Yesterday, Reuters’ blogger Felix Salmon in a well-written if somewhat verbose essay, makes the argument that “Greece has the upper hand” in its ongoing negotiations with the ad hoc and official group of creditors. It would be a great analysis if it wasn’t for one minor detail. It is wrong. And while that in itself is hardly newsworthy, the fact that, as usual, its conclusion is built upon others’ primary research and analysis, including that of the Wall Street Journal, merely reinforces the fact that there is little understanding in the mainstream media of what is actually going on behind the scenes in the Greek negotiations, and thus a comprehension of how prepack (for now) bankruptcy processes operate. Furthermore, since the Greek “case study” will have dramatic implications for not only other instances of sovereign default, many of which are already lining up especially in Europe, but for the sovereign bond market in general, this may be a good time to explain why not only does Greece not have the upper hand, but why an adverse outcome from the 11th hour discussions between the IIF, the ad hoc creditors, Greece, and the Troika, would have monumental consequences for the entire bond market in general.
But before we proceed with the analysis, we should point out one minor nuance: Salmon, and thus the WSJ’s Fidler, are correct that Greece has all the leverage in the world, in the same way that a suicidal person has all the leverage to take their own life as they stand on the ledge of a skyscraper. Because from a strategic standpoint, the reality is that over the past 2 years, the entire financial establishment has done everything in its power to mask the fact that Europe is currently undergoing a stealthy restructuring, without it actually being represented as a restructuring. The reason for this is that while an ex-event of default status quo allows the world’s financial establishment to continue marking sovereign debt, even highly impaired one (remember: central planners are always right, markets – always wrong in pricing risk, or so the central planners say), at whatever prices it desires (recall that one of the very first things to happen in the post-Lehman collapse was the elimination of the Mark-to-Market statute, thus affording banks a plethora of gimmicks to mark ‘assets’ on their books at any valuation that excel spews out based simply on input assumptions, which in some cases are openly fraudulent), a case of sovereign default will very likely make mark to market unavoidable, thus exposing the proverbial nudity of the emperor. It also has implications for the ECB, for CDS triggers, and other consequences, but those are of secondary importance for the time being. Most importantly, the Nash Equilibrium at least until now, had afforded creditors, who in many cases have known very well that they have ‘weak protections’ on their sovereign holdings (more on this in a second), the myth that they are not subject to subordination, or seniority claims on their holdings, and thus the sovereign market was uniform, orpari passu. The outcome of the Greek negotiations, should Greece indeed use the “nuclear option” and force a coercive cramdown on any one, or all, bondholder classes, would do away with this myth in the blink of an eye, and instantaneously create a split between what will hence be perceived as senior and subordinated sovereign bonds. These are all considerations that the ECB, that European banks, and most importantly European sovereigns (and Greece) are all too aware of, and since the need to fund future deficits will only rise, any impairment of the sovereign funding apparatus is not only suicide for Greece, but for Europe, and eventually for the rest of the developed world.
Additionally Salmon ignores a simple tactical observation, one which the hedge funds are all too aware of, namely that while the bulk of Greek bonds are issued under Greek-law (a fact we first observed back in June, when we made the assessment of just who it is that really holds the reins in the default process) and while lacking collective action clauses, can be ‘crammed down’ retroactively, a smaller portion, which is estimated to be between €25 and €40 billion, has been issued under foreign, primarily UK-law, with strong creditor protection, and with Collective Action Clauses, which require that anywhere between 66% and 75% of all creditors agree to a given process, in this case the ongoing Greek prepack exchange offer (more later), for it to occur. It also means that bondholders in all other European countries are carefully watching if contract rights of “strong” UK-indentures are abrogated either in Greece or elsewhere, which would be a signal that there is no sovereign debt in circulation that is safe any longer from future attempts to strip positive and negative covenants, or explicitly stated bondholder rights. This is especially topical, as with Greece about to proceed with a prepack (non) bankruptcy, all eyes will turn to Portugal which is next, and after that Ireland, Spain and Italy. In this regard, what happens in Greece, under the advice of Cleary Gottlieb’s Lee Buccheit, will be seen as a framework for all future bankruptcies that Europe will undergo.
And if Greece does proceed with what Salmon indicates is its “upper hand” course of action, what it will be doing, again going back to game theory, is defecting first, in the process forcing a broad sell off of weak, and potentially, strong indentures bonds of the other PIIGS nations, eventually leading to the collapse of demand for European paper, and the complete loss of confidence in the ECB, which has become a defacto source of equity for the PIIGS, an outcome which will eventually lead to the elimination of all funding for Greece itself. Which is why we said that Greece has as much leverage as one about to commit suicide… but at least it will be first – the line after it long and dignified.
Greek Bankruptcy 101
Before we get into the implications of what a scorched earth strategy by Greece would be, we would like to explain the process as it stands in Greece. Greece, has over the past nearly two years, been the functional equivalent of an insolvent corporation. The hundreds of billions in Troika bailout funding provided so generously to Greece is nothing but a prepetition Debtor in Possession (DIP) loan, with a first lien and collateral protection. The IMF may get paid back, but Greece will say goodbye to half its islands and historical monuments in the fire-sale that precedes. Furthermore, the ECB which as recently estimated by Barclays, has bought about €36 billion of Greek debt, is in effect a provider of equity financing. While this requires a tangential analysis, the ECB does not act as a Greek creditor, whose primary focus is to be repaid. No, the ECB would be more than happy to hold all the Greek debt, as it does not care one bit whether or not it gets paid interest – after all it can just print cash to fund its undercapitalized status should Greek bonds finally be recognized as worthless. If that were the case, Greece would be able to proceed with any debt transaction it desires, as