Reduction of Greek debt

As outlined in our July 2011 e-bulletin, a second financial package for Greece worth €109 billion was agreed after it became clear that the country would not be able to return to the financial markets in 2012, as originally envisaged. Despite the release of the sixth tranche of the IMF’s bailout in October, Greece raised concern over a potential default, with a debt mounting to 160% of its gross domestic product (GDP).

At the 26 and 27 October 2011 summit, Eurozone Member States obtained agreement from the Institute of International Finance purporting to represent private sector investors to take a voluntary loss of 50% on the face value of their Greek bonds (excluding bonds held as collateral by the ECB from Eurozone banks, as well as bonds held by the IMF, and the ECB on its own account). On the basis that the 50% “haircut” is “voluntary”, the representatives of the Eurozone Member States assert that the haircut should not be considered a Credit Event for the purposes of credit default swaps.

The above measure, together with a heightened programme of austerity, seeks to reduce Greece’s debt level to 120% of GDP by 2020.

EFSF measures

In our July 2011 e-bulletin we outlined that Eurozone Member States were seeking to strengthen the EFSF by increasing its effective lending capacity to €440 billion and through other measures. In October 2011, these measures were formally implemented following ratification of the necessary amendments to the EFSF Framework Agreement by 17 Member States.

The €440 billion is reduced by existing EFSF commitments to Greece, Portugal and Ireland to some €330 billion. This €330 billion would be reduced further to the extent the EFSF contributes funds to any Eurozone bank recapitalisations (see below). More importantly the figure would also be reduced if Spain, Italy or Belgium needed to “step-out” from their guarantees. The EFSF would therefore not be in a position to guarantee raising funds to bailout Italy or Spain if needed. In view of this fact, two additional means for assisting troubled Eurozone Member States were agreed at the 26 and 27 October 2011 summit. They are:

  • Guarantee bond losses – The EFSF will offer 20% first loss credit risk insurance to private investors when buying new debt issued by Member States, thus reducing their funding costs. This credit risk insurance faces a credibility problem in debt markets in light of the fact that, in the same package, the Eurozone Member States assert that the 50% “haircut” for private holders of Greek bonds is “voluntary” and should not be considered a Credit Event for the purposes of credit default swaps.
  • Create an additional facility for securing funds – One of the major limitations of the EFSF is that it is ultimately backed by Member States which benefit from its support. In order to address this systemic weakness, the EFSF will seek to create a “special purpose vehicle” which, like the EFSF, would provide funding support to Eurozone Member States. However, unlike the EFSF, it would be backed by investors other than Eurozone Member States (such as China or investment funds, for example).  

The details of the two additional mechanisms are still to be determined – at the moment it is profoundly unclear what the nature of the first loss risk insurance will be. However, if implemented and accepted by credit markets, the net effect of these measures, which could be used concurrently, would be an extension of the capacity to “bailout” Member States to over €1 trillion. The risk involved in granting 20% first loss credit risk insurance on €1 trillion of bonds is obviously much greater than the risk of buying €200 billion of the same bonds (as AIG could attest from its experience of massive losses on credit risk insurance); this fact has led to falls in the price of AAA-rated bonds previously issued by the EFSF despite being guaranteed by six AAA-rated countries. This risk ultimately rests on the guarantors of the EFSF and this concentration of risk upon them could lead to a deterioration in their own perceived creditworthiness and ratings.

The Eurogroup will seek to finalise their terms and conditions in November in the form of guidelines and in line with draft terms and conditions prepared by the EFSF.  

Political developments in Greece

Despite agreement having been reached on the above issues at the summit of 26 and 27 October 2011, the measures agreed may be held back or even be subject to amendment due to recent political developments in Greece.

On 31 October 2011 the Greek Prime Minister announced that a referendum would be held, possibly in December 2011, to allow the Greek people to either approve or reject the new bailout terms. The move has been widely seen as a surprise and meetings are taking place at the G20 summit this week to discuss its implications. It is not clear at this stage whether a referendum will take place. The French and German leaders announced that the issue needs to be resolved as soon as possible and that, pending resolution of the issue, the next tranche of money to Greece would not be provided.

The political situation in Greece continues to be tense and a vote of confidence has been called in Parliament. This will take place later this week. Developments need to be monitored on an ongoing basis.

EU economic governance and other changes

As discussed in our March 2011 e-bulletin, a series of measures to improve economic governance in the EU was proposed by the Commission in September 2010. These measures received their final approval in October 2011 and are expected to enter into force by January 2012.

At the 26 and 27 October 2011 summit, further measures going beyond those contained in the recently adopted package were also agreed. These include permitting the Commission and Council to examine national draft budgets for Eurozone Member States in the excessive deficit procedure. Leaders also adopted ten specific measures to improve the governance of the Eurozone. Among other points, they determined that (1) Eurozone summits will take place regularly and no less than twice a year, and (2) the President of the Eurogroup, the President of the Euro Summit and the President of the Commission will meet at least on a monthly basis, in order to ensure that more coherent messages are broadcast on behalf of the EU.  

At the summit, Eurozone leaders also issued a mandate to the President of the European Council to identify possible steps to “strengthen the economic union”, including the possibility of limited Treaty changes. At this stage, the precise nature of the measures which are envisioned is not clear. However, an interim report is to be presented in December 2011 and a report on how to implement the agreed measures finalised in March 2012.

The increased supervision measures (in particular the measure enabling the Commission and Council to examine national draft budgets for Eurozone Member States in the excessive deficit procedure) can be seen as a further erosion of fiscal sovereignty of the Eurozone countries, particularly those on the receiving end of the examinations, which has already provoked a popular backlash in Greece.  

Further integration of the Eurozone countries, with the prospect that they may create an inner core and vote as a block, poses political questions for the 10 EU countries outside the Eurozone which may try to resist erosion of their own power to influence the EU agenda.

Recapitalisation of the banking system

At the 26 and 27 October 2011 summit, Eurozone leaders also agreed to require major banks – which are also the main holders of Greek debt – to achieve 9% core capital levels by 30 June 2012. It is estimated that this will require about €106 billion in additional capital. This figure seems to have been calculated without marking to market Eurozone sovereign bonds (Italian ten year bonds are trading at around 90 cents on the Euro). As a last resort, banks will be permitted to rely on EFSF funding.

It should be noted that the Eurozone authorities’ previous estimates for bank capital requirements in stress tests have not been considered credible so much as farcical. All the Irish banks passed the first stress test and subsequently required massive recapitalisations from the Irish state. Indeed, Dexia passed the second round of bank stress tests in July 2011 with the gold medal as the best capitalised bank in the whole Eurozone only to be nationalised in October.

German law developments

In our July 2011 e-bulletin, we reported that hearings had taken place in three court cases in Germany which challenged the legality of German financial assistance provided to Greece and under the EFSF. On 7 September 2011, Germany’s Federal Constitutional Court dismissed the cases, finding that the laws authorising Germany’s bailout contributions were consistent with the German Constitution1. While the challenged acts were upheld, in relation to EFSF, the Court expressly noted that the Federal Government is, in principle, always obliged to obtain prior approval by the Budget Committee of the German Parliament before giving guarantees.

Following the 7 September decision of the Constitutional Court, a special sub-committee of the Budget Committee was set up in the German Parliament for the purpose of approving EFSF guarantees in cases where special confidentiality or urgency is required (pursuant to a request by the Federal Government). This move was quickly challenged by two Members of Parliament on constitutional grounds. Pursuant to the challenge, on 28 October 2011, the German Constitutional Court issued an injunction prohibiting any EFSF authorisations by the sub-committee.

According to the Court’s decision, the setting-up of a special committee possibly infringes on the participation rights of the German Parliament. Therefore, the circumstances under which the special committee may decide instead of the Parliament as a whole must be defined precisely. This requires a thorough definition of the terms “confidentiality” and “urgency”, as these are the prerequisites for the special committee to step in.

The injunction only has effect until the Constitutional Court reaches a full decision. Until then, the Federal Government is obliged to obtain the prior approval by the German Parliament before agreeing to any EFSF measures.