Default Greek: Good news?

Anyone who followed the news this morning would have learned of the bondholders’ agreement to accept a write-down of their Greek sovereign debt holdings of 172 billion euros. In financial jargon, bondholders have downgraded, which means they have come to terms with the fact that they will not receive all of their principal when the bond matures.

The figures announced this morning show that the potential amortization of the debt is up to 74%. What this means is that if you have lost (or invested) 100 pounds, you will receive 24 pounds. Good business? Doesn’t sound like that to me!

I can remember a quote given once where it was said that when you owe the bank 1,000 it is your problem, when you owe it 1 million it is a bank problem. Owning Greek government debt has become a bondholder problem, not a Greek government problem.

By “bondholders”, who do we mean? It appears that the main holders of Greek sovereign debt are Greek banks and the main banks of France and Germany. They may be the biggest losers in this, but there are probably many financial institutions, pension funds, and unit trusts that have invested a portion of their equity in these bonds, the effect of which is to see that portion of their stake reduced by as much as 74%.

That from any point of view is a huge loss and prompted me to decide to review the historical yields of Greek sovereign debt over the last few years to try to piece together the story in the context of risk for investors.

In 2008, when the credit crisis struck, sovereign debt was viewed by all credit rating agencies as a risk-free investment. Being risk-free meant that financial institutions could invest in these assets and have no reserves against possible losses on these investments. At the time, Greek 10-year bonds were trading at a yield of just under 5%.

In May 2010, the international financial community was realizing that the Greek government had no control over its finances and had been borrowing, squandering the backing of being part of the euro zone and the creditworthiness of Germany. This, you might think, looks something akin to a wandering teenage drug addict who “borrows” his parents’ credit card …

The first aid package was announced which slows down the Greek government by 110 billion euros. Yields on Greek sovereign debt rose to 12.5%, which for sovereign debt means that the market believes it would default.

The political ramifications in Europe of a possible Greek default and Greece’s possible exit from the euro led political leaders to establish the European Stability Mechanism which would come into action in mid-2013. It had probably already been accepted in political circles that Greece would default, but the ESM may prevent some of the other countries in Europe from following the same path. Politicians were looking for a way to continue the great European experiment instead of solving Europe’s economic problems.

In July 2011, a second rescue package was announced for an additional € 109 billion; this was purely to buy time to ensure that when Greece finally defaulted, it could be done in a more orderly manner. The 10-year gilt rate at this time was over 17%.

We now know that Greek debt has been restructured, with potential losses of up to 74% for bondholders. That, for the average person, would be considered a default. However, in the world of finance we have to wait for the International Swaps and Derivatives Association (ISDA) to meet to allow them to determine whether it is a default or not.

You may wonder why this is important. The reason is that many financial institutions buy Credit Default Swaps (CDS), which is like an insurance policy on whether Greece would default on its debt. If ISDA determines that it is a technical default, it will trigger € 3.2 billion of credit default swap payments (claims, in insurance parlance).

Personally, that would not help fill the gulf created by the loss of value of these assets. This insurance payment only compensates bondholders worth less than 2% of the lost principal.

Following the history of Greece over the last few months has led me to think about risk in a different way, and about the way the market tries to price risk. Before default, Greek 10-year bonds had a 23.1% yield. When Sovereign Debt is this high, it would suggest that default is more likely. One could argue: Does a 23% income offset a 74% capital loss? The answer is obviously no; and we can make this statement with the benefit of hindsight.

I think the deeper question is what does this say about professional money managers; Why were they happy to accept this risk? Is it because they were not really risking their own money, but the money of investors and shareholders? It also suggests that the market doesn’t calculate risk very effectively either, and that seems to be the case, especially since the same thing happened with subprime loans in 2008.

I think people have to start thinking about risk in a more fundamental way and not accept what financial advisers and professionals tell them, as the evidence suggests that they themselves are not very good at it.

What this teaches the enlightened investor is that you should not allow someone else to take control of your investments, but rather manage them yourself and decide what is the most appropriate compensation to accept.

There are many investments available that will give investors a good risk / return ratio. An investment that I am currently analyzing allows you to put only 20% of your capital at risk at any one time, but with the opportunity to generate an average annual return of 20 to 30%; sometimes more.

This, for many professional money managers, would be considered high risk; but then these are the same money managers who decided to invest in Greek sovereign debt …

I think we are now in a period where the old investment rules and protocols no longer apply. We have to start approaching investing in a new way and not accept the principles and advice that the so-called experts have been giving us over the years.

Developing your own investment expertise and personal financial plan is, I believe, the best way to go. In my opinion, investing has just given a paradigm shift. It would be a significant advantage for you to approach future investments with this in mind.

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