Greek default: good news?
Anyone who followed the news this morning will have heard of the bondholders’ agreement to accept a reduction in their Greek sovereign debt holdings of €172bn. In financial jargon, bondholders have pulled their hair out, which means they’ve accepted the fact that they won’t get all their principal back when the bond matures.
The figures announced this morning show that the potential debt recovery is up to 74%. What this means is that if you have lent (or invested) £100, you will receive £24. Good business? It doesn’t sound like me!
I can remember a quote once given where it was said that when you owe the bank 1,000 it’s your problem, when you owe them 1 million it’s the bank’s problem. Owning Greek government debt has become the bondholders’ problem, not the Greek government’s problem.
By “bonistas”, who are we referring to? It appears that the main holders of Greek sovereign debt are the Greek banks and the main banks in France and Germany. They may be the main losers from this, but there are probably many financial institutions, pension funds and investment funds that have invested a part of their capital in these bonds, the effect of which is to see that part of their holding reduced by up to 74%.
That, by any measure, is a huge loss, and it led me to decide to review the historical returns on Greek sovereign debt over the past few years to try to put the story together in the context of risk for investors.
In 2008, when the credit crisis hit, Sovereign Debt was considered a risk-free investment by all credit rating agencies. Being risk free meant that financial institutions could invest in these assets and have no reserves against potential losses on these investments. At the time, Greek 10-year bonds were trading at a yield of just under 5%.
By May 2010, the international financial community was realizing that the Greek government had no control over its finances and had been borrowing lavishly due to being part of the euro zone and Germany’s creditworthiness. You might think this looks like a wandering drug addicted teenager “borrowing” his parents’ credit card…
The first aid package that lent the Greek government 110 billion euros was announced. Yields on Greek sovereign debt rose to 12.5%, which for sovereign debt means the market believes it would default.
The political ramifications in Europe of a possible Greek default and the possible exit of Greece from the euro led political leaders to establish the European Stability Mechanism which would come into action in mid-2013. It was probably already accepted in political circles that Greece would enter in default. , but the ESM may prevent some of the other countries in Europe from following the same path. Politicians were looking for a way to continue the great European experiment instead of solving Europe’s economic problems.
A second rescue package for another €109 billion was announced in July 2011; this was simply to buy time to ensure that when Greece did eventually default, it could do so in a more orderly fashion. The 10-year gilt rate at the time was over 17%.
We now know that Greek debt has been restructured, with potential losses of up to 74% for bondholders. That, to the average person would be considered a breach. However, in the world of finance, we have to wait for the International Swaps and Derivatives Association (ISDA) to meet to allow them to determine if it is a default or not.
You may wonder why this is important. The reason is that many financial institutions buy Credit Default Swaps (CDS), which is like an insurance policy on whether Greece would default on its debt. If the ISDA determines it to be a technical default, it will generate €3.2bn in credit default swap payments (claims, in insurance jargon).
Personally, that wouldn’t help fill the chasm created by the loss in value of these assets. This insurance payment only indemnifies bondholders worth less than 2% of the principal they have lost.
Following the Greek story over the past few months has led me to think about risk in a different way, and the way the market tries to price risk. Before the default, Greek 10-year bonds had a yield of 23.1%. When sovereign debt is that high, it would suggest that default is more likely. You might argue: Is a 23% income worth a 74% principal loss? The answer is obviously no; and we can make this statement with the benefit of hindsight.
I think the deeper question is what does this say about professional money managers; Why were they happy to accept this risk? Is it because they were not actually risking their own money, but the money of investors and shareholders? It also suggests that the market doesn’t calculate risk very effectively either, and that seems to be the case, especially since the same thing happened with subprime loans in 2008.
I think people need to start thinking about risk in a more fundamental way and not accept what financial advisors and professionals tell them, as the evidence suggests that they themselves are not very good at it.
What this teaches the enlightened investor is not to let someone else take control of your investments, but to manage your investments yourself and decide what is the most appropriate compensation to accept.
There are many investments available that will give investors a good risk/return tradeoff. An investment I’m currently looking at allows you to put only 20% of your capital at risk at any given time, but with the opportunity to generate an average annual return of 20-30%; sometimes more.
This, to many professional money managers, would be considered high risk; but then, these are the same money managers who decided to invest in Greek sovereign debt…
I feel that we are now in a period where the old investment rules and protocols no longer apply. We have to start approaching investing in a new way and not accept the principles and advice that so-called experts have been giving us over the years.
I believe that developing your own investment experience and personal financial plan is the best way to go. In my opinion, investing has just given a paradigm shift. It would be to your significant advantage to approach future investments with this in mind.
