Beware of Greeks Bearing New AAA-Rated Gifts

 Jonathan Weil

Structured finance helped turn Greece into a disaster zone. It seems only natural that Greece would look to structured finance once again to buy time.

The spark that accelerated Greece’s debt crisis early last year was the revelation that Greek authorities had used some fancy derivative trades a decade ago to mask the true size of the country’s debt. Today it’s Greece’s creditors who are dreaming up the wacky financial engineering, in hopes that the European Union can keep pretending the nation isn’t bankrupt.

The term structured finance is simple to define, in spite of the images of complexity it often evokes. It is the art of making a transaction seem like something it isn’t, usually to achieve some desired financial-reporting or tax result.

For example, when a publicly owned company needs cash but doesn’t want to show more debt on its balance sheet, there’s a good chance it can borrow the money and design the deal to look like equity, even though in substance it’s a loan. Similarly, Greece would like to find a way to pay its creditors less money than it owes, while creating the appearance, in form, that it is repaying them in full.

So here’s the proposal some French banks devised for a “voluntary” rollover of Greek government debt. (“Voluntary,” for these limited purposes, seems to be synonymous with “coerced.”)

Under one option, creditors holding Greek bonds that mature by June 2014 would invest at least 70 percent of their redemption proceeds in new Greek bonds. The rest, as much as 30 percent, would be repaid in cash. The new bonds’ annual interest rate would be 5.5 percent to 8 percent, depending on how well Greece’s economy performs in a given year.

The Greek government would take 30 percent of the bondholders’ investments and lend the money to a special-purpose vehicle that would buy 30-year, AAA-rated zero-coupon government bonds. The special-purpose vehicle would guarantee the principal on the new bonds in the event Greece can’t make good on them. In essence, investors who own uncollateralized Greek bonds would become subordinate to bondholders who own the new collateralized version.

Under a second option, bondholders would invest at least 90 percent of their redemption proceeds in five-year Greek bonds paying 5.5 percent annual interest. There would be no guarantee.

Both arrangements would constitute a default by any objective measure. Getting new bonds from a basket case of a country in lieu of cash isn’t what Greece’s creditors signed up for originally. And who is still going to be AAA in a few years, anyway? Even the U.S.’s AAA rating looks shaky.

Europe’s leaders have been begging the credit-rating companies to bless the rollover proposal, so far to no avail. Standard & Poor’s has said it probably would treat the plan as a default, although the designation might only be temporary.

Default Ratings

There would still be other options. The European Central Bank, itself a big holder of Greek government bonds, has long said it would reject bonds with default ratings as collateral for loans. It could always change that policy, so it could keep lending to Greece’s banks and prevent them from collapsing.

Another player in this drama is the International Swaps & Derivatives Association. This is the group of large banks that determines when a default has occurred, for purposes of whether to pay purchasers of credit-default swaps who bought insurance on Greece’s bonds. The association’s general counsel in London, David Geen, has said it probably wouldn’t treat a rollover as a default. The association can decide however its members want, of course. No doubt their collective self-interest will prevail.

Everybody knows the rules; there are no rules. Here Europe’s political leaders have been trying desperately to pin blame for the sovereign debt crisis on credit raters such as S&P and Moody’s Investors Service. In May, French President Nicolas Sarkozy and German Chancellor Angela Merkel sent the European Union’s president a letter asking for an investigation of “the possible role of the rating agencies in amplifying crises,” as well as new proposals “to increase competition on the credit rating market.”

The same politicians then backed the French banks’ rollover plan, which depends on the ratings companies to determine the collateral eligible for Greece’s bailout bonds. Not that Sarkozy and his ilk care about logical consistencies. Their goal all along has been to preserve the legal fiction of Greece’s solvency, even if everyone knows it’s a lie.

Like all con games, structured finance works best when the people doing it believe in the con. In this instance, they clearly never did. Better to admit Greece can’t pay its debts and then deal with the problem, rather than delay the reckoning.

(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)