Debt Calculations Weigh on Restructuring Decisions

For the first time this week, a taboo was lifted. European officials can now use the "R" word— restructuring—in sentences that don't also have "not" in them.
Restructuring Greece's government debt—changing the conditions attached to its bonds to lessen the burden—is now something that can be talked about in polite company. (With the proviso that it will be the nicest, gentlest, most-investor-friendly restructuring possible.)
Jean-Claude Juncker, Luxembourg's prime minister, who heads up the meetings of the euro-zone finance ministers, described this as a "soft restructuring" or a "reprofiling." By this, he means finding a way to postpone at least some of the debt repayments—amounting to €66 billion ($94 billion)—Greece must make in 2012 and 2013. If that doesn't happen, Greece's borrowings from other European Union governments and the International Monetary Fund will merely be recycled to pay out private holders of maturing bonds.
The mission is complicated. Euro-zone governments have promised that holders of Greek and other government bonds won't be forced into concessions before mid-2013. They are also trying to avoid triggering payouts of credit default swaps, a type of insurance against bond defaults that are also used by speculators seeking to benefit from falls in bond prices.
Christine Lagarde, the French finance minister and Europe's likely candidate to be the next head of the IMF, told reporters that any rescheduling that would create a "credit event" was off the table. "We are not debating that," Ms. Lagarde said.
A credit event leads to a payout of CDSs, and can be triggered by a variety of occurrences resulting from a deterioration in a borrower's creditworthiness. It could be a debt moratorium in which debt servicing is suspended, a switch of currency or certain types of debt restructuring.
(Whether such occurrences count as a "credit event" is determined by a panel of dealers and buyers from the International Swaps and Derivatives Association, or ISDA. The amount of the insurance payout is derived by the discount from face value established at an auction of the affected bonds that then takes place.)
Why are Ms. Lagarde and others worried about triggering CDS payouts? There is, first of all, a stigma that would attach to Greece and by extension to its partners in the euro zone. Second, there is concern that it would reward speculators against euro-zone bond markets, but most significantly, officials say they are worried that those profits could spur further speculative attacks against other governments in the euro zone, such as Spain. Avoiding a credit event might also discredit the officially despised CDS market.
So, how would you avoid one? The answer is to make restructuring voluntary. David Geen, general counsel for ISDA in London, says: "Technically speaking, if a restructuring is not in a form that binds all holders [of the debt], it won't be regarded as a credit event." That suggests an offer to bondholders to extend their debt maturities or an offer to repay bondholders with new bonds would not trigger payouts.
Job done? Well, no. The key question is whether any voluntary "reprofiling" offer would succeed in postponing repayments of enough maturing debt to make a difference to Greece. Many analysts doubt it—particularly if investors view an enforced restructuring as likely after 2013.
But at least not triggering the CDS payouts would avoid stigma? Maybe not. As Mr. Green points out: "A default and a credit event are not necessarily the same thing." In fact, a "reprofiling" would be viewed as a default by credit-rating agencies—even if there is no "haircut" or loss imposed on bondholders.
Marko Mrsnik, sovereign rating analyst at Standard & Poor's, says: "Under our criteria, if bondholders are not repaid in full and on time, this would be considered a default.…That would include a voluntary debt exchange, or debt extension, even if there is no haircut in the principal.…We would consider it detrimental to the creditors."
OK, stigma. But at least you wouldn't reward speculators? Here, it's worth examining how much they would stand to gain.
According to the Depository Trust and Clearing Corp., the repository for just about all information on CDSs, the gross notional amount of Greek debt insured totals $77.9 billion. Most of that, however, is owed by banks to themselves. The amount of net debt insured that would trigger a payout from one party to another is $5.4 billion.
Actual payouts would be a fraction of that because bondholders wouldn't lose all their money. Some beneficiaries would be genuine investors, such as Greek banks. What's more, some CDS holders wouldn't exercise their rights, because they might expect a deeper haircut (and a bigger payout) later.
Policy makers are left with a contagion worry in the event of CDS payouts—and that might be a concern anyway if the rating agencies declare default. What's certain is that, compared with $500 billion of Greek government debt, any CDS payouts would be really small potatoes.