Greece's 100 billion-euro shadow over banks

By Gareth Gore

LONDON, May 25 (IFR) - European banks remain saddled with almost 100 billion euros of Greek government debt they can't sell, hedge or ignore, after a number of recent deals to offload the exposure to reduce the impact of a possible default ended in failure, according to bankers involved.

The deals have been thwarted by a lack of willing buyers for the debt -- even at record low prices -- and that exposed lenders have been unable to buy protection because of the high costs, with top bankers advising their clients all they can now do is cross their fingers and hope for the best.

"The vast majority of these banks have just been unable to do anything," said one European banker who has advised dozens of such banks. "Protection is too expensive, and markets for these bonds are illiquid, so many are riding out the problem. Right now, all they can do is shut their eyes and hope."

Greek domestic banks are by far the biggest holders of the country's bonds with some 50 billion euros of exposure, according to a handful of estimates. But another 50 billion is held at banks outside the country, with German banks alone exposed to around 19 billion of the paper, while French banks hold another 15 billion.

"For a lot of banks, their worst nightmare seems to be coming true," said another investment banker who advises financial institutions on the continent. "We now know that the Greek smoke was indeed fire and a lot of people have now found themselves heavily exposed."

It's the denouement of a once-popular carry trade that has fabulously backfired. Tempted by easy profits Greek debt paid slightly higher interest than similarly-rated German paper lenders from across Europe bought up the bonds through most of the last decade to hold as part of their mandatory capital buffers.

Such was the demand that the spread between Greek and German 10-year government bonds fell to about 20bp in 2004 down from more than 150bp five years earlier. That trend has now reversed, with a drop in the price of Greek debt pushing the spread to more than 1,400bp this week.

"Many banks would have looked at these bonds as liquid, zero-risk assets," said Tim Skeet, a financial institutions banker at RBS. "When you're putting together a liquidity buffer you need to look for something that offers a bit of yield, and these bonds did just that. There was a sensible rationale for buying this stuff."

COSTLY HESITATION

Some major European banks -- such as those with investment banking arms used to moving into an out of assets relatively quickly -- managed to reduce their exposure to Greece early on. But others, hampered by indecision, inertia or a conviction that the Greece situation would remedy itself, didn't sell out.

"The big question is the exposure of some of our clients," added the chief financial officer of one of Europe's largest investment banks. "At some point something has to happen."

As prices tumbled -- the 10-year bond now trades at 51 cents on the euro -- and fear grew that a default was inevitable, the window for selling was gone.

Perhaps remarkably, some banks even saw the drop in prices as a chance to increase their exposure to Greek bonds, so as to repo the instruments at full face value at the European Central Bank's open market operations. "One chief financial officer told me I was a complete idiot not to be buying bonds and that was only back in April," said one adviser, who asked not to be identified.

CDS MARKET NO PANACEA

Even the credit default swap market doesn't offer a way out. Indeed, net notional outstanding Greek hedges have decreased over recent months, falling to less than $6 billion now from more than $9 billion toward the end of last year, according to Depository Trust and Clearing Corporation data.

"CDS are beyond the level where you even bother to hedge," said one analyst. "It's easier in a way just to take the hit." The cost of protecting 10 million euros of five-year Greek bonds against default recently rose to 1.48 million amid increased speculation that Athens would default.

The inability of banks to sell or hedge such exposure partly explains why the European Central Bank has been so keen to silence any talk of a restructuring or default. Central bankers will be keenly aware of the potential repercussions on the region's banking system if such an event were to happen.

One potential tactic might be to delay any default or restructuring as long as possible. With every year that passes, exposure to such an event is decreased as bonds mature and are paid off in full. Of the estimated 270 billion of Greek bonds currently in existence, about a third will mature by the end of 2013.

But while that might lessen the blow for the banks, politicians are likely to find such a solution less palatable than a full-blown restructuring. That's because EU and IMF loans will have to fund those redemptions -- essentially a government-sponsored bailing out of private bond holders. Insurance companies, pension funds and central banks hold a further 170 billion of Greek paper.

Indeed, an added complication is the exposure of the ECB, which stepped into the market to buy Greek bonds last year. Under a default or restructuring situation, it would have to be recapitalized. Indeed, advisors say some clients see the ECB's exposure as a reason such an event will be delayed.

"These banks know they are in good company -- the ECB is in the same position and they too are unhedged," said the first banker. "There is the presumption that it doesn't really matter for the Landesbanken, they know they will get rescued. For them, this isn't an immediately pressing issue."

European banking stress tests expected next month will be closely watched for any disclosures over how exposed individual banks are. As political and economic pressures mount for decisive action, such banks will be hoping that the markets -- or more likely the state -- will be ready to mount a rescue.

"We are never going to be in a position where the restructuring of Greek debt doesn't have a market impact, it's just about minimizing that impact," said Henriques. "It's about buying time for the other European sovereigns, and buying time for the European banking system."

(This story is from the International Financing Review -- www.ifre.com -- a Thomson Reuters publication. Additional reporting by Michael Winfield and Christopher Whittall)