Greece: Targeted Subordination Of Official Sector Debt by SSRN

Lee C. Buchheit

Cleary Gottlieb Steen & Hamilton LLP – New York Office

G. Mitu Gulati

Duke University School of Law

July 15, 2015

Abstract:

If Greece’s debt is unsustainable, and most observers (including the IMF) seem to think it is, the country’s only source of funding will continue to be official sector bailout loans. Languishing for a decade or more as a ward of the official sector is undesirable from all perspectives. The Greeks bridle under what they see as foreign imposed austerity; the taxpayers who fund the official sector loans to Greece balk at the prospect of shoveling good money after bad. The question then is how to facilitate Greece’s ability to tap the private capital markets at tolerable interest rates. The IMF’s answer? Write off a significant portion of the official European loans to Greece or, at the very least, stretch out the grace and repayment periods of those loans until the Crack of Doom. There may be an alternative — persuading the official sector voluntarily to subordinate its credits, on a targeted basis, to new borrowings by Greece from the private markets. If the alternatives for the official sector are to lend the money itself (with the risk that the funds may never be recovered), or to write off their existing Greek loans now as a means of rendering the country presentable to the markets, subordination may be a more politically palatable option.

Targeted Subordination Of Official Sector Debt – Introduction

Scenario One

Guy walks into his banker’s office, sits down and announces “You know, don’t you, that I haven’t a snowflake’s chance of repaying all the money I have borrowed from you over the years?”

“What,” gasps the banker in horror, “you came all the way down here to tell me that!”

“Not at all,” replies the customer calmly, “I came down here to discuss the terms of a new loan.”

Scenario Two

Greek guy walks into a negotiating room in Brussels . . .

* * * *

Financial wardship

As of this writing, Greece is commencing the negotiation of its third official sector bailout package in five years. The total amount already borrowed under these packages, excluding the financial assistance provided to the Greek banks by the European Central Bank, already approaches €246 billion. The latest program, if fully implemented, could add as much as another €86 billion. Greece faces the very real prospect of being the financial ward of its official sector sponsors (the European Union and the International Monetary Fund) for the whole of this decade.

Two things have changed over the last five years. First, Greece’s economy has contracted painfully as a result of the fiscal adjustment measures upon which continued official sector assistance has been conditioned. The social and political backlash in Greece is perfectly visible. Second, the sheer size of Greece’s public sector debt burden — now in excess of 176% of GDP — is widely recognized as unsustainable. Although the maturities of these loans have quietly been extended (for decades into the future) and the interest burden reduced substantially, even the IMF has recently called for further debt relief including a possible write-down of the nominal amount due to official sector lenders apart, naturally, from amounts due to the IMF itself. Discussing massive new loans while simultaneously asking for a write off of the old loans extended by the same group of creditors will test the skills of any debt negotiator.

Both Greece and its official sector sponsors should wish to end this financial wardship. For Greece, it is a matter of pride and a sense that the country is regaining some control of its financial destiny. For the official sector, pouring in additional money while openly discussing the forgiveness of a portion of the money-already-poured-in poses an obvious political problem. The question is how. Greece will certainly need to borrow. If that money does not come from official sector sources, it must come from the private sector. But commercial lenders will be leery of extending new credit to Greece for so long as the risk of a Greek exit from the Eurozone is present. Private creditors will also naturally worry about lending new money to a country carrying a colossal and unsustainable stock of existing debt.

Last spring, when Grexit fears temporarily subsided, Greece was able to borrow in the international bond markets at an annual interest rate of less than 5%. The market’s logic was that by virtue of the maturity extension of the official sector loans coupled with very low interest rates on those credits, the official sector had structurally subordinated itself to any new private sector lending that matured before the official sector credits started to fall due. The buyers of these new bonds had apparently persuaded themselves that the official sector either could not, or would not, accelerate its loans and thus become an unexpected competitor for scarce Greek financial resources in the interim.1 The trick in the future will be to make a country with a debt to GDP ratio in excess of 176% presentable to the markets without inflicting an immediate, and politically unpalatable, nominal haircut on that debt stock.

Greece: Targeted Subordination Of Official Sector Debt

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