Greek Default for Dummies: Questions on Creditors Answered

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Greece has to come up with about 4 billion euros ($4.5 billion) by the end of May for debt payments. Then there’s the 1.5 billion-euro monthly tab for salaries and pensions.

As Prime Minister Alexis Tsipras’s government in Athens haggles over the details of its reforms and leans on its banks to keep buying Treasury bills, the question inevitably looms: what happens if the cash runs out?

Not all creditors are created equal. For example, the International Monetary Fund is more equal than others, first in the repayment queue.

Here are some of the questions you may have, starting right at the very beginning:

Q: What is a default?

A: Investopedia.com defines default as “the failure to promptly pay interest or principal when due. Default occurs when a debtor is unable to meet the legal obligation of debt repayment.”

Q: How much debt does Greece have?

A: The Greek government has about 313 billion euros of debt outstanding, most due after 2021. Add companies and banks and the total is closer to half a trillion.

Given that Greek banks are likely to refinance most of the maturing Treasury bills without protest -- with pension funds and local governments making up the shortfall -- the important near-term deadlines are May 6 and May 12, when the IMF is due to receive almost 1 billion euros in total.

The real crunch comes midyear, when almost 7 billion euros of bonds held by the European Central Bank mature in July and August.

Q: What happens if the IMF isn’t paid?

A: A missed payment date starts the clock ticking.

Two weeks after the initial due date and a cable from Washington urging immediate payment, the fund sends another cable stressing the “seriousness of the failure to meet obligations” and again urges prompt settlement. Two weeks after that, the managing director informs the Executive Board that an obligation is overdue.

For Greece, that’s when the serious consequences kick in. These are known as cross-default and cross-acceleration.

Q: What are cross-default and cross-acceleration?

A: Failure to pay the IMF would entitle some of Greece’s other creditors, including the European bailout fund, to declare a default. They would then have the option to demand immediate repayment of all their loans, a process known as acceleration.

Other lenders could then follow suit. While calling a default preserves creditors’ claims, acceleration -- the bit that hurts -- isn’t automatic. Each creditor decides on its own.

To varying degrees the debt is linked in a web of cross-default and cross-acceleration clauses that make it safe to assume that one default and acceleration would trigger demands for repayment on most, if not all, of the rest.

Greek debt features a variety of structures, with different terms and conditions and governed principally by Greek and English law. The obligations include bonds whose holders voted not to take part in a 2012 restructuring; notes issued in that restructuring; bonds held by the ECB; a series of loans from Europe’s bailout fund, including one used to sweeten the restructuring pill; notes issued last year; the 2010 Greek Loan Facility; and the IMF loans.

Q: What do the ratings companies say?

A: All three of the major rating firms consider official creditors such as the IMF as a different class to holders of tradable securities like bonds. Failure to service official loans wouldn’t necessarily cause a downgrade to a “default” category. Rather, that may come into play with a failure to pay those private bondholders.

Q: What about credit-default swaps?

A: The determinations committee of the International Swaps & Derivatives Association, the trade association that administers derivative contracts, must first receive a request for a ruling on what should happen to CDS contracts. It then makes a binding decision on whether a “credit event” has occurred, which may trigger the contracts.

There are now 622 contracts open, covering a net $592 million, according to Depository Trust & Clearing Corp., which runs a data warehouse.

In 2012, the contracts paid out after the country’s debt restructuring, which was the biggest ever.

Q: What would default do to Greek banks?

A: That depends on the attitude of the ECB and on the default itself.

With lenders losing deposits, only a drip-feed of Emergency Liquidity Assistance supplied by the Bank of Greece against deteriorating collateral is keeping them afloat.

While ECB President Mario Draghi indicated last week that ELA would continue as long as the lenders are solvent and have adequate collateral, bank solvency, especially of lenders using ELA, is very much a judgement call, says Gabriel Sterne, head of global macro research at Oxford Economics in London.

Failure to repay the ECB in July and August would probably result in the suspension of ELA, according to Chris Attfield, a strategist at HSBC Holdings Plc in London.

Any interruption in ELA would almost certainly trigger a fully fledged bank run, forcing the imposition of capital controls.

If the banks themselves are victims of the default after, say, a failed Treasury bill auction, then their insolvency would probably ensue and ELA would end.

Q: How would capital controls work?

A: In Greece, not so well.

Unlike the island of Cyprus, which this year lifted controls implemented two years ago, Greece has porous borders and mobile citizens. While controls would stop capital flight via the banks, there is still the cash residents have withdrawn.

Q: We hear a lot about Target2. What’s that?

A: It’s the payment system established by the ECB that allows euros created by each national central bank to flow freely in the 19-nation currency bloc. In 2013, an average 1.9 trillion euros of transactions per day were processed, according to the ECB website.

It also keeps track of who owes what to whom and at the end of March, Greece was in the hole to its partners for 96 billion euros, or more than 40 percent of economic output, according to the Bank of Greece. Courtesy of Target2, money created in Athens is circulating in Paris and Berlin after paying for Peugeot cars and Bayer AG’s aspirin.

As long as Greece remains officially in the euro zone -- even if a parallel currency circulates -- the nation’s Target2 liabilities are a political concern, not a financial one.

However, loss of access to Target2 “would crystallize the liability,” said John Whittaker, a fellow of Lancaster University Management School who has published on European payment systems. “The other central banks would then have losses in proportion to their share of the ECB’s capital.”

Q: What about Greek companies?

A: A sovereign default would probably be followed by corporate defaults.

Greek assets overseas would be fair game for creditors, though there aren’t many to grab. The former Coca-Cola Hellenic Bottling Co., the world’s second-largest Coca-Cola bottler, for example, is now called Coca-Cola HBC AG and is headquartered in Switzerland.

Also, capital controls would probably be accompanied by other measures, such as orders for companies to repatriate euros held overseas and prohibitions on dividend payments. The government might also introduce IOUs to substitute the missing euros -- in 2010 it slashed the price it would pay drug suppliers and then paid them with bonds.

Q: Could Greece default and remain in the euro?

A: Exiting the euro would only be possible if Greece left the European Union, according to Yannis Manuelides at Allen & Overy.

“The euro is an integral part of the union and it’s meant to be a one-way street,” he said. “There is no way to expel a member and to allow or force an exit would be very bad for the EU. They will do everything they can to avoid it.”

That may not be enough: According to Benedict James, a banking partner at Linklaters, capital controls would be “a staging post to an exit.” James agrees that the only way for Greece to leave the euro would be to exit the EU altogether.

In sum, Greece leaving the euro is likely to be messy, lengthy and painful for all concerned, with the Greeks suffering more than their partners and the lawyers profiting.

The real deadline is in June, when national parliaments start to head off for the summer break, said Zsolt Darvas, a fellow at the Bruegel think tank in Brussels who reckons that Greece will be able to scrape by for now.

For more, read this QuickTake: Greece's Fiscal Odyssey

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