Disappearing Ink

Posted by on Jan 10, 2012 in Uncategorized | No Comments

As Europe limps from poorly planned idea to poorly planned idea, they have now resorted to looking at the back of comic books for solutions.  They haven’t yet figured out how to use Sea Monkeys, but the Greeks have latched on to the possibilities of disappearing ink, or in this case, appearing ink.

There is a lot of talk about Greece adding a “Collective Action” clause to bonds documented under Greek law.  I’m not sure how they could really do this, though I guess they could just pass a new law that overrides terms existing bond documentation?  The big question is why are they doing this, what do they hope to achieve?

It seems that the negotiations to get “voluntary” debt reductions are not going well. It seems that there are some holdouts, either those that can’t afford to take the loss, those that hope the Troika keeps furnishing Greece with money to pay off existing bonds, or those who hold CDS and don’t want to give Greece such a big debt reduction that the potential for a future Credit Event becomes unlikely.

What would a Collective Action clause achieve?  Let’s say they institute a 75% agreement clause, so that if at least 75% of the holders of any individual bond issue, agree to the terms, then all bondholders are forced to accept the new terms.  Will adding a Collective Action Clause make investors agree to the changes?  I don’t see why that would happen.  If you didn’t agree to the plan being proposed by Greece now, why would you agree to the plan if all they have done is institute a Collective Action Clause.  You wouldn’t, so you would still have the same group of holdouts.

What happens if a bond doesn’t get 75% agreement?  Then those that agree get the new bonds, and those that don’t agree keep the old bonds.  Same as now. But if it is the same as now, why bother?  Maybe they need to make it 50% agreement?  Or 10%?   In any case, there may be individual bonds that don’t meet the Collective Action threshold.  For those bonds, it is exactly the same as it is now – except that the government changed the rules retroactively and jammed it down your throats (but more on that later).

What happens if 80% of the holders of a particular bond agree?  Then all bondholders are subject to the agreement.  Well, guess what, that is a Credit Event!  That is exactly what the Restructuring Credit Event is meant to capture.  If you vote NO, but are still subject to the change because enough others agreed, then you have a Credit Event!  Isn’t this what they are trying to avoid?  Adding the Collective Action Clause effectively guarantees that there will be a Credit Event.  So long as one holder of bonds with a large enough position to meet the “Default Requirement” and “Payment Requirement” holds out, or votes no, but is forced into agreement by the Collective Action Clause, then it is a Credit Event.  I cannot imagine a scenario where a Collective Action Clause doesn’t lead to a Credit Event.  So if they were hoping to avoid a Credit Event, they have failed.

Maybe they just want to clean up as many bonds as possible, and are fine with triggering a Credit Event.  That is believable, especially now that the net notional of Hellenic Republic CDS is just over $3 billion.  So maybe they have decided they prefer to trigger a Credit Event and basically force as many of the bonds as possible into being restructured.  They can deal with those bonds that didn’t meet the 75% threshold afterwards.

So a Collective Action Clause will ensure a Credit Event, but would make certain that all bondholders are subject to the restructuring and would leave very few “stubs” or old bonds outstanding.

It is unclear why bonds held by the ECB wouldn’t be affected.  It is unclear why bonds held by the Greek pension system would be unaffected.  In fact it seems hard to justify having a “preferred class of holder” once you’ve taken the step of changing the law retroactively.  Yet, since the ECB is unwilling to take a loss, the ECB holdings will somehow be treated differently.  So, not only is Greece retroactively changing the law, they are changing it in ways to benefit certain holders.

What about bonds done under UK law?  Those will still have to be dealt with, but guess what?  Bonds under the ticker “GREECE” which are governed by UK law total just over €18 billion.  Bonds under the ticker “GGB” which are governed by Greek law, total €237 billion.  If Greece can cut that big amount by 75%, the residual GREECE bonds should be much safer.  Why would holders of those bonds agree to a change.  So, holders that have some potential recourse to law outside of Greece would benefit.

Investors will flee locally governed bonds across the board if this occurs.  No one would hold bonds that are subject to arbitrary documentation change.  Donald Trump has had countless bonds default, yet he is able to return to the bond market time and again.  Why?  Because, he may stretch the rules to the limit and do everything possible to benefit his position, but at the end of the day, his companies and bonds are subject to rule of law, and investors can count on that.  Next time he comes to pitch bonds with a new story and a big fat juicy coupon, some investors will participate because they know the laws and their rights and they will take their chances.  Changing the laws retroactively is a horrible idea.  It will crumble the faith of bond holders.  Remember, these are the people lending to Spain at 4.75% for 5 years.  All they get is 4.75% each year and their money back at maturity (assuming no default).  They need the certainty that the rules won’t change midway through the term.  There are enough bad things that can happen to bondholders – inflation, growing debt, subordination, etc., but having the laws changed on them, is not something they can price in.

Collective Action Clauses will ensure a Credit Event, and will cause investors to pull away from sovereign debt markets as the willingness to treat certain holders preferentially and the willingness to change the laws arbitrarily are risks they aren’t getting paid sufficiently to take.

Now if only they could figure out how to use the Sea Monkeys we might have a real solution.