EU Sets Terms of Greek Bailout, Bond Holders Take a Hit

Recently, European Union policy makers agreed on the terms for the next round of bailout money to be released to Greece. While much of the plan is formulated around minimizing the moral hazard of yet another large bailout of a sovereign nation, the terms are rather generous (interest rates on the bailout loans have been cut by a third), not to mention placing some of the fiscal responsibility upon private debt holders as well as the country itself.

By far the most debated aspect of the new plan was bond holder participation, so-called private sector involvement (PSI) in the bailout. This complex and somewhat paradoxical scheme intended to save Greece billions by restructuring much of its forthcoming bond debt actually punishes bondholders and EU taxpayers. The problem with the outstanding bond debt is the outrageous interest rates and face-value discounts Greece had to offer to induce investors to purchase the bonds. Now, not surprisingly, Greece cannot afford to pay these rates, and as each payment cycle arrives, the debt total climbs almost exponentially. The solution ---a mercifully favorable solution for Greece --- is what is referred to as debt restructuring. This means that the issuer alters the terms of the loan, or bond in this case, to be more favorable; in this case, cheaper for Greece. This, however, means the bondholders are getting the short end of the stick, about 21 percent less on average than what was stated at the time of purchase. To avoid what could become a riotous situation in the banking community, the debt restructuring program is being offered as "voluntary", as forcing the debt holders to take a hit would be nothing short of criminal. Despite being elective, the EU expects more than 90 percent of all eligible debt will be restructured in one of four offered options: three different swap plans, a rollover option, as well as some buybacks.

Now here's the rub. Except for banks that hold these bonds in their vaults, I cannot see any incentive for the individual investor to participate in these restructuring options (perhaps individuals only account for 10 percent of the outstanding debt held, and was therefore already taken into account, I am not sure). It would clearly behoove a non-institutional bond investor to take at least a small speculative position on Greek bonds when the interest rates were at all-time highs. For that investor, nothing could compel him to take a 21 percent hit unless his only other option was to not get paid at all.

Institutionally on the other hand, this is exactly what banks want to hear. €35 billion is to be used as collateral for the new bonds issued in exchange for the old, to guarantee a triple-A rating. While this does mean the interest rate is substantially lower, it also means banks in Europe are allowed to carry them on their banking books (as opposed to trading books that have more lenient debt quality requirements). For the banks, this is a welcome solution. However, for the taxpayer, this means €35 billion that could be used in other ways (and there are many in Europe today) is doomed to sit in a government vault in Athens to guarantee payout of these new bonds.

While this deal is far from ideal from every perspective, it is a leap in the right direction for a sustainable future in Greece as well as the greater European Union.