Analysis of Greece's Commercial Bank Debt Exchange and PSI. Source: Author's calculations
Analysis of Greece's Commercial Bank Debt Exchange and PSI. Source: Author's calculations

Postmortems of last month’s European Union summit meeting have now turned to why the Greek debt rescue failed to restore investor confidence in the country’s finances. Many reasons are advanced: the failure to communicate clearly; the complexity of the plan; the inability to coordinate with the International Monetary Fund.

There’s a simpler explanation: The debt-reduction deal failed because it didn’t reduce the debt.

Instead, Greece gets a reduction in interest rates and a lengthening of maturities on its loan from the European Financial Stability Facility. But that loan also has been supersized, and the country has to pay back the additional official debt.

The government in Athens also gets a 20 billion-euro ($28.7 billion) bond-buyback program funded by the EFSF. But again, the country will have to repay the money used to finance the buybacks, plus 3.5 percent interest.

All this is modestly helpful because the Greek government has to pay more than 3.5 percent to fund itself on the market. The European taxpayer has at least done something to reduce Greece’s crushing debt load.

But the “contribution” the banks are required to make is a different story. We are told that the financial institutions holding Greek government bonds will have to write off some of the debt. We are told by the bankers’ lobby, the Institute of International Finance, that the reduction in the net present value of their bonds is 21 percent.

No Haircut

This number has nothing to do with the amount by which Greece’s debt will be reduced. What some analysts have mistakenly been calling a “haircut” is simply the discount relative to par value at which the new bond options will trade in the secondary market, assuming a Greek sovereign yield of 9 percent.

To correctly measure the service and reduction of debt, these must be compared with the 5.02 percent average interest rate that Greece currently pays on its bonds. When this is taken into account, even the much-touted 20 percent principal reduction on the discount bond option is much lower on a present-value basis, because the coupon rates are higher on the new bond than on the old bonds.

The 30-year discount-bond option, which would swap new debt for existing obligations at 80 percent of face value, for example, has a coupon starting at 6 percent, rising to 6.5 percent in year five and 6.8 percent in years 10 through 30. Greece realizes only 22 basis points of interest savings in the first five years and will have negative annual interest savings for the next 25 years.

Small Discount

Even after taking into account that Greece pays back only 80 percent of the original principal in year 30, the present value of debt falls only 1.78 percent under this option. This is a far cry from the 20 percent discount applauded by many analysts. And, to entice bondholder participation, Greece must borrow an additional 26.10 percent of the original face value to purchase the zero-coupon bonds’ principal collateral for the discount security.

In the attached table we use Institute of International Finance assumptions to show how the deal affects Greece’s finances.

The deal helps to extend Greece’s bond maturities. Yet, once it is concluded, the present value of the debt tendered falls by only 6.78 percent, or 9.15 billion euros, even if one accepts the surely over-optimistic assumption that 90 percent of bondholders will participate. This is an expensive proposition given that Greece must purchase 42 billion euros of zero-coupon bonds to collateralize the principal payments.

Raw Deal

Obviously, this is a raw deal for Greece. It also is a bad deal for the euro area, whose leaders again failed to contain the crisis. And it is a bad deal for the European taxpayer, who will shoulder all the sacrifices, while the banks make none.

How could things have gone so wrong?

One answer is that none of the participants involved -- the EU, the French and German leaders, the Institute of International Finance -- knew what they were doing. A 21 percent reduction in net present value sounds impressive, but it has no bearing on the amount by which the exchange will reduce Greece’s debt. No one appreciated that 30-year zero-coupon bonds are much more expensive in today’s low-interest-rate environment than they were 20 years ago, in the days of the Brady Plan. No one understood that the debt exchange effectively increased Greece’s annual interest payments once the cost on the debt to purchase the principal collateral was taken into account.

Hit to Lenders

It may be hard to believe that the experts could be so ill-informed. The only other explanation is that the sole purpose of the exercise was to mislead. The banks can claim that they are taking a hit when in reality they can exchange bonds currently trading at hefty discounts for debt whose market value will be half in the form of AAA collateral. German parliamentarians can be told that the private sector was forced to “participate” in the Greek rescue when in fact, even after rescheduling maturities, those lenders will still receive a large fraction of their original interest payments.

This deal should be thrown out. In its place, the EU should create a real debt exchange with real haircuts for the banks and a significant reduction in Greece’s debt stock.

The good news is that there will be an opportunity to change course. Greece’s debt is still unsustainable, and it will have to be restructured again.

(Barry Eichengreen is professor of economics and political science at the University of California, Berkeley. Peter Allen and Gary Evans are economists who worked on the Brady Plan restructurings of emerging-market debt in the 1990s and served as financial advisers to the government of Poland during its debt restructuring. The opinions expressed are their own.)

To contact the writers of this article: Barry Eichengreen at eichengr@econ.berkeley.edu; Peter Allen at peterallen@vom.com; Gary Evans at gevans33@msn.com.

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net.