CNN: Finally, Europe has a Deal
FT: EU Reaches Deal on Greek Bonds
Spiegel: Euro Zone Frees Greece of Half of its Debt
In the early hours of Thursday morning, Eurozone leaders reached an agreement on the next step in dealing with the Eurozone’s debt crisis. The primary goal of the Eurozone Summit, which began October 23, 2011, was to convince private creditors holding Greek debt to accept a voluntary “haircut.” The agreement aims to resolve the Eurozone’s three main problems: Greece’s debt crisis, the instability of the banking sector, and a weak bailout fund.
Under the new plan, creditors holding Greek bonds “voluntarily” agreed to a 50% write-down (“haircut”) on the value of Greek bonds, meaning that roughly €100 billion that Greece currently owes to these bondholders will be eliminated. This measure is intended to reduce the country’s debt to 120% of gross domestic product (GDP) (from 150% currently) by the year 2020. Private investors only agreed to the new plan after Eurozone leaders offered a €30 billion guarantee on the private investors’ remaining debt owned by investors. However, many analysts believe that the 50% haircut may not be enough to lower Greece’s debt to a sustainable level.
The second issue that the plan aims to resolve is the instability of the banking sector. To do so, European banks will be required to increase their capital ratios (the amount of cash the banks hold compared to their total assets, which include outstanding loans the banks have made), from 4% to 9%. The goal of the increase is to boost confidence in the European banks’ ability to absorb losses. It is expected that after the 50% write down of Greek debts, Greek banks will need to raise an additional €30 billion to meet the new capital requirements, Spanish banks €26 billion, Italian banks €15 billion, French banks €9 billion, and German banks €5 billion.
The third aspect of the agreement deals with increasing the power of the EU bailout fund known as the European Financial Stability Facility (EFSF). Under the terms of the deal, the EFSF’s lending capacity will increase from €440 billion to over € 1 trillion through the use of “leverage”. In other words, although the actual amount of the fund will not increase, it will effectively be able to lend more to countries in crisis. For example, under one proposal the ESFS would create a financial entity that would be funded by various sources, such as hedge funds, pension funds, and government investment funds (e.g., the state-owned Chinese Investment Fund). European leaders are considering other leveraging strategies and it may take some time before they reach agreement on the details.
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So, when I read the headlines, it sounds as if Greece were to decide today that they were going to default, that the entire value of their outstanding debt would be worthless and it could cause a systemic banking crisis. However, Last I checked, credit default swap rates were hovering around 5400-6000 basis points, which is consistent with the current secondary market rate of 40% (give or take) on the dollar (or Euro)for Greek debt. So, if fair market value is approximately 40% on the dollar as they are currently held, are the banks holding this debt not required to have already written down the value of these assets as they have gradually lost value over time. Therefore, in the event of a true hard default, the banks are only writing off the remaining 40% of value that these bonds hold. My feeling is that this should significantly ease the pain of a default (since the value has declined over time rather than from 100% to 0% all at once). However, the reporting I read does not seem to address this issue.
So to my questions:
1. What are the implications for a soft default so to speak, where the value of Greek debt declines (or the cost to insure it rises to parity with the underlying instrument) eventually to zero, but over a period of say six months to a year. Or, is the global economy better off with a hard default up front and sort out the mess later?
2. The regulatory implications are interesting depending on the answer to #1. Clearly, the ECB is acting in a way to prevent a hard default by mass purchases of Greek debt on the secondary market. Clearly, this action props up the secondary market for Greek debt, and inflates the value of the debt that the banks are holding. So, in essence, the banks holding this debt COULD unload it at a 60% loss, or they can continue to hold it. Should the EU/ECB force the banks to sell this debt to the ECB at a discount in order to prevent systemic risk (i.e. a forced regulatory sale "for the sake of the banking system" sort of thing). Or would this just make the problems worse in the long run?
This is an interesting time to be observing financial markets!
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