To quote Yogi Berra, “It’s déjà vu all over again!” In 2008 we witnessed Hank Paulson, the Secretary of Treasury, practically single-handedly take down the US and world economy when Lehman Brothers was allowed to fail. Ironically, the government had earlier rescued Bear Stearns (a company half Lehman’s size) saying that it was too big to fail. The hedge funds had bought and sold approximately $3 trillion worth of credit default swaps on Lehman’s $600 billion in debt. When Lehman fell so did the banking system. Three years later, we are looking at a very similar scenario across the Atlantic.
Like Lehman, the Greek government has issued more debt than it can possibly repay, which explains why you can buy its government bonds at pennies on the dollar. Lehman’s bonds became similarly underpriced as the scope of its financial problems became more and more public. Today’s secondary markets are pricing Greek 10-year issues at numbers that give buyers a jaw-dropping 35% yearly coupon return. By comparison, similar Treasury securities issued by the U.S. government (which are NOT expected to default) are yielding less than 2%. Germany recently issued bonds at rates even lower.
The discounts have the certainty of default priced into them, and, indeed, the Bloomberg news organization reports that the Greek government has been quietly asking its creditors to accept a 60% reduction in interest payments – which would still keep rates around 14% as opposed to the 35% level discussed above. Meanwhile, the German and French governments have persuaded European banks to exchange their Greek bonds for new securities with longer maturities and lower coupon rates. Those German and French banks have already had to write down losses on their Greek debts.
The effort to put the Greek debt crisis safely behind us has recently hit a snag, under circumstances that might interest the Occupy Wall Street crowd and students of the 2008 financial meltdown. According to the New York Times, a small group of hedge funds have been aggressively buying up Greek debt at pennies on the dollar, and now are refusing to negotiate any kind of a haircut. They’re betting that the European governments will eventually have to pay them the full face value of the bonds they bought at huge discounts, giving them big windfall profits at a time when everybody else is accepting losses for the sake of long-term Euro stability.
It may work. If Greece is forced to break off negotiations, formally default and unilaterally impose the 60% haircut, that default legally becomes a so-called “credit event.” A credit event would trigger the payment provisions of untold numbers of derivative contracts, which are basically private insurance policies called credit default swaps. The issuers of those contracts – chiefly those same European banks – would suddenly have to pay face value for the Greek bonds that everybody else is buying at a discount. But only if there is a credit event. When Lehman Brothers failed, it triggered a credit event on its bonds and this credit event is what caused AIG, the multinational insurance corporation, to fail. When the dust settled on that event, the US government (i.e. you and I as taxpayers) had to bail out AIG to prevent further failures to the tune of $182 billion. Currently the government is still owed about $46 billion of which $20 billion is a loan and the remainder is shares that the government hopes to sell to the public.
Just as in the Lehman Brothers case where few outside the US Treasury and Federal Reserve knew the extent of the disaster with Lehman’s collateralized default credits, nobody outside the European Central Bank (ECB) knows exactly how many of these derivatives are held by European lending institutions, but it is clear from the nature of the negotiations that all parties are carefully avoiding this trigger event. At least the Europeans have learned something from our mistake. The hedge funds, by demanding either full payment or a credit event, seem to have figured out a way to hold the entire European banking system hostage to their demands for profits.
The story offers a rare view inside the negotiating rooms where the European sovereign debt crisis is being managed, and suggests that responsible parties are, behind the scenes, working to resolve the crisis without a lot of the fanfare you see in breathless headlines. As the bank negotiations move forward, the “crisis” might not be as dire as the headlines make it out to be. There is even a chance that the hedge funds’ stand could backfire. A similar situation occurred during the General Motors (GM) bankruptcy. In that case, several hedge funds bought GM debt at pennies on the dollar and then demanded a greater share of the government proceeds for the bankruptcy. In those negotiations, the Obama administration insisted that the union pension plan be treated better than secured creditors in the bankruptcy filing or the government would not lend any funds and would allow GM to fail. Most of the hedge funds that bought either made a small profit or lost funds rather than the killing they anticipated.
The ECB is now inserting what are called “collective actions clauses” in their agreements with banks, which would let the lenders impose the concessions they had to make on all bondholders if a majority of holders agree to it. The hedge funds would either have to acquire a majority of Greek debt which would mean the hedge funds would take on much greater risk or lose their leverage – and most of their hoped-for profit. The results are not in yet, but there appear to be more options than when Lehman Brothers fell. Hopefully this means that in 2012 we will avoid a similar banking crisis to that of 2008. But then again, after Greece there is Italy, Spain and Portugal, so who knows?
Greek bond rates: http://www.bloomberg.com/quote/GGGB10YR:IND/chart
Proposed haircut on Greek debt: http://blogs.wsj.com/eurocrisis/2012/01/09/2012-kicks-off-in-a-bad-way-for-euro/
Hedge fund blackmail: http://www.businessweek.com/news/2012-01-11/hedge-funds-trying-to-profit-from-greece-as-banks-face-losses.html
