On the eve of what is expected to be the beginning of the end of the European sovereign debt crisis, many questions remain. Not the least of which is will the much anticipated ‘comprehensive plan’ be enough to halt the now eighteen month-old crisis?
The plan is purportedly being designed to ring-fence Greece’s debt, recapitalized the continent’s banks, and put an end to the credit contagion that began in Greece and has since spread to Portugal, Ireland, Italy and Spain. However, with less than twenty-four hours before the announcement is expected to be made, many details have yet to be worked out.
Here’s what we do know. It is expected that there will be three parts to the plan: reworking Greek debt, refortifying European banks in order to withstand losses on sovereign debt, and the leveraging the EFSF in order to drive yields down and fight contagion.
On the first count, there is little doubt that Greece’s existing bondholders – mainly European banks – will be asked to once again take a ‘voluntary’ haircut on the value of their bonds. Remember, the bond exchange must be voluntary in order to avoid a ‘credit event,’ in which Credit Default Swaps would be triggered. However, the degree of that haircut and the details of how the writedown will be implemented are more than a little tricky.
Recall that at the July 21 EU Summit, it was decided that Greek bondholders would be asked to exchange their existing bonds for new issuances which would have longer durations and lower yields. In doing the present-value math, this worked out to the bonds being worth 21% less. But with Greece’s economy continuing to falter – meaning that there is less revenue coming into the government’s coffers – the Greek debt-to-GDP ratio has continued to rise.
With officials faced with little alternative to an outright default in Greece, EU leaders will now ask the bondholders for even larger writedowns. And while the exact number has not been revealed, most reports suggest we will see a 50% to 60% cut in the value of the current bonds. Needless to say, the banks and holders of the bonds are not happy about the arrangement.
The primary problem bankers have with the plan is that any reduction in the value of sovereign debt – debt that was promised to never waver from par when the EU was formed – results in a corresponding reduction of the amount of capital on the banks’ balance sheets. Cutting to the chase, this means that European banks will need to raise additional capital because of the Greek debt exchange.
On the subject of bank capital, another part of the grand plan is to increase the amount of ‘tier 1 capital’ required. This too will mean that the banks will need to go out and find additional capital. The estimates for the total new capital required by the banks ranges from €60 billion to more than €200 billion. The key question is how much new capital the ‘comprehensive plan’ will require banks to raise. The next question, of course, is where will the banks find this money?
Finally, there is the issue of how best to increase the firepower of the Eurozone’s bailout fund, the EFSF. Although many proposals have been weighed over the past week, the odds now seem to favor a combination of the ‘insurance plan’ which would insure new bond buyers against the first losses of 10% to 20% on sovereign debt, and the ‘public/private special purpose fund’ which would see the EFSF partner up with private investors to boost the buying power of the fund. Of course, the details here have not been revealed and many feel that European leaders may not “go big” enough here.
The whole point to the EFSF is to create a bazooka fund to fight contagion. The idea is that if rates are rising too high, the fund can enter into the bond market to support new debt auctions with the end goal being to keep interest rates down. The only problem is that if the EFSF is not robust enough, bond vigilantes will likely continue to stay away and rates will continue to rise. And THIS area is the key to the future of the crisis. If rates can first, not rise, and then, eventually begin to fall, the program will have done its job.
The last area of concern is politics. The issue getting the most attention currently is the fact that Germany’s lower house of parliament has been given the right to vote on the comprehensive solution before it is made public. Thus, the plan must get approval from Germany before it can even be presented. Look for this vote earlier in the day on Wednesday.
For those of you keeping score at home, the EU Summit is scheduled to begin after 7:00 pm local time in Brussels. So, keep your eyes peeled and your ears to the ground for all the gory details.
Editor's Note: As always, feel free to weigh in with your thoughts on the plan due to be released Wednesday afternoon in the comments section below.
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