"There are a lot of optics to get exactly right, or European bond investors are going to start trying to get out of more than just their Greek bond holdings," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ. "This is about creating confidence in the markets that the euro — the currency and union — is not going to fall apart at the seams."

 
Euro Falls
The euro slipped 0.4 percent to $1.3824, on course for its biggest weekly decline since May. The yield on the two-year German note dropped to as low as 0.385 percent, with the 10-year bund yield sliding to 1.812 percent, also the lowest on record.

Greek two-year note yields added as much as 79 basis points to 55.84 percent, a euro-era record. Credit-default swaps insuring Greek sovereign bonds jumped 212 basis points to a record 3,238, according to CMA. The five-year contracts signal there's a 92 percent probability the country won't meet its debt commitments.

Greece said this week it will accelerate further austerity measures as pressure mounted from European partners before the payment of the sixth tranche of bailout loans under last year's 110 billion-euro loan package. A scheduled quarterly review of Greece's progress by the EU and the International Monetary Fund was unexpectedly suspended for 10 days and won't resume until mid-month.

 
'Knife's Edge'
German Finance Minister Wolfgang Schaeuble said Greece won't get its next bailout installment unless it meets goals under the aid package. At a closed-door meeting this week, he told lawmakers that the Greek government's budget reforms are failing, placing the country's financial situation "on a knife's edge," according to a report in parliament's HIB bulletin.

Greece needs to win approval of its next funding installment to keep its follow-on bailout package on track. If euro-area governments get spooked, they might not take necessary action to keep the rescue program on course.

There are no talks on Greece potentially leaving the euro, European Commission economics spokesman Amadeu Altafaj told reporters in Brussels yesterday. Neither exit nor expulsion is possible and euro-area membership is irrevocable, he said.

 
Participation Rate
Parliaments across the euro area must approve changes to the European Union's crisis fund for the bailout to proceed and for investors to decide whether to participate in the debt swap, said Hung Tran, deputy managing director of the Institute of International Finance. The Washington-based banking group is working with regulators and the Greek authorities on the bond exchange.

"We hope that different parliaments should move as quickly as they could," Tran said in a telephone interview. "The expectation seems to be end of September, early October."

IIF says 40 financial institutions have so far explicitly lent their support to the debt exchange. Those companies own about 70 billion euros in Greek government debt, or about 50 percent of the bonds eligible for the debt exchange.

 
'Small' Losses
More banks have signed up behind the scenes. IIF estimates that preliminary participation rates are between 60 percent and 70 percent, with more financial firms expected to sign on as formal terms become available. Greece said this week that the formal offers will be made in October.

Investors should take part in a proposed Greek bond exchange because the deal offers "relatively small" losses and needs full participation to succeed, Barclays Capital said in a report.

For participants, the effective loss is likely to be about 5 percent on average in net present value, not the 21 percent loss described in the proposal, the Barclays analysts said. That's based on a comparison of the old bonds' projected cash flows, in present value terms, with those of the new bonds.

If the bond swap fails, investors would likely recoup only about 40 cents on the euro, the report said. If the bond exchange succeeds, participating investors would likely recoup 74 cents.

"Our analysis suggests that investors should tender," the Barclays report said. "Most importantly, the alternative — holding out — would most likely result in a failed exchange and a default."

Nobel Prize-winning economist Robert Mundell, whose research contributed to the creation of the euro, said yesterday that a Greek default would trigger a run on banks of "monstrous proportions."

"This risk means that issues in Greece and the euro area are an international problem," Mundell told reporters in Budapest.

Bloomberg News

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