It's not pretty but euro debt grand plan is inching toward the finish line

10/26/2011 1:15 pm EST


Jim Jubak

Founder and Editor,

Now that the German Bundestag has signed off on the idea of some kind of leverage scheme (details, of course, still to come) to increase the fire power of the $600 billion European Financial Stability Facility, the big remaining obstacles to getting a grand plan from the European summit that begins tonight both center on banks/

First, there’s the question of how much of a “voluntary” write off EuroZone leaders can force on banks. Here good old-fashioned horse-trading seems likely to yield a solution.

In order to take Greek debt down below 120% of GDP (that EuroZone leaders have decided is a maximum if the Greek economy is to ever recover) banks have to take a much bigger hit to the value of their Greek holdings than the 21% they agreed to back in July.

Banks initially proposed a 40% write down—with massive collateral guarantees.

EuroZone negotiators countered with a 60% write down with no collateral.

Right now it looks like a compromise may be merging at 50% with a cash sweetener to get the banks to sign up. Banks would receive 15 euros in cash and 35 euros in 30-year, 6% coupon bonds for every 100 euros of Greek government debt they now own.

The banks certainly don’t want to trigger a Greek default because no one is sure how the financial markets would behave under those conditions. For example, would sellers of credit default swap derivatives, which insure against a bond default, be able to pay what they owe?

On the other hand, banks do have an important bargaining chip: Unless the write down is voluntary, it would create a market event that would trigger those credit default swaps—and that would send financial markets into uncharted territory. Make the write down too onerous, the banks have warned, and we’ll take our chances with a default. (Unlike an insurance policy with a clear trigger—death, for example—credit default swaps don’t get triggered until the International Swaps and Derivatives Association rules there’s been a credit event. The consensus now is that the association won’t call a credit event as long as it sees the write down as voluntary.)

Second, there’s the question of how much capital European banks will be required to raise to increase confidence in the EuroZone financial system. Here it looks like the most likely resolution is a punt.

According to a draft circulating ahead of tonight’s meeting, EuroZone leaders seem to be moving toward a “solution” that says that European governments are ready to back their banks with guarantees but that doesn’t give any hard figure for the amount of additional capital banks will have to raise. And banks will get nine months to see if they can raise the capital they need, however much that turns out to be.

That draft also talks about “broad agreement” to increase the capital ratio at banks to 9% but doesn’t give any details on how that ratio will be calculated or what accounting gimmicks might be available to banks.

If you think this is a complete punt on a contentious issue where there really is no agreement between France and Germany, you’re completely right. This “solution” would leave it to the European Banking Authority to set capital targets. We know how well that worked out with the stress tests of European banks.

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