Greece on the CAC Warpath.

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Jan 13, 2012 (2 days ago)

Greece on the CAC Warpath.

by Andreas Koutras

 According to newspaper reports Greece is one stepaway from introducing CAC in the bonds under Greek law. In this note we try to investigatesome of the possible ramification of this action for both Greece and Europe. Ifyou believe that introducing and activating the CAC’s is a way to punish thebad guys read on. 

Let me start by saying that the legal opinion of many isthat introducing a law imposing retroactively CAC’s may be worded in such a wayso as not to be an event of default. For the sake of the argument let us acceptthat premise. i.e. it can be done without causing too much trouble to beginwith. On the question of the activation however the majority of the legalobservers, agree that this would be an event of default. So what! Say some. Letit be a credit event and triggering of the CDS. Here is a hypothetical sequence of events: 

1.  Greeceactivates the law and calls for the majority, of whatever the percentage, todecide whether to impose the PSI to the rest of the bondholders.

• Question:Is the ECB part of it or has it beenexcluded?
• Answer: ECBis included. In this case the ECB, depending on politics, may decide tovote NO or YES. If it is a YES, then it votes itself into bankruptcy and the raisingof equity from shareholders (NCB; namely taxpayers). Unless of course it canwave a magic wand and cover the loss from some kind of other assets orprovision it has on its balance sheet. If the ECB votes NO then the PSI freeriders rejoice. Either way, it is not a happy position for the ECB to be in. PSImay be abandoned but the damage is now done. Greece has defaulted.
• Answer: ECBis excluded. Excluding the ECB from this would for sure be challengedby other bondholders. 
1. Themain argument for the exclusion would be that the ECB is mandated to safeguardthe financial stability of Europe and under this guise it purchased the Bonds.Thus it should be excluded from any restructuring. Thus bonds under the SMPwould be excluded while bonds owned by NCB may be included!
2. Thecounter-argument is that this is discriminatory and that the bondholder’sdecision making process is irrelevant. Investors buy debt for a variety ofreasons and to bias the repayment or restructuring according to this opens aPandora’s box.  
3. It would further make all other bondholderssubordinated to the official sector. This would cause havoc into the bondmarkets. More trouble than good. 
4. An unintended consequence of the exclusionof the ECB from the CAC’s is that now it would be easier to block the PSI.Why is that? Because now a bond-holder with only 15% of an issue might jump to25% or more if the ECB holding is taken out of the voting. In other words, itcan play either way. It is simply unpredictable and immensely messy. Lawyer’sparadise.

2. Greeceactivates the CAC’s that did not exist in the Bond’s birth. In other words itchanged unilaterally the legal term of a bond. This would trigger the CDS andeverybody would be happy. The CDS fulfilled the role it was constructed for.Should Greece care about this triggering? Not really unless it has soldmassively protection, which it has not. The CDS is a privately negotiatedcontract and whether it triggers or not in itself does not directly affectGreece. What affects Greece is the almost certain fact that Greece would be officiallytermed as defaulted in its obligations.

a.       Ifthe Greek debt is under default then we also have that all Greek banks areunder default. What would be the response of the small depositors if they hearthat Greek banks are bust? Your guess is as good as mine.

b.      Butif the Greek bonds are defaulted so is the ECB (if not excluded) which would beneeded to support the Greek banks. If it sounds complicated and crazy it isbecause it is complicated and crazy.

c.       Moreover,European banks would now have to replace the Greek collateral with the ECB withother creditworthy bonds.

d.      Allof the above are conditional on how long Greece would be under the defaultstatus. If it can be done in two weeks so that Greece only assumes the zombiestatus for 14 days and the Greek public is accommodative then there a chance ofsuccess.

e.      Ifthe default status is prolonged due to disagreements between bondholders orpoliticians then other factors kick in, like finding the credit lines fornecessary supplies of vital commodities. Also the questions of exit from the EZmight resurface.

f.       How about the funds from the Bank of Greece’sELA? They are the liability of the state which has now defaulted.

g.       Whatabout Target2. Is it going to function normally now that one member has gonebust?

h.      AsI mentioned in a previous note, why bother with the nuclear option for just fewbillion. Might as well legislate that all bonds become zero coupon for the next20 years (say). That would give ample time for Greece to recover.

Punishment?

Lastbut not least there is the fiduciary duty of the majority of the bondholdersnot to act totally against the interests of the minority bondholders. Thisis a very shuttle and interesting point. CAC’s serve the purpose offacilitating the speedy resolution and restructuring of debt against someincalcitrant  and often malevolentbondholders. They are not meant to be used as a punishment or for opportunisticreasons. There have been cases in the past were courts ruled against (See Buchheit, L and Gulati, M (2002), “Sovereign Bonds and the Collective Will”, Georgetown University Law) the CACmajority for basically abusing their dominant position.

Whatwould happen to Italy?

Italy along with Greece does not have CACin the bonds. Allowing Greece to introduce them in this cowboy fashion wouldcertainly alter the perceptions and risk profile of the Italian bonds. Nomatter what they say, what happens in Greece sets a precedence that no investoris allowed to ignore in the future.

I listed some of the questions that need tobe asked if one is to proceed with the activation of CAC’s in Greece. There is nodoubt that readers may have more and please do post them. The one thing that iscertain is that Greece would represent the largest sovereign bankruptcy inhistory. Many legal careers would be made on the corpse of Greece and manywould retire writing books about the whole shenanigans.  QuiBono? This is the real question to ask. Who benefits from such a mess? Evaluatingthe pros and cons it is not Greece. Like in the gold rush, those that advisedon prospecting and those that sold the digging were the only real winners.

Spot the Bad Guy

Sowho are the bad guys in this thriller? The investors that are free riding onthe back of the ECB? The ECB which forces a change in the law when it goesagainst its interest? The Greeks  who nowcan keep on restructuring both malevolent and innocent investors? Thepoliticians? The lawyers and advisors who benefit from a prolonged andcomplicated default? The IMF that may use this as an excuse to exit a projectthat has no real control of? Take your pick.

Conclusion

Inmy humble opinion the risks are much greater for Greece than the benefits. Andthe same goes for Europe. There are far better ways to deal with the debt ofGreece without creating havoc, entering uncharted legal territories orendangering the financial system and the markets. All it needs is a bit of coldcalculating logic and good unbiased advice.