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Greece Default Triggers Swaps, So Now What?

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So this is happening: Greece has technically, officially defaulted on its debt.

Now what?

The International Swaps and Derivatives Association, the trade group that oversees the market for credit-default swaps, essentially insurance policies against bond defaults, on Friday declared that Greece had undergone a "Restructuring Credit Event," which will trigger insurance-policy payments.

This is because Greece announced on Friday that it would force some of its private bondholders to accept a swap of old debt for far less valuable new debt, in an effort to cut its massive debt load by about 100 billion euros.

That Greece was declared in default should not exactly be shocking: It was widely accepted by most observers that sticking a gun to your creditors' heads and forcing them to accept less money in repayment would be considered a "default" by any other name.

And yet it does seem to have surprised a few people in financial markets this afternoon. The Dow Jones Industrial Average, up about 60 points earlier on Friday, was recently up by just 10 points. The euro was recently down about one percent against the dollar.

Still, considering how much energy has been spent in the past several months of worrying about a Greek default, the market's relatively calm reaction is notable. Shares of Morgan Stanley, which in the past has been a poster child for euro-zone credit exposure, were slightly higher.

The market yawn may have to do with the fact that, once hedges and offsetting swaps are taken into account, there is only about $3 billion worth of Greek credit default swaps outstanding. That should be enough for the global financial system to handle.

Compare and contrast that with the situation in 2008, when hundreds of billions of dollars in exposure to credit default swaps nearly brought down the insurance giant AIG. Only a government bailout prevented its full collapse.

We still don't know yet how well the system is going to handle the actual exchange of money when default-insurance payments start happening. And that won't start until an auction scheduled for March 19.

If you remove all hedges and offsetting swaps, there's about $70 billion in default-insurance exposure to Greece out there, which is a little bit bigger pill for the banking system to swallow. Is it possible that some banks won't be able to pay on their default policies? We'll find out.

Another worry is whether Greek and other European officials will work harder next time to avoid triggering these default policies, notes Peter Eavis in the New York Times.

Neutering the default-insurance policies could help keep banks that write insurance policies from having to pay up the next time Greece defaults -- which seems inevitable. But it could also weaken investor faith in the default-insurance system. If investors stop believing they can buy default insurance that actually works, then they might just stop buying risky sovereign debt.

And of course there's a lot more risky sovereign debt in Europe -- including the debt of Italy and Spain, bigger countries that will be harder to bail out.

Those countries have just watched their neighbor default on its debt in an orderly way without causing the end of the world, a lesson they might store away for future use, just in case. Prime Minister Lucas Papdemos called the deal - which shaves some euro105 billion ($138 billion) off Greece's euro368 billion ($487 billion) debt load - an important "historic success" in a televised address to the nation Friday night. "For the first time, Greece is not adding but taking debt off the backs of its citizens."

The country said 83.5 percent of private investors holding its government debt had agreed to a bond swap, taking a cut of more than half the face value of their investments as well as accepting softer repayment terms for Greece.

The radical swap aimed to put the country's debt-ridden economy on the road to recovery, and was a key condition to secure a euro130 billion ($172 billion) rescue package from other eurozone countries and the International Monetary Fund.

Charles Dallara, the managing director of the Institute of International Finance, which negotiated the deal with the Greek government on large investors' behalf, described the bond swap as "the largest ever" restructuring.

"This has been painful and the pain is not over yet. But I now can see light at the end of the tunnel for the Greek economy," Dallara told Greece's Mega television. He estimated Greece could return to the markets "within a few years" and said that if recovery continues, "I think the risk for Greece and the risk on the eurozone will be very manageable."

Of the investors holding the euro177 billion ($234 billion) in bonds governed by Greek law, 85.8 percent joined. The deadline for those owning foreign-law bonds was extended to March 23.

Creditors holding Greek-law bonds who refused to sign up will be forced into the deal - breaking a taboo that the eurozone had upheld until just weeks ago.

The decision to force losses on some bondholders means that the debt relief will trigger payouts of so-called credit default swaps, a type of insurance on bonds.

The International Swaps and Derivatives Association, the private organization that rules on such cases, said its committee "resolved unanimously that a Restructuring Credit Event has occurred."

When the debt relief plan was first announced last year, eurozone leaders and the European Central Bank worked hard to avoid a credit event because they feared the payout of credit default swaps could destabilize big financial institutions that sold them.

But since then, that prospect has started to look less threatening. The ISDA said that if triggered, overall payouts on CDS linked to Greece will be below $3.2 billion. The exact level of payouts will be determined on March 19.

The Fitch ratings agency downgraded Greece to "restricted default" over the bond swap - a move that had been expected. Fitch was the third agency to downgrade Greece into default, after Moody's and Standard & Poor's. The agencies are expected to raise the country's credit rating after the completion of the swap.

Earlier Friday, finance ministers from the 17-nation eurozone said Greece had fulfilled the conditions to get approval for the bailout next week. The IMF has set a tentative date of March 15 to discuss the size of its own participation.

The ministers also released up to euro35.5 billion ($47 billion) in bailout money to fund the debt swap. Investors exchanging bonds will receive up to euro30 billion - or 15 percent of the remaining money they are owed - as a sweetener for the deal and euro5.5 billion for outstanding interest payments.

European leaders hailed the deal as a seminal moment in their effort to stem the crisis and get Greece on its feet.

"The page of the financial crisis is being turned," said French President Nicolas Sarkozy.

And Greek Finance Minister Evangelos Venizelos told Parliament Friday: "I believe everyone will soon realize that this is the only way to keep the country on its feet and give it a second historic chance that it needs."

"A window of opportunity is opening" to reduce the country's euro368 billion debt by euro105 billion, or about 50 percentage points of gross domestic product, he said.

However, some economists are concerned that Greece is merely buying time. The breather allows European governments and banks to strengthen their financial defenses, leaving them less vulnerable if Greece eventually cracks.

The deal and expected bailout do "more to protect Europe from Greece than for Greece itself," said Jacob Funk Kirkegaard, research fellow at the Peterson Institute for International Economics.

Europe also has to contend with spiraling debt problems of Spain, Portugal and Ireland and Italy.

Markets, which had rallied on Thursday on expectations of a successful deal, were muted on Friday. The Stoxx 50 of leading European shares was up 0.6 percent, but the main stock index in Athens closed down 2.15 percent. The euro retreated 1.19 percent from recent highs to $1.3110.

On the streets of Athens, however, many were skeptical about the deal and pessimistic about the future. Panayiotis Theodoropoulos said the writedown was good "for them."

"For us? Nothing. Everyone looks out for themselves. In a while the people will be living on the streets," he said.

The debt crisis, sparked by years of overspending and waste, has left Greece relying on funds from international rescue loans since May 2010. Austerity measures including repeated salary and pension cuts and tax hikes have led to record unemployment with more than 1 million people out of work, a fifth of the labor force.

The country released statistics Friday showing the recession in the last quarter of 2011 was deeper than initially forecast, reaching 7.5 percent instead of 7 percent. The economy is expected to shrink for a fifth straight year in 2012, stagnate in 2013 and modestly expand in 2014.

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Steinhauser reported from Brussels. Nicholas Paphitis, Derek Gatopoulos, and Demetris Nellas in Athens and Geir Moulson in Berlin contributed to this report.

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