

,--: o-- o·::;.s delivered to the coffers of Dart ·-=--'-~- :;::o.::.ds. according to people with direct ;:: : ' -,:: ~ s·J-called vulture funds, which have • :-_ :: ::·.:::.tries- and if they do not get paid, ~ _ ~ :_ ": ~-=e fund, Elliott Associates, perfected ~ -_c ··e:c:s past." Landon Thomas Jr, "Bet on c: _o_·: :s 2012. On the bond redemptions =:.: -_ :c:-.:. €250 million, respectively, see Zsolt : _ ::-· =: ::-.tribution, November 2012, p 15. ..,_~: ::-.:::~:in", December 2011; and from IMF, ·-;~_:c-:' ::'-~ro.d Facility", March 9 2012.

-Arturo C Porzecanski

alongside other profits to eurozone governments, and that these "may be allocated by Member States to further improve the sustainability of Greece's public debt".34

As Standard & Poor's has pointed out, however, since the ECB's newly-minted Greek government bonds were exempted from the retroactively applied CACs and were thus protected from any forced write-downs, the practical effect was that all other bond holders became effectively subordinated to the ECB in terms of payment:

The ECB's swap has established a new precedent by adding another class of superior creditor to the existing group comprised of the ESM [the upcoming European Stability Mechanism], the IMF, and other multilateral development banks. We believe that this development could further weaken the prospects of peripheral eurozone sovereigns currently receiving official funding to regain the ability to access the capital markets and could raise borrowing rates of those sovereigns still accessing the primary markets.35

Moody's concurred, because given that "the ECB holds a significant proportion of the outstanding debt of Greece, Ireland, and Portugal ... the subordination of private sector creditors may make it more difficult to re-access the markets once their existing support programs run out in 2013".36

Moreover, the European Investment Bank was also exempted from any haircut to principal or interest on its (relatively small) investment portfolio of Greek government bonds, thereby subordinating private bond holders just as the ECB had done - and likewise setting a precedent that will factor in the risk assessments made by private creditors." And yet, the EIB is a regional development bank- namely, an end-investor - and its holdings of Greek government bonds were not part of the eurozone's emergency financing for Greece. Therefore, a number of private investors understandably complained about why the EIB's portfolio was spared alongside the ECB's when their respective roles as providers of financing for Greece were so different."

2. Critique

2.1

34 35

36

37

38

Bank recapitalisation It is notable that the extent of debt relief required of private creditors was a function of at least two judgment calls that certainly can be questioned. The first was the decision to recapitalise the Greek banking system with EU and IMF funds - and to do so very generously. This recapitalisation became necessary largely because of the

Eurogroup, "Eurogroup Statement", FebruaiY 21 2012. Standard & Poor's, "ECB Greek Bond Swap Results in Effective Subordination of Private Investors", February 24 2012. :).1oody's Investor Service, "Greek Bond Pact Confirms Seniority of Eurosystem's Sovereign Debt Holdings", February 27 2012 . The EIB has confirmed to this author that Greek government bonds held as part of its treasury assets were exchanged for new bonds that are out of the scope of the PSI offer and that don't include CACs in their documentation. Email message from EIB's Investor Relations and Marketing Office, July 20 2012, available upon request. The financial terms of the ne"· bonds are identical to the former ones. The exchange doesn't generate any profit or loss in the bank's accounts. John Glover and Esteban Duarte, "EIB Pri,ileges in Greek Debt Plan Spur Complaints from Private Investors", Bloomberg .\'ell'S, :).'larch 2 2012.

43

39

40 41

42

44

Behind the 2012 Greek default and restructuring

hit to Greek bank balance sheets from the punishing sovereign debt restructuring. For example, Greece's four biggest banks reported a combined loss of €27.9 billion (nearly $37 billion) from having participated in the country's debt exchange." The decision to recapitalise the banks with public funds increased the size of the official­sector loan package by €50 billion, and thus the extent of losses imposed on private creditors - to minimize the government burden of servicing all the new official debt the sovereign was taking on. The irony is that a less punishing restructuring would have reduced the hit taken by Greek banks, and thus the magnitude of the recapitalisation bill.

As a March 2012 IMF staff report freely admits, "a typical recapitalization program would see viable banks recapitalized using [Greek] government bonds (with perhaps some regulatory forbearance on capital ratios while problems are worked out) and the unwinding of unviable banks". In the case of Greece, there was a political decision to depart from the customary "owing to the need to secure liquidity support from the Eurosystem, and to reassure regulators of Greek bank subsidiaries in neighbouring jurisdictions"!0

Moreover, it was decided that all bank deposits would be protected and so would all the senior unsecured creditors of Greek banks. This is a very expensive way to nurse an insolvent banking system back to health, and it yielded a stunning result: those who had bought bonds issued by Greek banks fared much better than those who had bought sovereign bonds - the inverse of the usual outcome. During the 2010 bailout of Irish banks (which had become victims of a property rather than a sovereign meltdown), the ECB had insisted that senior bond holders in bailed-out banks should not suffer losses, giving the Troika's position on Greece a precedent. But the ECB would go on to change its mind not even six months later, when faced with the prospect of having to also rescue Spain and its banking system.

At a July 9 meeting of eurozone finance ministers, ECB President Mario Draghi reportedly argued in favour of imposing losses on senior bank creditors in the case of Spain, especially if a bank had to be pushed into liquidation. The ministers initially rejected the ECB's view out of concern that European financial markets would react badly, but the ECB's shift became a sign that the tide was turning on the issue of how bank failures ought to be dealt with in the eurozone!' Sure enough, by late August the government of Spain had approved a decree spelling out the terms of its support for banks (starting with the nationalised lender Bankia), and as part of the

Marcus Bensasson, Maria Petrakis and ?\atalie Weeks, "Greek Banks Post $37 Billion Losses on Debt Restructuring", Bloomberg News, April 20 2012. IMF, "Greece: Request for Extended Arrangement", p 29. Gabriele Steinhauser and Brian Blackstone, "Europe's Bank Shifts View on Bond Losses", Wall Street Journal, July 15 2012. Senior bond holders did suffer major losses in the September 2008 failures of Lehman Brothers Holdings and Washington :Vfutual. Danish authorities forced write-downs on senior, unsecured bond holders when they shut down Amagerbanken and Fjordbank :vfors in 20ll. Gabriele Steinhauser, "Senior Creditors Rarely Get 'Haircuts' ", Wall Street Journal, July 15 2012. Miles Johnson, "Spain Gives Bankia Urgent Cash Boost", The Financial Times, August 31 2012. "The memorandum of understanding on the terms of the bailout requested by Spaln on June 9 says Spanish authorities will 'require burden sharing measures from hybrid capital holders and subordinated debt holders in banks receiving public capital' as part of efforts to minimize the cost to taxpayers of restructuring." See Charles Penty and Esteban Duarte, "Spain Bank Bailout :Vfeans Forcing Losses on Cooks, Pensioners", Bloomberg News, July 12 2012.

2.2

programme inY~o:: :-: to take losses be:':~= .a

Debt sustainabilii:'• The second judr;~~-==

debt forgiveness = : = deemed to be · s-.::5:~, arbitrarily at 20:: neither of defau~: :::~:,: outsized mistakes c·-::: circumstances, a:-.:: ::::, and thus its faih:~-::; ::

Recent exper:-o::-_~:

Greece's public de":: ',­later- and that it ~-.-: -of the default anc :-:::e: stock of debt had ~":::: from forecast, but ::-_::: difference. And tl:.:: :::.

that took place ir. ::: ' numerator proved :;-~-

Figure 3: Ratio of Gre (percentages as pro\::-:

-2011F

Source: IMF and authors

;:_:-_~ s :-.-~:t:ign debt restructuring. .: c. :::::":clned loss of€27.9 billion ::::.-:- ::·..:.:::::y·s debt exchange.39 The .:..: _:_ ::-:-::.;~d the size of the official­:.:r::-:::-_: ::' :Jsses imposed on private :-::;::--::~:::gall the new official debt .7'' ;: ..::-.is:-:ing restructuring would

:~_-_:; the magnitude of the

,.:_-::-_ :' ~ typical recapitalization -~ : :::-:-:--::;:: ~owmment bonds (with .:-::. :_: s -.. -~_::e problems are worked

~ :.:-_-:: ::.so of Greece, there was a · :·.·:::::~ to the need to secure

:--:-_:_c ;·..::= :t:sulators of Greek bank

; -·-: ..: _::: :C,;; :;Jrotected and so would ; -::-:-__:; :; .:: >"ery expensive way to : ::._::-_:: :: :::t::ded a stunning result: c::-_,_c :':.:=·= ::.uch better than those :: :.:-_-:: ·_:;·..::o:.i outcome. During the -::-_-::-_, :;' ~ :;Jroperty rather than a ;.-:-:-_:: ·: ::-.d holders in bailed-out

; ;:·:;::::·=-- c•n Greece a precedent. ~---:-:_ s:x ::r:.:mths later, when faced .:: :: : :' :: ~-;J.ng system. .;:o:' -=: =::; ?resident Mario Draghi : so: .. ::: ::: .::::k creditors in the case : _:_:: ::~·.::dation. The ministers

:.:-_c.: ::: ·..::: p ean financial markets ::. -_ _:-_::.:~-":ide was turning on the ::: :.:-_-:- -:-·_::.:·zone!1 Sure enough, by ::. ::.-::::==spelling out the terms of :. .o:. :.=: ::imkia), and as part of the

: :.:-.:.: :- :': S37 Billion Losses on Debt

--,o··: :r: Bond Losses", Wall Street .. _ ... _::_ ::-.e September 2008 failures of ..;__:_~~:-::.=-:-:::creed write-downs on senior, :- ::-.: c- ::~:Cank Mors in 2011. Gabriele ., - . -:.:: :-.L,- 15 2012. "' .. :.:: Times, August 31 2012. "The ·-;-: __ ; ::o: ":::· Spain on june 9 says Spanish c: :::.::::::-_.:elders and subordinated debt : -: =-.:.:-=.:Ze the cost to taxpayers of :: : :_-_, :C.:: :ut ~eans Forcing Losses on

2.2

Arturo C Porzecanski

programme investors in bank preference shares and subordinated debt will be forced to take losses before any state aid can be received by Spanish financial institutions.42

Debt sustainability The second judgement that is highly questionable is the decision to demand huge debt forgiveness from private creditors so that Greece's debt burden may reach a ratio deemed to be 'sustainable' (defined arbitrarily at 120% of GDP) by a given date (set arbitrarily at 2020). The fact is that ratios of debt-to-GDP are reliable predictors neither of default probabilities nor of creditworthiness."' Moreover, it is easy to make outsized mistakes when trying to forecast a ratio of debt-to-GDP during exceptional circumstances, and the IMF staff is notorious for its errors in forecasting such ratios and thus its failures to predict debt sustainability- or unsustainability.44

Recent experience is instructive: in May 2010, the IMF staff projected that Greece's public debt would reach €325 billion by the end of 2011 - a year-and-a-half later- and that it would represent 145% of 2011 GDP. The staff's estimate at the time of the default and restructuring decision, made public in March 2012, was that the stock of debt had reached €329 billion in 2011, which was a very minor deviation from forecast, but that it had come to represent 165% of 2011 GDP - a whopping difference. And the reason was a major underestimation of the contraction in GDP that took place in a very short a time, such that while the IMP's forecast for the numerator proved quite accurate, that for the denominator was considerably off.45

Figure 3: Ratio of Greek government gross debt-to-GDP (percentages as projected by IMF staff for 2010-2011)

170

~ ,,-----------------------------· ,, , ,

150

130 f/ '

;· 7

110

90

70

"' "' 0 ~o c:-~ ~5 N

0 0 0 .8o ,~ 0 0 0 0 :::>0

"' N N EN ~N N EN N .<:: " 1;' " -" -"' " .<::

" " >

" " " u.. :::> 0 e :::> :;; "' ..., 0

..., z "' :;; :;;

-2011F ·--· 2010F

Source: IMF and author's calculations.

45

Behind the 2012 Greek default and restructuring

43

44

45

46

47 48

46

Within months of the supposedly successful March 2012 debt restructuring, in

fact, the Troika began to doubt the debt sustainability projections behind the exercise, because the Greek economy continued to contract more sharply than expected in the

May to September period." Evidently, the massive losses imposed on private creditors

and equally impressive debt relief obtained by the government had failed to spark a recovery of consumer and investor confidence - not even a rally in the newly issued

Greek bonds, for that matter, which continued to trade at huge discounts to par.

Starting in September, IMF Managing Director Christine Lagarde began putting

pressure on European governments to provide some debt forgiveness or debt service

relief of their own to offset the deterioration in Greek fiscal solvency prospects.

When Germany and other governments objected, she upped the ante by threatening

that unless something was done to reduce Greece's debt burden, the IMF would not

disburse additional funds to the country." An agreement on the matter was finally

reached in late November, when the eurozone governments consented to more

lending for Greece, in part to enable it to buy back and retire bonds in private hands

at the heavily discounted market prices. They also agreed to refinance past loans to

Greece at longer maturities and lower interest rates, as well as to pass on to Greece

the profits the ECB has made on the bonds it had purchased."' The debt buyback was officially announced on December 3 and involved a

solicitation of offers for an exchange of Greek government bonds (maturing between 2023 and 2042) for six-month notes to be issued by the EFSF, via a modified Dutch auction, targeted mainly at the bonds held by Greek banks and international hedge

funds. While far less coercive than the March restructuring, Standard & Poor's

determined that the auction amounted to a selective default and Moody's likewise

began to refer to it as Greece's second default. The reason was that since bond holders

would be receiving a fraction of the value promised by the original securities, and the

government and the ECB were leaning heavily on Greek banks (which held around €15 billion of the bonds) to tender into the exchange, the buyback had all the

hallmarks of a distressed debt operation."' In the event, the auction was closed with

offers for €31.9 billion being accepted at a cost of 34% of face value, in exchange for €11.3 billion of EFSF notes. 5° This enabled the Greek government to retire almost€21

billion (equivalent to more than 10% of GDP) of obligations for a mere one-third of

their redemption value upon maturity.

On the irrelevance of debt-GDP ratios for assessing the probability of default, see Paolo ::-.!anasse and Nouriel Roubini, '"Rules of Thumb' for Sovereign Debt Crises", Joumal of Intemational Ecmzomics, July 2009, pp 192-205. On the irrelevance of debt-GDP ratios for the determination of creditworthiness bY the credit-rating agencies, see Ricardo Hausmann, "Good Credit Ratios, Bad Credit Ratings: The Role of Debt Structure", Rules-Based Fiscal Policy in Emerging Markets, ed. by George Kopits (:"\ew York: Palgra;-e MacMillan, 2004), pp 30-52. Charles Wyplosz, "Debt Sustainability Assessment: Mission Impossible", Re>iew of Economics and Institutions, Fall 2010. JMF, "Greece: Request for Extended Arrangement", and prior L\lF staff reports from the dates noted in the chart and the text. The October 2012 edition of the IMF's World Economic Outlook ('NEO) estimated that Greece's GDP at constant prices would drop by a cumulati;-e 21.7% betw·een 2007 and 2013, whereas thirteen months earlier, the September 2011 edition of the W"EO had projected a GDP fali of 10.8% on that same basis. IMF, World Economic Outlook Databases, October 2012 and September 2011. "The need to speak truth to weakness", Tile Economist, December 1 2012. Eurogroup, "Eurogroup Statement on Greece", :"\ovember 27 2012.

3.

49

so

51

52

Just as the past seY

of debt to GDP, and t1

who is to say that Gr' bottom, restoring its c: in breaking the viciou' ever more stringent fis

Greek economy could

into past experiences

positive macroeconor:

especially when initi3

case of Greece. GDP ~

two years of fiscal adh

gradual gains in cons: And yet, the I1fF

Troika's demand for ·

holders in February :

2017, with real GDP g

pessimistic forecast tc

meaningful rebound : to 2013 (as estimatec

success as one of Eu:

2000 to 2007.52

Conclusion Greece is a country tr_

by its eurozone paGJ governments in Athe:

bonds, such that th

exceptionally long rr: early 2010, yet once\

in May 2010, the fir:<

the rug was pulled f

starting in October :

bailout by making co

As the months pa

agency downgrades

"We define a [debt] restr default, in which the in,.< partially) the investor's ac (Selective Default)", Dece: a Concern Following Gree Hellenic Republic Minis: Results", December 12 2C• George C. Tsibouris et a;. 2006, p 19. IMF, "Greece: Request fo: 4.2% per annum during :

'<.:.~ ~~-- .: : :.:: debt restructuring, in :..:~~:: ~: ·:::::::ms behind the exerdse, -=: ~~ '::-~.:.~ly than expected in the ~:: '~' ~=::'::sed on private creditors

:: ,::: ~ ~=~-<=:::lt had failed to spark a : _: ~~-~:: a ~ally in the newly issued

:::".::~ ": ::-:.:g-e discounts to par. : = :-~'~':::-,c Lagarde began putting =-~ .::~:: :':~gh-eness or debt service : ::-:~~,: :':>cal solvency prospects. '~--~ -:::::::::.:he ante by threatening ' .::~:: ::-~.::ccn. the IMF would not

:~-=~- ~=--: ::: -::he matter was finally .::: ~- o::-_~_;;::-::s consented to more

•- .:.:-_: ::c:~;; :Conds in private hands ~ "c:~~:: :: :cfinance past loans to -::: :O' :-.~:c:: a.s to pass on to Greece

: :-~ :: -:::-:::-:::.~er 3 and involved a :::-:-~::~~-:::-_: ::- :::1ds tmaturing between ~::-~~ ::-~~ :::_::s:. Yia a modified Dutch

:---=~· : "'-~:; :;.nd international hedge :-:::::-.::~.::::--.g, Standard & Poor's

=-" ::'-:::'"·.::t and Moody's likewise : =-~ : .~:;,s that since bond holders

: :~~ ::-~~ :::gina! securities, and the ~ =-:~~;- ':-a.aks (which held around .:::-~:.:-~.::~ :he buyback had all the :- o:-~: :::-_;; auction was closed with

:' :':;.cc ,~alue, in exchange for =~ z: ~. ~::-~:nent to retire almost €21 : ::- ~- ,Z ":: : :-.s :'or a mere one-third of

·' :e:ault, see Paolo Manasse and - ·.:: ::International Economics, ]uly

-_:_' : ~:~===-~ation of creditworthiness by - ~- ~~ 3cJ Credit Ratings: The Role of ~ ~ :~~:: se Kopits (New York: Palgrave

Review of Economics and

-c :::C :e;corts from the dates noted in

'0: es:imated that Greece's GDP at - c::: ~: ~ 3, whereas thirteen months

- - : = ~ :::.: :f 10.8% on that same basis.

3.

49

so

51

52

Arturo C Porzecanski

Just as the past several years demonstrated the futility of trying to forecast ratios of debt to GDP, and to rely on them to antidpate a sovereign's debt sustainability, who is to say that Greece's GDP could not bounce back vigorously once it finds a bottom, restoring its creditworthiness ahead of schedule? Once the country succeeds in breaking the vicious cycle of undermined investor confidence driving the need for ever more stringent fiscal austerity, which has kept depressing economic activity, the Greek economy could well deliver a surprise on the upside. The IMF's own research into past experiences with large fiscal consolidation programmes has shown that positive macroeconomic developments tend to accompany large fiscal adjustments, especially when initial economic conditions are exceptionally difficult - as in the case of Greece. GDP growth usually recovers sharply back to trend during the first two years of fiscal adjustment, driven by an improvement in private investment and gradual gains in consumption and the trade balance."

And yet, the IMF's debt sustainability forecast for Greece, which justified the Troika's demand for massive debt forgiveness on the part of private sector bond holders in February 2012, envisioned an anaemic economic recovery in 2014 to 2017, with real GDP growth averaging less than 3% per annum. This was a decidedly pessimistic forecast to make for a country with a high probability of experiencing a meaningful rebound in future years following a GDP collapse of 17.5% during 2009 to 2013 (as estimated by the IMF in early 2012) - a country with a track record of success as one of Europe's fastest-growing economies during the pre-crisis period

2000 to 2007.52

Conclusion Greece is a country that until 2009 had learned to live- and had been allowed to live by its eurozone partners - with a relatively high level of public debt. Successive governments in Athens were able to count on a stable, predictable demand for their bonds, such that the public debt was characterised by very low coupons and exceptionally long maturities. Investor confidence started to erode in late 2009 and early 2010, yet once Greece was finally helped by its eurozone partners and the IMF in May 2010, the financial markets began to calm down. But then, all of a sudden, the rug was pulled from under bond investors by Chancellor Merkel's insistence, starting in October 2010, that private creditors needed to 'contribute' to Greece's bailout by making concessions affecting the expected return on their holdings.

As the months passed, the threatening intra-European rhetoric escalated, rating­agency downgrades multiplied, and the spectre of a potentially painful default

"We define a [debt] restructuring to include buybacks as an alternative to a potential conventional default, in which the investor or counterparty· stands to fare even worse, and which motivates (at least partially) the investor's acceptance of such an offer", Standard & Poor's "Greece Ratings Lowered to 'SD' (Selective Default)", DecemberS 2012. See also ).1oody's Investors Service, "Debt Sustainability Remains a Concern Following Greece's Second Default", December 14 2012. Hellenic Republic Ministry of Finance, "Hellenic Republic Anoounces Exchange Offer Transaction Results", December 12 2012. George C. Tsibouris et aL, "Experience "ith Large Fiscal Adjustments", IMF Occasional Paper No. 246, 2006, p 19. IMF, "Greece: Request for Extended Arrangement", p 93. Real GDP growth in Greece averaged nearly 4.2% per annum during 2000--2007, see Hellenic Statistical Authority, The Greek Economy, various issues.

47

Behind the 2012 Greek default and restructuring

started to loom ever-larger. Consequently, private sector demand for Greek

government bonds evaporated during the course of 2011. Spurred on by the Troika,

the authorities had to react to the lack of affordable financing by announcing ever

harsher fiscal austerity measures. The confidence of Greek households and businesses

tanked, causing a retraction in consumption and investment spending. And the

economy began spiralling down into what has since become the greatest depression

in that country in nearly a century. In sum, it was Chancellor Merkel's very public,

hard line on Greece and its private creditors that paved the road for the eventual

default which imposed outsized losses on investors - an outcome that could have

been avoided, or at least minimised.

What became the largest and one of the most punishing sovereign defaults in

history was justified by IMF forecasts of debt unsustainability that are prone to large

error, arrived at after a questionable decision to protect Greek bank creditors and

depositors most generously. Along the way, private investors were subordinated to

the ECB and its network of national central banks, as well as to the EIB, setting a

precedent that would weigh on investors in other faltering countries around Europe's

periphery. Local law was rewritten in Greece with retroactive effect to facilitate the

change in payment terms via the introduction of CACs - another troubling

precedent, particularly because more than 97% of the outstanding bonds of Spain,

Italy and Portugal are similarly governed by local law, such that these countries could

also enact similar legislation to facilitate the imposition of large losses on their bond

holders."

Greek government obligations in the hands of private investors were successfully

restructured to give the sovereign an extraordinary amount of debt relief, but as of

early 2013 the victory was looking Pyrrhic because of the seemingly enduring

reputational and market damage done in the process. According to a June 2012

survey of major financial institutions that are primary dealers in debt issued by

European governments, Greece may have to wait at least another five years before it

can again sell bonds to investors: three of 20 respondents expected it to take at least

a decade before Greece can place new debt again, ten said that investors would not

purchase Greek bonds any sooner than 2017, while five predicted that it would be

2015 at the earliest." This suggests that the default and restructuring may have

turned Greece into a ward of the ECB, EU and IMF for an extended period of time, a

prospect reinforced by the fact that after the distressed debt exchange in December

2012, more than 75% of the total stock of Greek government debt is held by these

53 Moody's Investors Service, "Unilateral Action Threatened by Greece is Also Available to Other Sovereigns", February 6 2012.

54 Anchalee Worrachate and Lukanvo ~lnnnda, "Greece Seen Blocked From Debt ~farkets Cntil 2017", Bloomberg News, June 25 2012.

55 In June 2012, Cyprus became the fifth of the eurozone's 17 states to seek a financial lifeline from the Troika, while also attempting to obtain a large loan from Russia, claiming inability of the gowrnment to refinance its debt obligations at reasonable interest rates and the need to support its weakened banking system. Jonathan Stearns and Stelios Orphanides, "Cypriot Government :\'eeds Aid to Refinance Debt, Shiarly Says", Bloomberg News, July 6 2012. As of late 2012, the fiscal situation in Cyprus was looking "more serious than Greece", according to luxembourg Prime ~finister Jean-Claude]uncker, "·ho headed the group of eurozone finance ministers. Stephanie Bodoni, "Cyprus's \•Voes ':\lore Serious Than Greece/ Juncker Warns", Bloomberg News 1 December 14 2012.

48

official creditors. And

from bank and soYe

markets, such as C~

eurozone's financial v

March 2012, and all ·

vividly the many graY

will inspire the instit

restore its credibilit1·.

•-::.::·:>r demand for Greek ::: ~ ~ S:;mrred on by the Troika,

~-= ::-:.~-~~-·=~ng by announcing ever f .:::-:-~"~ :-. :·~seholds and businesses c -~-·.::;::::-.cnt spending. And the

·=-= :·-:::: :::::.-:: the greatest depression ; :: :-. ~::: .:J: or :\ferkel's very public,

: ;- '' -:::. :ci' !Oad for the eventual :-; - ;.::-_ :·.::come that could have

:: ;·.::-..:s:'C:-.? sovereign defaults in ;:~-~-=~:::that are prone to large ;: :::::: .:::-::ek bank creditors and ::: ~=--·:::;:::s \\·ere subordinated to "" -'-' ·.·:-:::: ::.s to the EIB, setting a l.. :::::-.:-.;;- ::·.:ntries around Europe's :::::: ~ :~..-e effect to facilitate the

::: ::_.l"Cs - another troubling : ::-_:: :·.::s:a.nding bonds of Spain, ,-,.- ; .: ::-.::-.at these countries could o:::::: :: :::.:ge losses on their bond

;- :-.-·.o::: ::-.':estors were successfully -: .o=: ·.:::-.: of debt relief, but as of ~ _,:: ::: ::-,e seemingly enduring ·:·::::: .-'o.:cording to a June 2012

c-..:::.~:-.· :.e1lers in debt issued by l: .-::~;: ::.::other five years before it ·=--: :::-. :s ;:xpected it to take at least ::::-. s.'.::: :jat investors would not _:: :'.·::: :;:-:edicted that it would be L.: ~=--i restructuring may have ::: .o:-_ ;:x:ended period of time, a

;:;'::: ::-::·::;:exchange in December ~:- :::-:.:::;:nt debt is held by these

~:;:;: :e is Also Available to Other

:, o:C 0 ::•:r. Debt Markets Until 2017",

:::: ·;:: :c :;,e:,C a financial lifeline from the "-~ :.~-=.g inability of the government

:.:-. : ::-_;, ::-.eed to support its weakened ;- ·: ~ :·:e::-::-.ment Needs Aid to Refinance : __ : :::-_ e :"seal situation in Cyprus was ~ ::--= e ;_ ':::-..'s:er] ean-Claude ]uncker, who

c: ~- ::-::::-.:s's Woes 'More Serious Than

Arturo C Porzecanski

official creditors. And the sad tum of events in Greece has also scared investors away from bank and sovereign debt obligations issued in other European periphery markets, such as Cyprus, Italy, Portugal and Spain, thereby aggravating the eurozone's financial woes. 55 This is why the Greek default and debt restructuring of March 2012, and all the events that led up to it and then followed it, illustrate so vividly the many grave flaws inherent in the eurozone project- flaws that hopefully will inspire the institutional and other reforms needed to assure its viability and

restore its credibility.

49