Special Greece Jul11

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Greece debt swapQuestions and answers

27 July 2011

Greeces debt swap with private-sector par-ticipation

A position paper published by the International Institute of Finance(IIF), a global association of financial institutions, offers an ap-proach to private-sector participation in Greek debt swap that hasthe explicit support of 30 financial institutions. This raises impor-tant questions, which we answer in the following:

How big is the private sectors participation?

The private sectors participation is calculated based on assump-tions about the amount of Greek government bonds privately held(par, not market values) and about the rate of participation in theproposed mechanism. The IIF expects participation equal to 90%of the private sectors aggregate holdings. According to the insti-tute, the given maturity profile results in a contribution to Greecesfinancing by the private sector of EUR 54 bn between mid 2011and mid 2014 and of EUR 135 bn altogether in the period frommid 2011 to the end of 2020.

0

20

40

60

80

100

120

140

160

180

Privat sector contribution via bond buyback programm

Privat sector contribution via bond exchange/bond roll-over programm

Credit enhancements for bond exchange/bond roll-over programmEFSF-loans to Greece for bond buybacks

Recapitalization of Greek banks

Direct loans to Greece

Contribution

EFSF/IMF

Composition of the new Greece package

Source: Thomson Reuters, Raiffeisen RESEARCH

How does the debt swap work?

Participating investors would have the following four options ofvoluntary bond exchange or rollovers:

1. Bond exchange into new 30 year Greek bonds issued at parwith step-up coupon payments (4.0% for the first 5 years, 4.5%for the 5 years thereafter, and 5.0% for the remaining periodto maturity). The new 30 year instruments are collateralized

AnalystsGottfried Steindl, [email protected]

Julia [email protected]

Jrn Lange, [email protected]

Peter [email protected] [email protected]


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by triple-A rated zero-coupon bonds. Those bondsare purchased by Greece (like the Brady bondmodel) using funds provided by the EFSF.

2. Rolloverof maturing Greek bonds into new 30-

year instruments issued at paron the same condi-tions as in option 1 and with the same system ofcollateralization.

3. Bond exchange at a discount (80% of the facevalue of the old bond) into 30-year instrumentsissued at parwith higher coupon payments com-pared with options 1 and 2 (6.0% for the first 5years, 6.5% for the 5 years thereafter, and 6.8%for the remaining period to maturity), but with thesame system of collateralization.

4. Bond exchange at a discount (80% of the facevalue of the old bond) into 15-year instrumentsissued at parwith coupon payments of 5.9%. Onthis model, there is only partial collateralization(80% of the loss, up to 40% of the notional valueof the bond). This collateralization is performedwith funds that Greece (again financed by theEFSF) puts in an escrow fund.

The IIF assumes in its proposal that the four optionswill be chosen equally (each 25% of regis-tered parvalue).

How do the losses work out by theNPV method?

On options 1 and 2, the old bonds are exchanged orrolled over at the full par value into the new bonds.The net present value (NPV) of the coupon payments(average coupon of 4.5%) is discounted at a rateof 9%, which results in a price value of about 46.2on 100. The zero-coupon bonds function as a kindof lump-sum repayment vehicle to which the investorhas a claim in case Greece defaults. These bonds

have a NPV of about 33.6% (100 discounted at arate of 3.7%) at the beginning. The total of the NPVs(46.2 + 33.6) comes to just under 80%, which corre-sponds to the cited discount of about 20%.

On option 3, the par value of the old bonds is ex-changed into new bonds at a discount of 20%. TheNPV of the coupon payments of the new bonds (ave-rage coupon of 6.42%) discounted at a rate of 9%amounts to about 66 on 100. If one takes the dis-count into account and adds the NPV of the collateralprovided (zero bonds), the result is again an NPV

for the new instruments of just under 80% (66 - 20 +33.6), or the cited loss of about 20%.

Also on option 4, the par value of the old bonds isexchanged into new bonds at a discount of 20%.The NPV of the coupon payments of the new bondsset at a maturity of 15 years and discounted at a rateof 9% amounts to about 47.6 on 100. Collaterali-

zation is achieved up to a maximum of 40% of theinstruments notional value (at the beginning 40% of80% = 32%). The total of the NPVs from the (maxi-mum) collateralization and the coupons here again yields an NPV of about 80% (47.6 + 32), or thecited loss of about 20%.

Supposing that the assumed rates are the market ra-tes at the time of debt swap / roll-over, the new bondwill be traded at close to 80 in case of option 1 and2 and at 100 in case of option 3 and 4.

What are the risks for investorsduring/after debt swap?

The collateral in options 1 through 4 relates to theprincipal, not to the coupon payments. So, whereasa triple-A risk may be assigned to the principal, theinterest payments are subject to Greeces sovereignrisk.

In case Greece defaults during the maturity period,the investor loses the scheduled interest payments. In

options 1 through 3, the difference between the NPVof the zero-coupon bonds and the par value of 100may be added to that. The collateral for the princi-pal must first be amortized over the maturity period;only after 30 years (upon final maturity) is the fullamount guaranteed (provided the AAA-rated issueris solvent). At the beginning, the substitution rate onthe principal is thus about 33.6%, which graduallyrises to 100% by the end of the maturity period of thezero-coupon bonds.

When the bonds are rolled over (option 2), it is notclear whether investors will still bear Greeces full

sovereign risk between the time of declaring theircommitment and that of the rollover or will alreadyhave a claim to the principals collateral on the basisof the commitment undertaken. After all, many yearsmay pass between the voluntary commitment to arollover and the bonds maturing. It is also unclearwhether the instrument will remain tradable duringthat time inclusive of or separated from the rollovercommitment.

In option 4, the collateral does not consist of zero-coupon bonds, but rather presumably of interest-be-

aring instruments with high credit ratings (probablyalso triple A). The advantage is that the collateralneed not be amortized first. The disadvantage of thisoption is the lower substitution rate in case of a de-


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fault (at most 40% of the notional of the old bondwhich gives at most 32% of the face value of the oldbond).

Whether the new bonds will be tradable is not dis-

cussed in the position paper. We, however, see noobstacles to a secondary market for the new instru-ments.

What rating will Greece get andwill CDSs be triggered by the debtswap?

According to Fitch, the restructuring program will re-sult in Greeces being rated in restricted default.The bonds affected by the exchange/rollover will berated in default as soon as the offering period forthe four proposed options ends. However, the defaultratings are to remain in place only for a short timeuntil the actual exchange process begins. The defaultwill be cured with the issuance of the new debt inst-ruments to the participating investors, and Fitch willgive new ratings to both Greece and the outstandingbonds. According to available information, Fitch willclassify Greece and its debt instruments in the lowspeculative category.

According to initial statements by the International

Swap and Derivative Association (ISDA), credit de-fault swaps (CDSs) on Greece will not be triggered.The offered debt swap is no credit event. However,the relevant committee will not submit its final verdictuntil the offer becomes binding. According to currentreleases, the critical factor for the preliminary judg-ment is the voluntary status for participation in thedebt swap. Moreover, from a legal standpoint, whathappens is an exchange of old bonds for new oneswithout any change of the terms associated with theold bonds. A Change in terms is called restructuringwhich constitutes a credit event.

How do the losses calculated bythe NPV method affect bank balancesheets?

The downgrade of Greece to default might necessi-tate an entry in the balance sheets for the old bonds.For example, the Institute of Public Auditors in Ger-many (IDW), according to a press release of 19 July2001, considers taking an impairment charge ne-cessary in the case of all the approaches discussed

ahead of the summit meeting. The new bonds should,in our view, provide a reference point for the levelof provisioning and writedowns. However, the pre-cise amount of correction needed will depend on the

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selected option, past and future accounting practi-ces, and the market environment at the time of theexchange and accounting. We currently assess thesituation as follows.

Options 1 and 2 represent an exchange of the oldbonds into new bonds at 100% of par value. Intheory, that should mean no need of writedowns.However, the conditions of the new bonds are signi-ficantly worse than interest usually paid on the mar-ket. Consequently, a significant price drop may beexpected already on the first trading day. That willcorrespond roughly to the NPV loss of 21% underthe assumptions in the IIF proposal. How this priceloss is handled, however, depends on the accoun-ting environment. If the new bonds are booked intheir trading accounts, banks will have to adjust the

book values quickly to market values and write offthe difference through the profit-and-loss account(P&L). But if the new bonds are booked in the hold-to-maturity (HTM) banking accounts, a valuationadjustment will only be necessary if a permanentvalue loss has occurred. However, we believe that isa difficult argument to make considering the collate-ralization of the bonds par value by a high-qualityzero bond portfolio. If the new bonds are bookedin the available-for-sale (AFS) banking accounts, novaluation adjustments will be necessary through P&L,but the difference between book and market valueswill have to be reflected in the revaluation reserveand hence in equity.

In options 3 and 4, banks only receive new bondsequivalent to 80% of the old bonds par value. Wetherefore believe the difference relative to book valueshould be offset directly through P&L. If the old bondswere booked in the trading accounts, at current mar-ket prices this would probably mean writeups andhence a gain. Bonds in the HTM accounts, on theother hand, are likely to incur losses in most cases,while those in the AFS accounts should be capital-neutral. The losses recognized in P&L will replace

the unrealized losses in the revaluation reserve in thestatement of equity. Since the new bonds are likely tobe much closer to the market in these options, we donot expect appreciable price losses for them in thenear term under the IIF assumptions.

What does this mean for the ban-king sector?

The burdens arising from collateralization would beenormous for Greekand Cypriotbanks, and reca-

pitalization of those banks seems likely. For otherEuropean banks, the effects are less clear. Possibleburdens arising from the banking accounts stand incontrast here to writeups from the trading accounts.


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The burdens are likely to predominate for the Euro-pean banking sector. Set against that, however, aremostly profits from operating business and capital re-serves. As long as a contagious spread to other pe-riphery states can be avoided, this should not cause

any major banking institution financial distress.

What will happen if an investordoes not participate in the voluntarypro-gram?

So far, the restructuring program has been presentedto the financial sector as a voluntary offer, to which30 well-known institutions have given their support.There is no plan for compulsory participation by allholders of government bonds. Nevertheless, the tar-get participation rate is set very high at 90%. How-ever, the free rider incentive is also very high, es-pecially for holders of short-date Greek governmentbonds. If an investor allows an old bond simply to runout, he will receive, according to current information,the claims arising from the bonds in full (coupons andpar value at 100%).

How will Greeces debt profilechange?

Based on the IIFs assumptions, the bond exchangewill result reduce debt by EUR 13.5 bn (about 50%of the exchange is expected to occur via options3 and 4 = EUR 67.5 bn; a 20% discount on thatamount results in the above-mentioned EUR 13.5 bn).However, Greece is buying this debt reduction at thecost of a higher interest burden.

Another debt reduction of EUR 12.6 bn is expectedto result from a bond buyback facility. This facility willprobably be financed by the EFSF; its aim will be topurchase outstanding bonds below par value. The

problem is that the more prices on the Greek bondmarket advance, the more expensive this project be-comes. Therefore, the bonds might be purchased toa lesser extent from private investors and to a grea-ter from the European Central Bank (ECB). The ECBcould directly determine the price discount with theEFSF, and this could ward off market speculation onprice gains.

The lower limit for the discount on par value may beput at about 20%; otherwise, these investors wouldbe better off than they would be with an exchange/rollover. But if one sets the price reduction on parvalue at 25%, this program will be very expensiveat about EUR 50 bn and would probably not finda place in the second Greece packages announced

financing framework of EUR 109 bn. The target dis-count is therefore likely to be between 30% and 40%.

Altogether, the sought debt reduction of EUR 26 bnoffers some relief, but it is certainly not a big step

toward making the Greek national debt sustainable(the debt level stands at about EUR 360 bn). That issupposed to (and must, in our opinion) take place byway of other measures. One thing to mention is cut-ting current deficits. Another is making governmentmore efficient and industry more productive with ex-tensive assistance from the EU (a long-term process),so the economy returns to a sustainable growth path.Finally, the high debt level must be made sustainableby means of a reduced interest burden.

How will Greeces interest burdenchange?

How high is the interest load now?

Since most outstanding government bonds were al-ready issued before the outbreak of the debt crisislast year, the coupon payments to be made on themby the Greek government appear very low compa-red with present yield levels. Of the debt instruments(bonds and notes) maturing by 2020, 33.4% havea coupon of at most 4.5%, which corresponds to theaverage interest rate of options 1 and 2 (excluding

collateralization costs). Another 23.1% of the debtinstruments maturing by 2020 have a coupon thatis more than 4.5% but at most 5.9% (interest rate ofoption 4). Altogether, more than half (56.4%) of thedebt instruments have a coupon that at most matchesthe average interest rate in option 4. Greece wasthus able in the past to finance itself at relatively fa-vorable conditions. On the other hand, only 12.5%of the securities to be serviced in the period to 2020have a coupon that falls in the range between 5.9%and 6.42% (average interest rate in option 3).

4.5% < Coupon 5.9%

5.9% < Coupon 6.42%

Coupon > 6.42%

Others (Zero, Floating, etc.)

1% < Coupon 4.5%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Share of EUR-denominated outstanding Greek bonds

1% < Coupon 4.5% 4.5% < Coupon 5.9%

5.9% < Coupon 6.42% Coupon > 6.42%

Others (Zero, Floating, etc.)

Coupon payments on Greek bonds

Source: Thomson Reuters, Raiffeisen RESEARCH

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These favorable financing conditions are also reflec-ted in the implicit interest rate (this years interest pay-ments as a percentage of last years national debt),which the EU Commission estimates at only 4.5% in2011.

What interest rates result from the four op-tions of bond exchange/rollover?

Interest rates on EFSF loans are now at about 3.5%.For Greece, this is the cheapest source for funding.The interest rates offered in the bond exchange/rol-lover average 4.5% (options 1 and 2), 6.42% (op-tion 3), and 5.9% (option 4). However, additionalinterest costs arise for Greece on options 1 through3 due to the collateralization. Every EUR 100 fromoptions 1 through 3 is to be collateralized with an

investment of about EUR 33.6 in zero-coupon bonds.This amount must be additionally borrowed from theEFSF, for which an interest rate of currently 3.5%would apply, or EUR 1.18. The interest rates on op-tions 1 through 3 thus increase for Greece due to col-lateralization costs by about 1.18 percentage points.Hence, applying the debt swap the interest load forGreece will actually increase, but the rates offeredare way below market conditions.

What does this solution of the

Greek problem mean for other EU pe-riphery states?

First, the easing of ESFS lending conditions (maturitylengthening and interest rate reduction) is worth men-tioning because it benefits not only Greece, but alsoIreland and Portugal. This step is especially welcomebecause of the critical influence of the interest ratelevel on a countrys long-term solvency. In particular,considerable interest relief of about 200bp accruesto Ireland, which has had to pay the highest inte-rest rates on EU loans due to EU disputes over lowIrish taxes on corporations. In this connection, ratingagency Fitch has already emphasized the positive ef-fectsof the lower EFSF lending rates now also appli-cable to Ireland and Portugal on the debt dynamicsofboth countries. It is also positive for the future ratingsof the two countries that EU policymakers are veryconcerned that the current debt swap of Greece ispresented as a one-time special case within the euroarea. The wording of the EU resolution (exceptionaland unique solution) suggests that EU policymakersare not now considering using the Greece packageas a blueprint for other periphery countries. The re-ception of the EUs declaration of intent by the rating

agencies has thus been correspondingly positive.

At the same time, however, the current Greece pa-ckage sets a precedent for debt restructuring withinthe European Monetary Union, although such a resultwas still vehemently ruled out by policymakers andthe ECB just a few months ago. One therefore has

to wonder how credible the latest political promisesare and whether Greeces debt swap will actuallyremain an exception if the economic and budgetarysituation in Portugal or Ireland develops worse thanexpected.

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This report was completed on 29 July 2011

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