Pari Passu and Bouillabaisse

I have always thought that “pari passu” and bouillabaisse a couple of the coolest things to say, but with the latest plan by the ECB to exchange their Greek bonds for new bonds only they would hold it is worth taking a closer look at “pari passu”.

This is not meant to be in any way legal advice, but as a credit market practitioner these are my thoughts about some potential problems with what the ECB and Greece are doing, and are worth digging into deeper with your lawyers, especially if you are motivated to slow the process down.

There have been some stories stating that the deal is already done.  That may be true, but so far Bloomberg has not updated notional amounts outstanding on existing bonds, so the deal may be done and they haven’t told the right people yet to get the data updated, or the deal is “done” as in agreed in principal but not actually done in a real world way.

Pari Passu

The bulk of Hellenic Republic debt is issued under Greek Law.  The documentation is flimsy and one-sided.  Here is a little section from the offering circular for the March 20^th, 2012 bonds.

Status:	Direct, unconditional, unsubordinated and unsecured obligations of the Republic.
Negative Pledge:	None.
Cross Default:	None.
Purchase:	The Republic may at any time purchase or otherwise acquire Bonds in the open market or otherwise.

Not a whole lot to rely on as a bond holder.  The bonds documented under English Law are a lot more interesting.  I am working from the offering circular for the 5.2% bonds due 2034 (funny how in 2004 no one thought 5.2% coupon for a 30 year bond was a bad deal or unsustainable).

2. STATUS OF THE BONDS AND NEGATIVE PLEDGE

The Bonds constitute direct, general, unconditional, unsubordinated and, subject to this Condition, unsecured obligations of the Republic. The Bonds rank pari passu with all other unsecured and unsubordinated obligations of the Republic outstanding on 30 April 2004 or issued thereafter without any preference granted by the Republic to one above the other by reason of priority of date of issue, currency of payment, or otherwise. The due and punctual payment of the Bonds and the performance of the obligations of the Republic with respect thereto is backed by the full faith and credit of the Republic.

So long as any Bond remains outstanding, the Republic shall not create or permit to subsist any mortgage, pledge, lien or charge upon any of its present or future revenues, properties or assets to secure any External Indebtedness, unless the Bonds shall also be secured by such mortgage, pledge, lien or charge equally and rateably with such External Indebtedness or by such other security as may be approved by an Extraordinary Resolution of the Bondholders (as described in Condition 10).

Until now, the pari passu language has largely been ignored.  While pari passu may be fun to say, I’m not sure it is particularly well defined in the legal sense and I am seeing some evidence that it has been interpreted dramatically differently by various courts.  The direct translation is “on equal footing” and Black’s defines it as “proportionally; at an equal pace; without preference”.

Do the actions of the Hellenic Republic and the ECB breach the pari passu condition?  The “terms” of the bonds the ECB is getting will be “identical” to the old bonds except they will be explicitly exempted from certain rule changes that may be made (collective action for example).  The intent is clearly to create a “superior” class of debt.  While the ECB isn’t getting collateral or breaking the negative pledge argument, these bonds no longer seem to me to be “pari passu with all other unsecured …”  The “without preference” clause of the Black’s definition seems the area to target, but again, how courts have determined it, will play a big role.

It is obvious that the new bonds held by the ECB are (or soon will be) superior to the old bonds, but is it in a way that breaches the “pari passu” covenant?  There are a few factors that make it easier to pursue the case.

Since the clause would be breached if any bond was “elevated” it doesn’t matter whether the ECB holds any English law bonds.  If the ECB held Greek law bonds and these English law bonds were deemed to no longer be pari passu with those new bonds, that breach would be sufficient to trigger this covenant.  So the fact that it doesn’t rely on the ECB holding any English bonds is a benefit since it makes it difficult for the ECB to work its way around this issue since they can’t just treat their English law bond holdings separately.

The other key reason this may be worth pursuing is that generally English law favors creditors.  Not only does English law generally give strong protection to creditors, but since England has not been a part of the “solution” in the way France and Germany have, their courts don’t have a bias to support their politicians over the law.  So you would get to litigate the case in a court system that tends to favor creditors and does not have a strong reason to support the decision at the expense of the law (unlike a Greek, or even French or German court).

So what does it all mean?  Now we move to the “Event of Default” section.

7. EVENTS OF DEFAULT

If any of the following events (each an “Event of Default”) occurs:

(a) the Republic defaults in any payment of interest in respect of any of the Bonds or Coupons and such default is not cured by payment thereof within 30 days from the due date for such payment; or

(b) the Republic is in default in the performance of any other covenant, condition or provision set out in the Bonds and continues to be in default for 30 days after written notice thereof shall have been given to the Republic by the holder of any Bond; or

(c) in respect of any other External Indebtedness in an amount equal to or exceeding U.S.$25,000,000 (or its equivalent), (i) such indebtedness is accelerated so that it becomes due and payable prior to the stated maturity thereof as a result of a default thereunder and such acceleration has not been rescinded or annulled or (ii) any payment obligation under such indebtedness is not paid as and when due and the applicable grace period, if any, has lapsed and such non-payment has not been cured; or

(d) a general moratorium is declared by the Republic or the Bank of Greece in respect of its External Indebtedness or the Republic or the Bank of Greece announces its inability to pay its External Indebtedness as it matures; or

(e) any government order, decree or enactment shall be made whereby the Republic is prevented from observing and performing in full its obligations contained in the Bonds

So part (b) would be the relevant section.  The pari passu covenant/condition would have been breached.  There is a cure period, but since they would have to reverse the decision not just on the English law bonds, but also the Greek law bonds, there is no easy workaround.  There are various procedures that bondholders have to follow, but the end would be acceleration of the payments.  That acceleration would likely derail the bailout plans, or just cost the taxpayers of the EU a lot more money.  Greek law bonds don’t have this right, so it is only the smaller (but still large) amount of English law bonds outstanding that can play this game.  You do run into the issue of having to collect from Greece in the end, which has been a problem all along with fighting Greece – even if you win a judgment, it is hard to enforce.  Any asset with cross default language would be triggered and CDS would almost certainly get triggered, unless the Troika paid off all the English law bonds in full.

While we are in the “Events of Default” section, (d) and (e) are worth a quick glance.  I think they have been careful to avoid doing anything that would trigger this language (or they have just been lucky), but as the crisis and negotiations intensify, either of these seem to have a real possibility of being triggered.

Even the Greek law bonds have some similar protection (must have been included by accident) in their Event of Default section

(d)        any government order, decree or enactment shall be made whereby the Republic is prevented from observing and performing in full its obligations contained in the Bonds,

It is probably hard to trigger under those sorts of statements, but it will be interesting to watch the language that comes out in the “retroactive collective action” clauses.

Tender

There may also be some opportunities to fight the action based on the “tender” clause.  This will be specific to English law bonds and can be avoided just by not including English law bonds in the ECB’s deal (whether they have English law bonds or whether the deal is already “done” is still anybody’s guess).

(2) Purchases

The Republic may at any time purchase or otherwise acquire Bonds in the open market or otherwise. Bonds purchased or otherwise acquired by the Republic may be held or resold or, at the discretion of the Republic, surrendered to the Agent for cancellation (together with (in the case of definitive Bonds) any unmatured Coupons attached thereto or purchased therewith). If purchases are made by tender, tenders must be made available to all holders of Bonds alike.

So Greece can buy bonds in the open market.  They can then cancel bonds purchased that way or otherwise.  Okay, but can Greece do a deal to buy (or exchange) only the bonds held by the ECB and cancel them?  There is no way that is an open market purchase.  This clause specifically states that if purchases are made by tender, the tenders must be made available to ALL holders.  Is the exchange with the ECB actually a tender offer?  I think at best this is unclear.  There is no way it can be viewed as an open market purchase (even though the ECB originally acquired them that way), and there is the “otherwise acquired by” language that seems like a loophole.  But what is the tender language meant to pick up?  Are there times when a tender offer is mandatory?  Can they really just say this is something else?  Possibly, but what is the intention of this?  Aren’t tender offer rules designed specifically to ensure that certain holders don’t get preferential treatment?  If the position is big enough, why wouldn’t a court deem it necessary to do this as a tender offer rather than some made up term the ECB and Greece are going to try and use?

This can only be pursued if it turns out the ECB holds some English law bonds, and even then, only to the specific bonds they have.  That might be relatively easy for the ECB to work around, depending on their holdings, and is only an issue if the “exchange” they are doing would be deemed a tender.  Clearly more knowledge about when something has to be done by tender under English law is required.  If they breached the law and did this deal already, and it should have been done by a tender, can you also try and collect from the ECB as a party to the transaction?  That becomes interesting.  If you can get a claim on the ECB through this, then you finally get a shot at the deep pockets.

None of these ideas are obvious winners in litigation, but they don’t seem too stupid to explore in more depth.  Especially with March 20^th rapidly approaching, anything that can be used to convince them to pay you out at par rather than accepting PSI may be well worth the effort.  With the latest PSI rumors showing an even worse package, the downside from fighting, delaying, and possibly winning is higher, is marginal.  Will a settlement after a payment default really be that much worse than the PSI default settlement?

The Troika and Greece are trying to change the rules of the game on the fly.  Who knows what the long term consequences will be (probably bad), but they are also likely to create a lot of unintended short term consequences.

http://www.tfmarketadvisors.com/2012/02/19/pari-passu-and-bouillabaisse/

"The Shape Of The Next Crisis" - A Preview By Elliott's Paul Singer

Submitted by Tyler Durden on 12/09/2012 15:00 -0500

• Bear Market
 
• Ben Bernanke
 
• Ben Bernanke
 
• CDS
 
• Counterparties
 
• Credit Default Swaps
 
• Creditors
• default
 
• ETC
 
• European Central Bank
 
• Fail
 
• Federal Deposit Insurance Corporation
 
• France
 
• Germany
• Greece
 
• Japan
 
• Lehman
 
• Managing Money
 
• Middle East
 
• Monetary Policy
 
• Portugal
 
• Quantitative Easing
 
• recovery
 
• Risk Management
 
• Sovereign Debt
 
• Stop Trading
 
• Too Big To Fail
 
• Totalitarianism
• Twitter

Transcribed from a speech given by Paul Singer of Elliott Management

Investing is an art, more so than a science. And for me, what I get paid for is managing the “dark art,” if you will, of risk management and trying to be a visionary and having a dark vision at all times about what can go wrong.

It’s a particularly fruitful and impactful time to be thinking about risk management and the thing I want talk about today is what I’ve described as “The Shape of the Next Crisis.” That doesn’t mean we’re going to be talking about the timing of it or exactly what to short or how to make money from it. But it’s to provoke thought about what the elements are, the current landscape, the various aspects that will shape the timing, as well as the amplitude, the predictability, the suddenness of the next crisis.

It’s not something that I can talk about in any kind of hierarchical fashion. There are a number of elements that are in play, some of which are novel, completely new in virtually the human landscape.

But they combine in what I think of, when I’m thinking of risk management and how to hedge my portfolio, what I think of as kind of “an evil stew.”

But here they are, and it should be obvious when you really think about it, but you have to bring these elements from other facets of life to see how they impact trading and investing.

On Modern Communications and Information Processing

It is increasingly the case (and I’ll give you a couple of recent examples) that people coalesce, form, and reform ideas in a much more powerfully focused, and abrupt, and stark way than they ever have in the past.

One of the most interesting examples of this is the so-called “Arab Spring” where the forces underlying these societies – totalitarianism, security services, violence, oppression, etc. – have existed in the countries that have been affected for decades. All of the sudden it started in January with a singular small event in Tunisia. And now it’s a few months later and there are 11 countries in various stages of more or less similar wide-spread revolts.

And how did this happen? You speak to experts in the Middle East, you speak to experts in that area or in those particular countries, and you don’t get a satisfactory answer. You get “totalitarianism.” The answer, I believe, relates to social media and the way people are connected - it’s the Internet, it’s Facebook, it’s Twitter – and the way people process information enabling people to develop the same thoughts simultaneously and to act and coalesce physically as well as emotionally.

The vector changes with something like this are virtually instantaneous. In 6 months, for 11 countries that have been more or less family run or totalitarian, to be in revolt is a very, very powerful illustration of this point.The Flash Crash about a year ago in stocks, where all of the sudden, the technology of the marketplace and the way the exchanges had their rules about processing orders in relationship with other exchanges, coalesced one afternoon, to have hundreds of stocks virtually evaporate all at once - within seconds or minutes or five minutes or half an hour.

This is a very powerful element and will serve as an accelerant in the next crisis so hold that one up on the blackboard, metaphorically speaking, while I talk about the next elements.

On The Financial System And Leverage

Let’s talk about financial institutions and the financial system. The major message that I want to give you (and I’ve invited challenge on both parts of my thesis here and I’ve never had anybody challenge it): The major financial institutions in the US and around the globe are utterly opaque; and The next financial crisis will happen faster, more suddenly.

We cannot (I have 110 investment professionals), and I surmise that you cannot, understand the financial condition of any bank, major financial institution. You can’t see the actual size of the balance sheet. You have no idea what that derivatives section means…it’s 10 to 100 times the size of the actual balance sheet.

So when people say, “Well, it used to be 40x leveraged,” (some of them were 90x leveraged) “but now they’re 15 to 20 times leveraged.” Well that’s just great. Except you go to the derivatives and see numbers in the trillions and trillions and trillions and there is no clue, you have no clue, no understanding, of what that is actually composed of. Is that composed of trades that are basically unwound where all you have is counterparty risk? Is that composed of actual hedges of upper tranches the way we would have in an admitted hedge fund?

So you are looking at balance sheets without any real understanding of how the balance sheets and the companies would perform in the event of a crisis. Which of these trades or trillions of dollars of trades, which in normal times oscillate like this [very small motion] and that’s why they’re so big, would in really bad times start going like this [large motion]. And if you actually have capital of only half a percent, or one percent or five percent of your actual footings, not just unwound trades that happen to still be on balance sheet, but actual footings, you’re in trouble.

The kind of thing that wound up the financial system three years ago is expected to be different in form than the kind of things that would unwind the financial system the next time. But I’m going to argue that the next time will be faster. If you think back to ’07 and ’08, it was episodic. It wasn’t just suddenly that in the second or third week in Sept that Lehman goes under and that’s the crisis and the whole world collapsed. No, there were several episodes leading up to that.

After that, what kept the entire financial system from coming to a grinding halt was quite simple. It wasn’t that all of the other firms were in much better shape than Lehman. It’s very simple, it’s that governments, here and in Europe, underwrote the entire system. Ben Bernanke, of whom I’m not a fan... at all, has been quoted as saying that in the absence of the government guarantee and underwriting, 12 of the 13 biggest banks in the world would have gone out of business following Lehman. Whether it’s 12/13, or 13/13, or 6 or 8 of 13, is completely imponderable, but the point is actually well-taken. In the absence of that guarantee there would have been a cascading collapse because of the opacity.

There are people in this room that are on trading desks or manage trading operations at investment banks. You know for a fact that you knew nothing about the financial condition of your five biggest counterparties. And so your relationships, and your willingness to trade, with those counterparties was dependent on rumor or credit spreads widening or not widening. And that’s a very terrible place for the financial system to be in.

So take the opacity, take the fact that you can’t really understand the financial condition, and take the fact that the leverage hasn’t really been rung out. And what you realize is that the lessons of ’08 will actually result in a much quicker process, a process that I would describe as a “black hole” if and when there is the next financial crisis.

The next financial crisis obviously can only happen if, believably, the governments either cut loose the major financial institutions - believably and credibly unwound the guarantee - or even more difficult and scary, if the government guarantee were not enough. And that’s one of the next elements in the shape of the next crisis. As you know, risk has migrated upward, it’s migrated from lenders and borrowers really to governments. It’s gone on the balance sheet of the US, the ECB (the various countries of Europe, particularly Germany, France, etc.). That the credit of Europe, the credit of America, is being called into question in the starkest way is part of what will shape the next crisis.

But before I get to that part, and explain how I think that impacts, I want to come back to the trader and trading part of this. The lesson of ’08, which is indelibly stamped upon every hedge fund forehead and trading desk head, is: Move your assets first, stop trading first, sell the paper first, and ask questions later. Those that moved from Lehman days or weeks before the end were happy. Those that sat there thinking that they were protected in prime brokerage accounts or protected in some other ways, or that firms like Lehman wouldn’t be allowed to go under were stuck in the company (of course Lehman is still in bankruptcy) with claims trading at 20-something cents on the dollar, depending on where you are in the capital structure.

On 'Orderly Liquidation' And How Dodd-Frank Has Made The System More Brittle

 So, I want to put one more element in place in the trading and financial institution part of the equation.

And that’s the law that was signed into law a few months ago, Dodd-Frank. I don’t know what it’s actually called, but it is the financial institution reform law and it is designed purportedly to make the system safer. “Safe” actually, not just “safer.”

In my opinion, what Dodd-Frank has actually done is to make the system more brittle and complete the picture, in my mind, of a black hole, meaning a very vicious, sharp and abrupt process if you put together all of the things that I’ve said so far.

So what is it about Dodd-Frank that contributes to this black hole, or contributes to this brittle, unsafe condition? It’s the “Orderly Liquidation Authority,” a very humorously named part of this law because what I think it actually represents is a very disorderly process. Under this authority, which was purportedly designed to provided a “not-Lehman” outcome (you know, no government bailout and a calm resolution of large financial institutions), under this process the FDIC has the authority, contrary to all US bankruptcy practice and law, to seize financial companies which are quote “in danger of default.”

Under previous bankruptcy law, companies had to default, actually default, or managements voluntarily put them in bankruptcy in order for them to be in bankruptcy.

“Danger of default,” if you think about that, plus with the other parts of this that I’ll describe, means that if a company is in trouble, and it’s large and opaque, then it’s in danger of default and can be seized any day. And if I say any moment it’s only a slight exaggeration, because by statute the process of throwing a company into the Orderly Liquidation Authority is about 48 hrs long, and is effectively unreviewable (even though there is an injunction attached to this process with the Treasury secretary and a couple of other people looking at it).

So companies can be seized that are in danger of default, and what is the FDIC ordered to do and what can it do? It is ordered to throw out management…quite bizarre. It is enabled to discriminate among classes of creditors similarly situated... strange. It’s enabled to move assets around and transfer assets to bridge companies. And it’s enabled to go against people in or out of the company who are quote “responsible for the financial condition.”

Let me define Systemically Important Financial Institutions first and then continue on. Under this legislation, the government is supposed to designate certain companies as “systemically important.”

I’ve been quoted as saying that I feel that’s nutty. It’s nutty because no financial institution should be too big to fail. All financial institutions should be governed by the same rules regarding leverage and risk. And companies can become systemically important, or un-become systemically important, extremely quickly in today’s world as a result of taking on leverage, changing their positions.

Let’s put that all together. If you are trading with a big company and that company or other companies have been identified as systemically important institutions, if you are observing a large company getting into trouble, what you know is that you have to pull your assets because those assets can be transferred (regardless of the financial condition of the subsidiary that your assets are a part of, whether it’s a prime brokerage subsidiary or otherwise). You don’t know how your claim will be treated, so you have to sell the bonds that you own; if the guy down the block, Bob’s Big Bank [is a similarly situated creditor and] has been designated as systemically important, that guy may be getting a priority recovery.

So the whole thing militates toward stepping away abruptly from any company that is designated as systemically important. So I think that the opacity, the lessons of ’08, the vicissitudes and thoughtlessness of Dodd-Frank, militate in favor of a very, very abrupt resolution.

On Japan And The Confidence-Destroying Implications Of Monetary Policy

There isn’t time to flesh out in detail the other accelerants of what the next financial crisis might look like, but let me just say a word or two on monetary policy. Monetary policy, which is now doing virtually all of the job creation work in the United States (in particular) and of course in Japan also, has created a very distorted recovery and some people think, including myself, that it’s been at least partially responsible for inflation in commodities and gold.

Quantitative easing which is this duration shortening mechanism, zero interest rates which is extraordinarily unusual and is now in the United States as well as Japan, as well as the long term entitlement insolvency in the United States, are platforms for a possible loss of confidence.

And In Conclusion

I think people who are managing money or investors who are trying to figure out what the next crisis may look like, should be processing these elements and thinking about how they can interact, together with the modalities of modern communications and the way people process information, to create something very sudden.

Nobody in America has actually seen, or most people probably can’t even contemplate, what an actual loss of confidence may look like. What I’m trying to struggle with as a money manager, who really seriously doesn’t like to lose money, is how to protect our capital and how to think about the next crisis.

If you think about some of these elements and how they might interact, you might come up with other paths of transmission or risk and pain. But I wouldn’t go about your business thinking it’s business as usual in a typical post-crisis, post bear market recovery.

Questions And Answers Section...

Q: [Thoughts on Europe]?

A: Yeah, that’s really important. My view about Europe starts with my view 15 yrs ago (and by the way, on Wall St if you’re early, you’re wrong). My view 15 yrs ago was that the Euro was an inappropriate backdoor experiment on quasi-sovereignty. And all it would take would be a stark variation in economic performance or geopolitical or military considerations or interests. And here we are and there’s been a stark divergence and the Euro is in the process of centrifugal force and breaking up.

Will it break up? It’s entirely unclear, and I’m not going to predict that it’s going to break up or whether Greece is going to actually leave it. What I will say is that it doesn’t make sense for the underperforming countries to actually be part of this. Everyone looked like they were getting benefits during the period of time when there was convergence. Exports for Germany, lower interest rates for Greece and Portugal and Spain and the rest.

Big risks were built up, big variations in performance, and now Germany in particular is writing out checks. As long as Germany keeps writing out checks, the euro can limp along, Greece can limp along.

But the answer to your question is the fixes to this, even if to kick the can down the road, are deflationary, they’re harmful to growth despite the fact that a breakup of the euro would fall upon Greece. Pulling out by Greece from the euro would trigger other consequences in several of these other countries, would create a banking crisis which would have to be dealt with.

So there is near term pain in doing, in my view, the right thing. But the medium- to longer-term pain of writing out checks to insolvent countries like Greece (insolvent, it’s not a liquidity crisis, insolvency), is ultimately something that’s going to be dampening growth in Europe, dampening global growth, possibly creating the transmission mechanism for the next banking crisis. So I think we’re watching it. And by the way, how do I think it’s going to actually happen that the situation is resolved? It’s going to be from the bottom up, the political process. It’s going to be on the streets, it’s going to be hundreds of thousands of Greeks, or hundreds of thousands of Germans demonstrating against the bailouts.

The elites want to keep writing the checks because their paradigms, their desire to have this experiment (because that’s what it is, it’s only 12 or 13 yrs old) continue. That’s what their dream was: one Europe - sovereign. And they were going to get to sovereignty through the back door. It isn’t working out at the moment; I don’t think it’s going to work out. And the fact that it’s not working out is quite painful and the way they’re doing it is stretching out the pain.

Q: [Insights on using CDS on sovereign debt to hedge your portfolio]?

A: Very good question. The question was about buying credit default swaps on countries or companies in order to hedge your positions, as a general risk management tool. I think that’s a really great question, it’s one that people like us really struggle with.

One of the things that 2008 (I had forgotten to say this before, so thanks for reminding me) showed us about risk management was that some of the tools that we thought that we had for risk management were actually tools that could be harmed or defeated by the actions of governments. And governments have shown an increasing inclination to push us around, us as a community. Meaning overnight bans on short selling, statements and the beginnings of action against credit default swaps, so-called “naked” credit default swaps.

Credit default swaps in the abstract, or actually in practice up till recently, are very effective at bringing liquid tools for taking judgments long and short about securities, and countries, companies that otherwise would be completely illiquid. Borrowing sovereign debt to sell short is not easy.

When countries and companies get into trouble, it’s very easy and very standard to be blaming speculators and credit default swaps as one of the reasons, or the main reason why a spread is blowing out and why the country or company is in trouble (because when a spread blows out, financing opportunities and possibilities diminish, etc.). Who can say what portion of CDS trading is so big that it actually creates prices rather than just discovers prices?

But one of the very difficult parts about running a portfolio that is aimed to be absolute return or very risk conscious and trying to avoid the consequences of the next crisis, is that it’s very difficult to predict using tools like that, which of these tools will be left unimpaired, or which will be suddenly impaired or destroyed by government action.

One of the things that bothers me about running a gold position is (since gold is, really to me, a thermometer about how people think about real money versus fake money or versus paper money possibly for the first time in people’s lives of anybody in this room), if gold actually is starting to be priced at a price that would represent real fear about paper currencies, what will governments do to derivatives or actual gold to keep themselves from being subject to what they feel is inflation caused by speculators?

So I think everyone who is using these complicated instruments needs to understand that governments have sent out a shot across the bow that they are not in the mood to allow for free markets, when the free markets challenge the “everything-is-fine-and-we-can-kick-the-can-down-the-road” way of governing.