Paying the locusts – what the PSI means for Greek bond investors

Early this morning it appears that at last Greece and the European authorities are at the final stages of  launching a bond swap with the private sector – known as the private sector involvement (PSI) procedure – which will aim to reduce Greece’s debt-to-GDP ratio to 120.5 percent by 2020 (currently 160 percent). The deal will receive blanket press coverage, we are going to focus on the PSI element.

The PSI ensures that the private sector will suffer a real loss while the public sector (national European central banks and the ECB) will not suffer any losses. Central banks have this privileged position as they are prepared to provide further finance to Greece (akin to a rescue rights issue diluting existing shareholders). Of course, it is not in the politicians’ interests for the central banks to bear any losses as a result of lending to Greece and of course it is the politicians that set the legal and regulatory framework. Not only can politicians change the goal posts, they can change the ball you are playing with. Politicians, and the authorities, are exercising their imbedded power.

This deal will cause the private sector to suffer a disproportionate level of losses both in absolute and relative terms to the public sector. This punishes the private sector investor in Greek debt relative to the private speculator who was short Greek debt. We noted in an earlier blog that governments perceived owners of their debt to be good investors, whilst investors holding short positions in government debt are evil speculators.

The problem with the PSI procedure is that it does not reward these economic agents accordingly. This PSI precedent means that in the future, should a government debt crisis occur, private investors will be less willing to support troubled government debt, and speculators will be rewarded for being short. Obviously this will impact the sustainability of government finances at precisely the time they would be seeking to generate confidence in their ability to service their debt obligations.

What does this PSI look like in pounds, shillings, and euro cents? Those investors that are short Greek debt will make money, the legal power of the state means the authorities suffer no damage, while the private sector will suffer losses. The locusts will feed well, the authorities will not eat less, and the private investor will waste away.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Discuss Article

  1. Guy Foster says:

    Whilst undoubtedly the PSI does involve rewarding sellers at the expense of investors the opportunity cost is harder to fathom. Somebody must bear the cost: Should it be Europe’s taxpayers at large or should it be the bond bond investors who incorrectly calculated the reward they were receiving for lending to Greece.

    OK, so the argument may be simplistic considering the pressure banks are under to hold domestic government debt but the eurozone is one of the few markets where they have a genuine choice about which liquid bonds they populate their balance sheet with.

    The bond swap now places a great burden from an “ambitious” deal on to the public sector.
    The public sector is wearing a reduction in interest on bilateral loans.
    Dramatic impact to European banks may ultimately fall on the public sector so taxpayers aren’t that relaxed about that element either!

    Losses have been suffered by both sectors. It’s not perfect but I don’t feel the private sector has got a bum deal here.

    Posted on: 21/02/12 | 11:17 am
  2. The Slog says:

    I sense a bit of Draghi over-confidence here.
    Maybe the ratings agencies will give him a nasty shock…

    Posted on: 21/02/12 | 1:39 pm
  3. cfwade says:

    Just like after every other sovereign crises!  Seems to me that investors ALWAYS have short memories!   

    Posted on: 21/02/12 | 7:14 pm
  4. Central Bank News says:

    I agree that it sets a dangerous precedent, but bond investors are big boys – they should know what they’re getting themselves into. When you buy bonds or lend money, return of capital is critical, and these people just misjudged the risks. Anyway, it’s probably better than outright repudiation.

    I think one of the larger issues is how we get from crisis measures to longer-term growth and sustainability initiatives, because all this austerity and firewalls etc is just meant to keep the whole thing patched up enough to stop it from completely falling apart, and with 30-year bonds, a little bit of long term thinking may be well placed! 

    Posted on: 22/02/12 | 7:22 am
  5. Yohay says:

    I certainly agree that this is unfair. I believe that the loss will eventually be 100% and that Greece will declare bankruptcy. This agreement seems like another move to pass the time until the next LTRO. 

    Posted on: 22/02/12 | 8:30 am
  6. oldmoore says:

    Let’s get real.
    Greece is bust (and so are several other states) and there is a cat’s chance in hell that the Greeks will stick to/achieve the 2020 target. Then what?

    This manic idea that going for growth will ‘sort the problem’ has to be ditched once and for all. All such a policy will do is shift the cost onto the next generation/s. Why should our kids pay for the reckless activities of incompetent politicians and bankers over the past 50 years?

    Time to start over and do it properly next time.     

    Posted on: 22/02/12 | 11:18 am
  7. longodds says:

    In the final analysis ,a foreign-government debt is an unenforceable contract. If payment is withheld,the bondholder has no direct remedy. Even if specific revenues or assets are pledged as security, he is practically helpless in the event that these pledges are broken. It follows that while a foreign government obligation is,in theory, a claim against the entire resources of the nation,the extent to which these resources are actually drawn upon to meet the external debt burden is found to depend in good part on political expediency.” ……….Security Analysis ( published 1934)

    I am a holder of M&G fixed interest funds but in this case have little or no sympathy for private investors as any risk assessment must have considered this outcome or total default.

    Both sides ie those who “supported” (the longs) and those who “speculated” ( the shorts) invested for gain having assessed the risks.

    Some you win ,some you lose.

    Posted on: 22/02/12 | 5:12 pm
  8. TIPSTER says:

    There are wider implications to the ECB’s structural subordination of all private investors. The ECB is in danger of ridiculing the European bond market into a farce where the rules of risk and return are jaded beyond recognition. 

    The bond market is beginning to represent something more akin to a CDO market. A CDO market where the seniority of the tranche you hold is not dependent on the construct of the instrument but is rather discriminated by the character of the holders. The less close you are to the Eurozone political elite, the more subordinated you are.

    Senior tranche holders of European bonds – the ECB
    Mez holders – the Eurozone banks (subordinated to central bank but simultaneously supported – e.g. via massive LTRO etc)
    Equity holders – private investors.

    Welcome to the new Eurozone mutated CDO market. 

    Posted on: 02/03/12 | 7:50 pm
  9. TIPSTER says:
    Posted on: 02/03/12 | 7:54 pm

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