Greek credit swaps buy a reprieve for euro zone

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A strong buy-in to the world's biggest sovereign bond overhaul promises to avert the nightmare scenario for the struggling euro zone.

Greek government officials said late Thursday that the owners of 80 per cent of the €207-billion of the country's privately held bonds had agreed to swap their holdings for debt of much lower value. Various media outlets later predicted a participation rate as high as 90 per cent. The official figure was to be released Friday morning.

The effort, which will erase 53.5 per cent of the face value of the bonds, is designed to reduce Greece's national debt by more than €100-billion and was a condition for the country's second bailout, worth €130-billion.

There are still issues to be settled, but a failed bond swap would almost certainly have triggered a disorderly default, an event that almost every economist and euro zone politician agree would instantly take the 17-nation euro zone close to destruction.

The Institute of International Finance, which represents the banks and other investors negotiating the debt swap, recently estimated that a disorderly default would cost the euro zone €1-trillion. Banks would require emergency recapitalizations and the weakest countries, notably Ireland and Portugal, would need new rescue programs. The European Central Bank would lose much or all of the value of its €177-billion in Greek bond holdings.

In Athens, several hours before the deadline to accept or reject the bond swap, a government minister told reporters after a cabinet meeting that no surprises were expected.

"I look forward to maximum participation by the private sector, which will contribute significantly to the effort to adjust and restore our economy," Prime Minister Lucas Papademos said, according to a statement from his office.

Greece had said it would abandon the deal if it did not receive at least 75-per-cent participation in the offer. Success was virtually assured, however, because the government used strong-arm techniques to ensure the "voluntary" bond swap's success. It had made it clear that the swap was an all-or-nothing deal and there would be no special offers for the investors who held out.

Athens went so far as to pass legislation to equip the bonds retroactively with collective action clauses, or CACs, that would force any recalcitrant investors into the bond swap (though not the European Central Bank, which is not required to take a "haircut" on its Greek bond exposure).

Triggering the CACs required no less than a two-thirds take-up. Based on the assumed participation rate of 80 per cent or higher, it was almost certain Thursday night that the CACs would be used.

If that were to happen, it's probable that default insurance, known as credit default swaps, or CDS, would come into play.

RBC Capital Markets currency strategist Elsa Lignos said in a research note, "We still think we are almost certain to reach the threshold to introduce CACs and still think it's unlikely that the voluntary take-up will be high enough to avoid using them, which sets us up for a Greek decision on Friday to force the losses on holdouts and a subsequent decision from [the International Swaps and Derivatives Association]to trigger CDS."

Few economists think a CDS payout would seriously rattle the markets. That's because the net amount held by investors – $3.25-billion (U.S.) – is small compared to the overall size of the Greek debt restructuring.

What was not known Thursday night was the status of the 14 per cent of Greece's bonds that are not covered by Greek sovereign bond law. It is thought that much of those bonds are held by hedge funds, which apparently are gambling for a higher payout.

Their participation is needed if Greece is to meet its target of a debt-to-gross domestic product ratio of 120 per cent by 2020, down from a wholly unsustainable 160 per cent today.

While optimism that the debt swap would succeed lifted the markets Thursday, there was little sense that a successful deal would mark a turning point for the Greek economy.

Greece's unemployment rate continues to climb as the severe austerity programs, which have raised taxes substantially and aim to eliminate as many as 150,000 civil-servant jobs, depress economic activity. The country is entering its fifth year of grinding recession.

On Thursday, Elstate, the Greek government statistics agency, reported that the national jobless rate had risen to 21 per cent, twice the euro-zone average, while the youth jobless rate had hit 51.5 per cent, a doubling over three years. That is Europe's highest, leading to fears that social unrest will intensify this year.