Greek defect: good news?

Anyone who has followed this morning’s news will have heard of the bondholders’ agreement to accept a reduction in their Greek sovereign debt holdings of €172bn. In financial parlance, bondholders have pulled their hair out, meaning they have accepted the fact that they will not receive all of their principal back at maturity of the bond.

The figures announced this morning show that the potential write-off of the debt is up to 74%. What this means is that if you have borrowed (or invested) £100, you will receive £24. Good business? Doesn’t ring a bell to me!

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

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

That, by any measure, is a huge loss and led me to decide to review historical Greek sovereign debt yields over the past few years to try to piece the story together in the context of risk to investors.

In 2008, when the credit crisis hit, sovereign debt was considered a risk-free investment by all credit rating agencies. 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%.

By May 2010, the international financial community was realizing that the Greek government had no control over its finances and had been borrowing profligately due to being part of the euro zone and the creditworthiness of Germany. You might think this looks like a wandering junkie teen who “borrows” his parent’s credit card…

The first aid package that lent the Greek government 110 billion euros was announced. Greek sovereign bond yields rose to 12.5%, which for sovereign bonds means the market thinks it would default.

The political ramifications in Europe of a possible Greek default and Greece’s possible exit from the euro prompted political leaders to set up the European Stability Mechanism that would come into action in mid-2013. It was probably already accepted in political circles that Greece would join in 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 a further €109 billion; this was simply to buy time to ensure that when Greece did eventually default, it could do so in a more orderly manner. The 10-year gilt rate at the time was over 17%.

We now know that Greek debt has been restructured, with potential losses of up to 74% for bondholders. That, to the average person would be considered a breach. 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 be wondering 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 the ISDA determines that it is a technical default, it will generate €3.2 billion in credit default swap payments (claims, in insurance jargon).

Personally, that would not help fill the chasm created by the loss in value of these assets. This insurance payment only indemnifies bondholders for less than 2% of the capital they have lost.

Following the story of Greece over the past few months has led me to think about risk in a different way, and the way the market tries to price risk. Before the default, Greek 10-year bonds were yielding 23.1%. When sovereign debt is this high, it would suggest that default is most likely. You could argue: Is a 23% income offset by 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 actually 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 need to start thinking about risk in a more fundamental way and not accept what financial advisors and professionals tell them, as the evidence suggests they are not very good at it themselves.

What this teaches the enlightened investor is not to let someone else take control of your investments, but to 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 trade-off. An investment I am currently reviewing allows you to put only 20% of your capital at risk at any given time, but with the opportunity to generate an average annual return of 20-30%; sometimes more.

This, to 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 feel that we are now in a period where the previous 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.

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