Markets Hinge on Greece, a Market Looking for Perspective

Greece Needs Money to Avoid Default, But Complications Arise
Europe's financial issues have all the ability to gravely affect U.S. propositions. We have witnessed in the past, starting just last December, a stable climb in equity values. This climb is certainly coincident with the European Central Bank's (ECB) release of billions in loans to European banks. Not only a form of quantitative easing, but in reality a thawing of frozen European bank liquidity.
Presently, equities are moving sideways or otherwise stalled-as if they hold suspense in whether an economic shoe will drop. Certainly such is the case. For Greece; its debt, the exposure of this debt to world banks, and credit default swap parties, all swing in the balance, only for all to wonder of net losses.
Firstly we have Greece's need to reduce its debt. Aside from simply cutting its fiscal budget, the call is for Greece to reduce its sovereign bond payments. To make the reduction, private bond holders have been identified as targets. Where the taxpayer supported ECB has negotiated an exemption from loss, private bond holders will take a loss. Private bond holders are primarily composed of European banks, tied to international money like Lehman.
Cuts to bonds are 53.3% of face value, as negotiated by the International Institute of Finance, lead negotiator for the private sector. A 53.3% reduction in outstanding bond payments (or redemptions) comes from an effort of Greece to cut its fiscal budget, on the debt side, by 170B euros. Cuts to bond payments are demanded by the Eurozone for Greece to receive its second round of bailout money. Greece needs a second bailout, of real cash, by March 20... to make a 14.5B euro bond payment.
Who Wants to Take Half Off Their Investment
Cutting Greek bonds by 170B euro seems fairly expected and anticipated. Greece's fiscal budgetary cuts, however, are still very slippery and hard to hold. Currently, the goal is to see if the 53.3% cut in bond asset value will be accepted by private bond holders. The agreement due date for private bond investors is March 8.
Greece is hedging its own participation in the bond reductions by saying that if 90% of bond holders don't agree to the cuts, it's not obligated to continue with the plan. Big questions remain in the event bond holder participation is in the 75% to under 90% range. Should such a range develop, Greece says it will consult with the public sector.
Naturally, the glitch is that private bond holders aren't really excited to lose 53.3% off the top of their investment. Add to it the lost interest over the period of the bonds, and some say 70%. For large investors, these issues are why credit default swaps (CDS) are purchased.
A CDS is simply insurance purchased against loss on an investment. Should a bond issuer default (Greece), the CDS pays a negotiated percentage of the purchase value of the asset. CDS platforms get the asset and you as purchaser get the negotiated payment.
A key event that leads to CDS payment is default. Defaults are called credit events. A credit event can occur when one creditor is given payment priority over another creditor....subordination. Another credit event can occur when a majority of creditors take a reduction in payment or terms of payment, involuntarily.
Credit Default Swaps Could Cover the Losses
Looking to lose money, obviously anyone bondholder will get curious about their insurance policy. Curiosity is addressed to the International Swaps and Derivatives Association, which monitors CDS's. Because CDS's are essentially insurance policies, CDS questions are analyzed according to contract law. This means that if certain terms are not addressed in the CDS agreement, they will be addressed by Agency interpretation, rules, statute, or court rulings. In the end, there are no statutes, rules or court decisions. Which leaves agency interpretation as the law.
Euro bond holders asked two questions of the ISDA about their CDS insurance:
1) If creditors (bond holders) take a reduction in obligated payments on a bond versus the ECB not taking a reduction, is that a subordination? That is, where private investors take a cut in principle, but the ECB's principle is the same, is that a subordination.
2) If creditors submit to a bond cut of 53.3%, in numbers sufficient to bind all creditors, (2/3 of bond holders of record based on the Collective Action Clause), does that result in a credit Event (default)?
Maybe Credit Default Swaps Work, Maybe Not
The ISDA answered both questions saying no credit event is implicated at this time. For the ECB question, ISDA officials said documents addressing the 53.3% bond reduction mentioned no subordination. Though in reality it's a subordination of creditors to other creditors, it's not according to the ISDA.
Binding all bondholders through the Collective Action Clause is another issue. The Collective Action Clause is a product of legislation recently passed by Greece having retroactive effect. It requires that once 2/3 of bond holders agree to a measure, such measure can be treated as a collective act, and imposed upon all bond holders. It's akin to collective bargaining, and its associated laws.
Should the Collective Action Clause be enforced by Greece, the bond reductions will not be voluntary at that point. By implication of the ISDA's decision, such enforcement of the clause by Greece will be a credit event triggering CDS payments.
Bottom line: 1) Greece needs a second bailout of 130B euros to make a March 20 payment on bond redemptions of 14.5B euros. 2) Greece needs to cut 170B euros of debt and the Eurozone expects it to come from private bond holders. 3) The International Institute of Finance negotiated at 53.3% reduction on behalf of private bond holders. 4) March 8 is the due date to see if private bond holders will take the voluntary reduction. 5) Should 90% of private bond holders not accept the reduction, Greece will have to make a move against public entities holding their bonds. 6) Should the Collective Action Clause be invoked, or Greece not meet the demand of cutting 170B euros, a credit event is likely and will trigger CDS payments.