Back in October, at one of the many Euro summits, the European government leaders uhm, persuaded the Institute of International Finance, representing large banks and insurers holding Greek debt, to accept a 50 percent “voluntary” haircut on their holdings. ISDA’s credit event determination committee fell into line, and ruled that since it was “voluntary”, the writedown did not constitute a credit event that would trigger CDS payouts.
Germany was the main country pushing for these haircuts, euphemistically termed “Private Sector Involvement” (PSI). There have been stories in the last week that Germany is pushing for even bigger haircuts–on the order of 75 percent. Not to be outdone, a member of the council of the European Central Bank–which has always been twitchy about PSI–has mooted a counterproposal: 0 percent.
Glad to see that the bargaining range is narrowing! Pretty soon Germany will be demanding that the bondholders pay the Greeks and the bondholders will be demanding that the Greeks pay the banks double what they owe.
Germany’s insistence on PSI is strange in many ways. The conventional rationale is that it is necessary to punish–and hence deter–morally hazardous risk taking. But given that the whole pretense of the Eurozone was that all government debts were created equal, and given that Basel treated Greek debt as riskless as Germany’s, any moral hazard is ultimately traceable to European governments and regulators. How dare those banks do what they were told to?
Moreover, the Greek PSI had to walk a thin line. The story was that only Greek debt would get a haircut: this was necessary to prevent disastrous runs on Portuguese, Italian, and Spanish debt. But it is hard to give a coherent rationale for that: investing in Greek debt was morally hazardous, but investing in Portuguese debt wasn’t? Really.
No political promise is credible–especially in Europe right now, and especially given that the logical basis of the promise is dubious at best. Pushing for a bigger haircut on Greek debt is bad news for Portuguese, Italian, and Spanish debt because bigger haircuts on Greek debt raises the expected haircut on the debt of these other countries. It raises both the size of the haircut, conditional on one occurring, and the probability that haircut will actually be applied to these other countries (i.e., that the promise will be broken): if Germany is so insistent on haircuts for Greece today, why won’t they be just as insistent for Portugal tomorrow, despite their fine words to the contrary. (This is the essence of the ECB councilor’s argument.)
Finally, the big problem with a Greek default has always been that banks and insurers would suffer huge losses that would jeopardize their solvency. That is, a Greek default that led to big writedowns would impose big losses on German, French, Dutch, etc., banks. These losses could be big enough to require some taxpayer bailouts. But a big “voluntary” haircut would do the same thing. Thus, Germany’s insistence on a big PSI always seemed like financial S&M.
One last thing about this divergence of views. It makes it clear that despite all of the stirring pronouncements, nothing is settled in Europe. Nothing. Everything is still up for negotiation. And the parties are moving apart on key issues, not closer. Today’s surge in Italian and Spanish yields and subsequent ECB intervention is in part a manifestation of the realization that that we are not even at the middle of the beginning.