Europe Wrestles With Solutions for Greek Debt Crisis

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Youth demonstrate in front of the Greek Parliament on Tuesday.

When it comes to Greek bonds, Europe is trying to have its cake and eat it, too.
Germany and other strong euro-zone countries, trying to fashion a second bailout for Greece, want the country's private-sector creditors to bear some of the burden in exchange for granting new taxpayer money to Athens. The European Central Bank, however, backed by France, doesn't want to do anything that would cast Greece into default or trigger losses for banks that hold its government bonds. 
The impasse deepened with a letter released Tuesday from German Finance Minister Wolfgang Schäuble to ECB President Jean-Claude Trichet and other euro-zone finance ministers. Reiterating Germany's approach, it rejected the milder option and called for a "quantified and substantial contribution" from private creditors.
At root is a consequence that is difficult to escape. Anything that meets Mr. Schäuble's demands and substantially hits Greece's creditors—and thus substantially reduces the amount of money Germany and others must put in—will also very likely be seen by credit-rating agencies as a default on Greek debt. It also will have at least some impact on banks' finances. Nearly 70% of the exposure to Greek government debt outside Greece is concentrated in French and German banks. 
"It is hard to envision a set of circumstances where they can provide genuine debt relief—private-sector debt relief—to Greece and for that not to be viewed essentially as a default event," said David Riley, head of sovereign ratings at Fitch Ratings.
German Chancellor Angela Merkel, on a visit to Washington, discussed the issue with President Barack Obama. The two agreed that the European debt crisis must be brought under control, with Mr. Obama predicting "disastrous" results if there is an "uncontrolled spiral and default" in Europe. "We think that America's economic growth depends on a sensible resolution of this issue," he said.
Ms. Merkel agreed, and said the problem was Europe's to solve. "The stability of the euro zone is...an important factor of stability for the whole of the global economy. So we do see clearly our European responsibility. And we're shouldering that responsibility together with the IMF," she said.
Greece received a bailout of €110 billion ($160 billion) from euro-zone countries and the International Monetary Fund in May 2010. But because Greece hasn't been able to access markets to refinance its debt and fund its deficits, as the aid planners had hoped, that wasn't enough, and the country needs more aid.  

The markets' pessimism toward Greece reflects a more fundamental factor: Even the tougher German plan doesn't reduce Greece's staggering debt. It only delays repayment.
"The overall issue isn't addressed," said Fabian Zuleeg of the European Policy Centre, a think tank in Brussels. "The overall debt burden far exceeds the capacity of Greece to generate the kind of revenues that are needed to ever meet it."
European leaders aren't ready to cut Greek debt by forcing holders to accept less than the full amount due. Mr. Schäuble acknowledged that Greece will need more money as soon as next year. Making creditors, particularly banks, feel some pain alongside taxpayers—often dubbed "burden sharing"—is seen as a way to smooth political consent for a new Greek bailout in countries like Germany and Finland. How that should be done is unresolved.
There are, broadly, two competing visions. One, advanced in Mr. Schäuble's letter and by Germany at a closed-door meeting of senior European finance officials last week, calls for a voluntary bond exchange. Creditors holding soon-to-mature Greek securities would be offered new bonds on similar terms that are payable several years hence. 
f enough creditors take up the offer, it reduces for a time the need for new funds to cover about €30 billion in long-term Greek debt coming due next year, starting in March.
The second vision, acceptable to the European Central Bank, calls for no bond exchange and no inducements. Instead, private creditors would be cashed out in full at maturity—and then encouraged to re-lend some of that money to Greece on the same terms.
Analysts say that approach likely wouldn't result in a debt default, and wouldn't cause losses for banks. The downside: It won't do much to reduce the amount of new money that euro-zone countries will have to lend. Without blunt inducements, very few private-sector lenders would voluntarily commit their money to Greece.
The debt-exchange plan would garner more volunteers but have stiffer consequences—for ratings, for European lenders, for the ECB and for bank write-downs.
Mr. Riley of Fitch said his firm would likely consider an exchange offer for new bonds at similar terms—against the background of Greece's financing woes and tied to new euro-zone rescue money—as a default. Standard & Poor's delivered a similar verdict last week.
A default would be embarrassing for European leaders, who have pledged to avoid such a thing, and would put the ECB, which has accepted a lot of Greek bonds as collateral for its lending, in a tight spot. The IMF on Tuesday also expressed concern; its top official in Athens, Bob Traa, said European authorities had to be cautious about any kind of debt restructuring.
"There is no such thing as being a little bit pregnant," said Mr. Traa. "Once you unleash a restructuring scenario, this is not very helpful."
Depending on how the exchange was structured, it would likely cause at least some write-downs for European banks. German banks were holding about $22.7 billion of Greek government debt as of Dec. 31, the most recent data available, according to data from the Bank for International Settlements, while their French counterparts were sitting on nearly $15 billion. (The figures are adjusted to account for certain hedges the banks have.)
Some of those holders, such as Germany's Nord LB Group, are bracing for pain. The bank, which reported holding €273 million of Greek sovereign debt as of March 31, said last week that it "believes it is likely that there will be a haircut on Greece's national debt and has therefore taken precautionary steps." A Nord LB spokesman said the lender it absorbed a €44 million write-down on the value of its Greek government debt during the first quarter.
Dimitris Drakopoulos, a fixed-income strategist at Nomura International PLC, argues that European policy makers are unlikely to settle on a restructuring that will trigger substantial impairments at banks holding government debt. "The impact will be pretty contained on this one," Mr. Drakopoulos said.
The more draconian approach some German officials are pushing, however, "will cause a lot of capital impairments," Mr. Drakopoulos said. But he said he doubts such losses pose a systemic risk to the European banking sector, because the total amount of Greek government debt held by the Continent's lenders is a relatively small portion of their overall capital base.
Whether banks must take a write-down is a complicated technical question. Greek loans recorded on the so-called banking book, which are expected to be held until they mature, may avoid impairment if their repayments are simply delayed, without any change to the interest rate paid.
An exception to this, notes Peter Elwin of J.P. Morgan in a recent report, are bonds that were once classified as available-for-sale but later moved to the banking book. Those, he says, would have to show "material impairments." Mr. Elwin also says bonds still held as available-for-sale would show impairment.
But the treatments depend on how banks and auditors interpret the rules. The rules are "very tricky," said Mr. Drakopoulos, whose report last month outlining the potential accounting fallout was widely circulated among European investors. "It's a mess, a total mess."
 
—Marcus Walker and Bernd Radowitz in Berlin, Laura Stevens in Frankfurt and Alkman Granitsas in Athens contributed to this article.