Greece is on the edge. Part of their bail out, the voluntary losses Greek bond holders were supposed to accept, is falling short.

Private holders of €206bn in Greek bonds have until Thursday evening to decide whether to take part in a swap where they would trade bonds for a package of bonds and cash that would knock about €100bn off Athens’ debts.

Greece must get 75 per cent of holders to participate to avoid forcing the deal on holdouts through so-called “collective action clauses” which were inserted retroactively into Greek bonds by the government last week. If less than 66 per cent participate, even the CACs would become invalid, scuppering the entire deal.

The ECB is already saying voluntary participation will be too low and now there is talk of forcing the holders of Greek debt to take their haircut:

Greece expects bondholders to accept a one-time offer to write off about 100 billion euros ($140 billion) of Greek debt and is ready to force them to participate if necessary, Finance Minister Evangelos Venizelos said.

So far, only 20% of Greek bond holders has agreed to a hair cut, far below the 66% threshold quoted for the swap of new Greek bonds, along with a 53.5% hair cut, to be successful.

Last Friday Moody's downgraded Greece to the lowest level possible. Some are even lamenting the actual no default but really a default situation of Greece, simply because they want all of those credit default swaps to pay out.

In the midst of this a leaked memo analyzing the impact of a Greek default was published by Athens News. The leaked analysis shows a Greek default will cost at least €1 trillion.

There are some very important and damaging ramifications that would result from a disorderly default on Greek government debt. Most directly, it would impose significant further damage on an already beleaguered Greek economy, raising serious social costs. The most obvious immediate spillover it that it would put a major question mark against the quality of a sizeable amount of Greek private sector liabilities. For the official sector in the rest of the Euro Area, however, the contingent liabilities that could result would seem to be:

• Direct losses on Greek debt holdings (€73 billion) that would probably result from a generalized default on Greek debt (owed to both private and public sector creditors).
• Sizeable potential losses by the ECB: we estimate that ECB exposure to Greece (€177 billion) is over 200% of the ECB’s capital base.
• The likely need to provide substantial additional support to both Portugal and Ireland (government and well as banks) to convince market participants that these countries were indeed fully insulated from Greece (possibly a combined €380 billion over a 5 year horizon).
• The likely need to provide substantial support to Spain and Italy to stem contagion there (possibly another €350 billion of combined support from the EFSF/ESM and IMF).
• The ECB would be directly damaged by a Greek default, but would come under pressure to significantly expand its SMP (currently €219 billion) to support sovereign debt markets.
• There would be sizeable bank recapitalization costs, which could easily be €160 billion. Private investors would be very leery to provide additional equity, thus leaving governments with the choice of either funding the equity themselves, or seeing banks achieve improved ratios through even sharper deleveraging.
• There would be lost tax revenues from weaker Euro Area growth and higher interest payments from higher debt levels implied in providing additional lending.

There would be lower tax revenues resulting from lower global growth. The global growth implications of a disorderly default are, ex ante, hard to quantify. Lehman Brothers was far smaller than Greece and its demise was supposedly well anticipated. It is very hard to be confident about how producers and consumers in the Euro Area and beyond will respond when such an extreme event as a disorderly sovereign default occurs.

It is difficult to add all these contingent liabilities up with any degree of precision, although it is hard to see how they would not exceed €1 trillion.

There is a more profound issue, however. The increased involvement of the ECB in supporting the Euro Area financial system has been such that a disorderly Greek default would lead to significant losses and strains on the ECB itself. When combined with the strong likelihood that a disorderly Greek default would lead to the hurried exit of Greece from the Euro Area, this financial shock to the ECB could raise significant stability issues about the monetary union.

What's even more bizarre is Greece will officially be in default, if an only if the International Swaps and Derivatives Association says they are. That's when all of those credit default swaps would be triggered. By avoiding calling a default a default, those who bought CDSes on Greek bonds cannot collect. Most amusing. The Wall Street Journal is calling this a major damage to the CDS market. Oh my, suddenly risky debt would once again become risky.

Reuter's financial blogger Felix Simon has been on the CDS case for Greek bonds and now he is also saying Greece needs to default.

The cat’s out of the bag now. Greece had no choice but to default. Portugal and Ireland do now have the choice. And while the cost of default is large, so is the cost of carrying a whopping great debt load. It’s up to the leaders and voters of those countries to determine which is the least bad option.

Below is Felix Simon's video explaining Greek bonds and their sovereign CDS counterparts a tad.

When it comes to politicians and banks who love them, I think that's Schrodinger's cat, Mr. Simon.

Update: There is now forced action to get the bond holders to sign on. NASDAQ is reporting Greek needs 90% participation and will use force:

Greece has said it wants a participation as high as 90% to go ahead with the bond swap. If participation falls well below that, Greek finance minister Venizelos has indicated that Greece will not hesitate to bind reluctant creditors into the deal through the use of collective-action clauses.

These are legal tools that were retroactively fitted into Greek-law bonds, allowing the will of a majority of creditors prepared to support the terms of the debt restructuring to be binding for all creditors.

The use of CACs is not a market-friendly approach and is set to trigger pay outs under credit default swap contracts because it is a classic case of a debtor coercing a creditor under the rules of the International Swaps And Derivatives Associations.

In the case of Greece, the specific terms of the CACs that are likely be used if the 90% participation rate isn't met allow the deal to be forced through by a small number of creditors that Greece has definitely secured given the willingness indicated by the 12 IIF steering committee members and the expectation that Greek and Cypriot banks will not hold out.

Specifically, under the Greek CACs a vote is held with a quorum of 50% of bond holders of all bonds in question.

This means that at a minimum, the swap can proceed if holders of just half of the EUR177 billion in bonds, or EUR88.5 billion, are present for the vote. A majority of two thirds at that vote is binding on all creditors, including those present for the vote and those who were not present. Under the minimum participation scenario, Greece can push the deal through with the support of the holders of a mere 33% of the EUR177 billion, or some EUR59 billion.

The Financial Times Alphaville is also analyzing the collective action clause as well as the types of Greek bonds:

The first part makes plain that collective action clauses, which would let a majority of quorate bondholders bind others, will be triggered. There’s been a lot of fuss about this, but it’s worth remembering that the CACs now in Greek law bonds provide for a 50 per cent quorum within the 66 per cent threshold. That is it. The end.

Also worth noting, it’s likely that holders of Greek bonds who do want to participate in the swap will probably turf them over to custodians by Tuesday night, not Thursday’s official deadline, because the bonds have to go through settlement systems.

08.08.12, 1PM EST, Update 2: Participation is at 53.5%. The Financial Times:

Greece inched nearer to a successful €206bn debt restructuring after private sector bondholders representing almost 40 per cent of securities said they were backing the deal.

Banks, insurers and asset managers holding €81bn in Greek debt have agreed to exchange their bonds for new instruments that will leave them with losses of about 75 per cent.

As Wall Street cheers, with less than a day to go, it's a long stretch to 90%.

The deadline for participation by bond holders is March 8th.

Update 3: Bloomberg is reporting the finalized Greek bond swap deal was successful yet still triggered $3 billion in credit default swaps:

Greece’s use of collective action clauses forcing investors to take losses under its debt restructuring triggers payouts on $3 billion of default insurance, the International Swaps & Derivatives Association said.

A total 4,323 credit-default swap contracts may now be settled after ISDA’s determinations committee ruled the use of CACs is a restructuring credit event, according to a statement distributed today by Business Wire.

Make of that what you will. Many are pointing to the fact the ISDA is a rigged group, with the same institutions issuing credit default swaps and receiving payouts running the organization. Elliot Spitzer wrote up a detailed piece stating Wall Street is simply gaming the Greek bail out situation.

As the negotiations over the write-down of Greek debt unfolded, one of the critical questions that seemed to be hovering over the markets was: Who bought credit-default swaps on Greek debt, and who would owe big sums to cover the CDS obligations if there were a default. Remember that back in the housing crisis of 2008, it was largely the inability of AIG to make payment on the credit-default swaps it had sold that triggered the cascade of incipient failures that required enormous government intervention. Remember the $182 billion investment taxpayers made in AIG—$12.9 billion of which went straight to Goldman Sachs?

In Greece, any such problem was magicked away. A special committee that governs credit-default swaps got together and said: The Greek bailout—a write down of 50 percent of the value of Greek debt—is voluntary and thus does not trigger the contractual terms of credit-default swaps. That means the companies that sold the CDSes will not have to cover the losses they had insured—the decline in value of the Greek bonds. Who votes on this committee? This will shock you: the very banks that issue, and often purchase, the CDS’s at issue: Goldman, JPMorgan Chase, Citibank, UBS. No government entity at all. Just the same players who have an enormous interest in whether or not the CDS obligations are enforced. And this special committee votes in secret, with no public accountability.

Magic Secret Decoder Ring

• IIF - The organization who wrote the Greece default analysis, linked above. Stands for Institute of International Finance.
• PSI - The Greek bond hair cut and swap program. Stands for Private Sector Initiative.
• EFSF - Group issuing the new bonds, the European Financial Stability Facility
• CACs - Corrective Action Clauses
• CDS - Credit default swap, a pay out which insures the bonds if Greece defaults, officially, on their debt.