Interesting Issues on Greek Debt: Non-Participation in Exchange, and Non-Trigger of CDS

It is interesting that the 50% writedown on Greek debt applies only to privately held debt (held by banks and I guess any other private individuals or institutions) NOT to the bonds held by the European Central Bank. (I believe that any bonds held by the European Financial Stability Facility will be excluded as well). The Economist notes the matter; also see this Bloomberg story.

How this discrimination actually works is interesting. The writedown is voluntary, and will be effected by an exchange of old bonds for new ones at some time in December. It seems that anyone is free to forego the exchange, and that will include the ECB. Holding on to your old bonds, however, will put you at some risk that the terms of those bonds will be changed down the road, along the lines of squeezing minority shareholders.

Why is the deal is struck this way, to allow the ECB and other public entities to avoid a loss? There is a cost: if the public sector holders also took part in the exchange, then the Greek solvency problem could be solved with a smaller writedown. That is, if the private sector only holds 60% of outstanding Greek debt, then a 50% writedown on that is equivalent to a 30% writedown on 100% of the outstanding debt.

What would happen if the ECB had to write down the value of its Greek debt? Would that be a problem for its balance sheet? Maybe.

Another possible explanation for the discriminatory treatment is that the purchases of Greek debt by the ECB were to help the banks in the first place, and those purchases might have been at close to face value. So letting the ECB avoid the writedown and putting more of it on the banks is just ex post recognition that the banks owned all this debt in the first place.

This situation also creates the potential for some private holders to not do the exchange, essentially casting their lot in with the ECB. How that strategy will play out is anyone's guess.

The second interesting thing is that the voluntary exchange will not, it appears, qualify as a credit event that would trigger credit default swap payments. CDS would normally be triggered if timely interest and/or principal payments are not received, and I guess an exchange does not meet that test. I have often had students question the idea of "voluntary" exchange in situations where one party is under duress. In this case of a voluntary bond exchange, I must admit to thinking that the definition of "voluntary" is sounding pretty Clinton-esque. I imagine there are some European banks who bought CDs to hedge the default risk of their Greek bonds and are pretty unhappy now to see that the insurance will not pay out.

Of course, none of this is written in stone yet...the last installment of bailout money to Greece has been held up by the political turmoil in Greece after Papandreou said he would put the deal to a vote.