Investor Views of Euro Zone Brighten

09.02.2012 14:43

WSJ: The European Central Bank's Liquidity Injection Seems to Have Bought Time for Weak Countries to Get Better
The hopes for a successful conclusion to the latest Greek debt talks take financial markets closer to having the sword of Damocles removed from over investors' heads.

There is much to a Greek restructuring deal yet to be accomplished, but analysts say it increasingly looks likely that Greece will avoid a disaster scenario where it doesn't have the money to pay its debts and is forced to leave the euro zone.

But that doesn't mean the worries for Europe are over.

That is even the case for Greece, where it is unclear how many holders of its government bonds will accept losses under a "voluntary" debt reduction plan—a program that would enable the country to avoid the humiliation of being declared in default. As a result, many analysts believe Greece will have to force its bondholders to take the deal and end up technically defaulting on its debts under the arcane rules of the bond market.

Such an event would likely trigger payouts on credit-default swaps designed to protect debt holders, analysts say. That could spark fears of collateral damage to banks on the hook to make good on the payouts.

And, if, as expected, the European Central Bank receives a better deal than private-sector bondholders on its Greek positions, the difference in treatment will raise concerns for bond investors in other debt-strapped countries. "This could have some implications for Italian, Spanish, Irish and Portuguese markets where we see the ECB every week increasing its share of these countries' debt," says Ioannis Sokos, interest-rate strategist at BNP Paribas in London.

For the time being, analysts and investors see some reason for near-term optimismeven if it is tempered by long-term caution. "If you sort [Greece] out in a neat way, even if it involves CDS…it can lead to a short-term relief rally," said BNP's Mr. Sokos. "But while it's a short-term positive, it doesn't change the overall dynamic of the euro-zone debt crisis in Italy, Spain or Ireland."

The progress, albeit halting, has boosted sentiment in European markets already on the mend thanks to the ECB's efforts to ease fears of a fresh financial crisis by providing banks with cheap, long-term loans.

This change of fortunes has been clear in short-term bond markets for Italy and Spain.where prices have gotten a lift from banks investing money borrowed from the ECB. The yield on Italian two-year debt has fallen to 3% from a high of 7.8% in November.

Getting to a resolution on Greece requires a host of moving parts falling into place over the next several weeks. The country faces a tight deadline of March 20, when it will have to pay out investors holding a €14.4-billion ($19.1 billion) bond.

To slice its debt load in half, Greece is asking bondholders to accept losses of roughly 70% of face value on the bonds. At the same time, the country is negotiating a €130 billion cash infusion from the European Union and International Monetary Fund in exchange for massive cuts to government spending. These arrangements must be agreed to by governments across Europe as well as Greece's Parliament.

Reaching agreement on the framework isn't the end of the process, notes Peter Schaffrik, head of European rates strategy at RBC Capital Markets in London. "The next bridge that has to be crossed is to put it to the guys who actually hold the bonds," he says.

That is where analysts think the markets could face a hiccup. For Greece to reach a goal of reducing its debt-to-gross domestic product ratio to 120% will require 100% participation of private bondholders, says Cagdas Aksu, European rates strategist at Barclays Capital in London. Given the big losses they are being asked to take, "with a purely voluntary structure it's going to be very difficult" to meet the debt targets, he says.

With that in mind, Greece is expected to pass legislation in the next week that would impose "collective action clauses" on its bonds, which under certain circumstances allow it to impose the restructuring on all bondholders. While that would help Greece reach its goals, it could also force the payouts on CDS. That is "probably quite likely," says Mr. Aksu.

That brings back memories of the contagion stemming from the collapse of Lehman Brothers and could spark worries about already strained European banks having to make payouts.

As of Sept. 30, 2011, some 29 banks from nine European countries had bought or sold such protection. Most banks appear to have bought and sold roughly equivalent amounts of Greek CDS protection. That means, at least in theory, that the contracts should cancel each other out, largely eliminating any net exposure. But with less than €4 billion in CDS estimated to be outstanding, "the contagion risk is not necessarily going to be substantial," says Mr. Aksu.

—David Enrich contributed to this article.