A trip to the barbers

Greece is in urgent negotiations with its creditors to complete the euphemistically named “private sector involvement” demanded as part of the current international rescue package.  The Institute of International Finance, acting on behalf of the banks who are the major creditors, agreed in principle to a 50% “haircut” on the value of Greek government bonds last year.

Now that is some hairdressing!  The last time I visited the barber I left rather less than 1% of myself on the floor.  Even Sweeney Todd, the Demon Barber of Fleet Street, made his final cut only about 10% down.  But the barbershop quartet of the EU, ECB, IMF and German public opinion are demanding more drastic action. And it must be voluntary – the puppet masters are keen to avoid a forced default that would trigger CDS payouts and put more pressure on the other peripheral eurozone countries.  No-one wants to bring the Barber of Seville out of retirement, for example.

The time for orderly negotiations is running out, though. Greece has a €14.5bn bond maturing on 20^th March that it has no hope of repaying without more money from its European partners, and they are refusing to pay without a signed deal on bondholder losses.  And with an estimated six weeks needed to put legal paperwork in place, an agreement is really required by the end of this month.  But in today’s complex international financial markets, it’s no longer a simple negotiation between a debtor and its creditors.

For a start, there are over a hundred different bonds in issue, and tens of thousands of bondholders, of which only a relative few are directly involved in the talks.  And many of the creditors come from different negotiating positions.  For example, the traditional bondholder will be looking for as small a haircut as possible, to minimise his losses, while accepting that he needs to take some pain to provide some certainty and reduce the risk of another restructuring later on.

But those bondholders who have insured their potential losses via CDS contracts are holding out for a forced default so that their insurance pays out.  They are using various delaying tactics to push the issue to a head.  Some speculators are no doubt even over-insured, holding naked CDS, so any agreement is bad for them, while others have bought very cheap bonds recently and even a 40% payout will be a profit to them.  And then there are the CDS writers (or protection sellers) who are looking for as large a voluntary haircut as possible so there is no forced default requiring them to cough up in a year or two.

What will be the impact on UK local authorities if the negotiations fail?  Assuming no-one is a direct investor in the Greece, credit losses seem unlikely.  European banks holding Greek bonds have already impaired their assets, writing off sizeable chunks to reserves, and most could take a full 100% hit without too much difficulty.  And the total CDS market in Greece is relatively small, so another AIG-style disaster seems unlikely, unless contagion spreads and the market starts to price in hard defaults by Spain and Italy too.  There is still a small chance of this, so I wouldn’t be betting millions of the Council’s money on it all turning out rosy.

A forced default will certainly cause some volatility in other European government bond yields, including gilts.  And with 100 housing authorities borrowing £13bn from the PWLB four working days after the likely default date, that won’t be very welcome.

David Green is the Head of Sterling Consultancy Services, a provider of treasury management advice to local authorities and other not for profit organisations.  This is the writer’s personal opinion and does not constitute investment advice.  It should not be relied upon when making investment decisions.