It’s summer 2013, and Greece is basking in praise. After three grueling years meeting the terms of its multibillion euro bailout loan package from other European Union members and the International Monetary Fund (IMF), and pursuing austerity measures that have frozen public-sector pay and decimated state spending, the Mediterranean country has chipped away at its debt and been allowed back into the international financial markets with open arms. European leaders, meanwhile, are also congratulating themselves for preventing a banking crisis by holding Greece to the pledge it made back in 2010 that it would pay back all of its debt on time. Greece’s biggest creditors — northern European’s overstretched financial institutions — are heaving a sigh of relief since they have had time to hedge their exposures to Greek debt after receiving EU assurances that until 2013, none of the coupons on the sovereign debt they have been holding will be cut.

As summer 2011 begins, many experts are not convinced that the “official,” happily-ever-after version of the EU’s debt crisis will play out. Even as European finance ministers weigh up whether Greece is meeting its current targets to receive the next tranche of the bailout package, there are a number of other “endgame scenarios” in which Greece restructures its debt either before or after the terms of the 110 billion euro rescue expire in June 2013.None are ideal, and “all come at a cost,” said Lee C. Buchheit, a New York-based lawyer at Cleary Gottlieb Steen & Hamilton, who participated as a panelist with other banking and finance experts during a Wharton co-sponsored conference held at the European University Institute (EUI) in Florence, Italy. The event was titled, “Life in the Eurozone: With or Without Sovereign Default?”

“What I’m hearing here sounds an awful lot like what we were hearing in the U.S. after the Bear Stearns bailout,” noted panelist David A, Skeel, a law professor at the University of Pennsylvania. “It’s what many economists were calling ‘constructive ambiguity.’ If you don’t know you’re going to be bailed out, that’s a good thing, because you will act as if you’re not going to be bailed out. In the U.S. in 2008, constructive ambiguity proved to be a complete failure. Everyone assumed the worst, and acted as if the best was going to happen,” he said. “That’s where we are in Europe now. People keep saying that in 2013, there are not going to be any more bailouts. Unless something dramatically changes in the next two years, that’s not a credible promise at all, and we should act as if it is not a credible promise.”

With Ireland and Portugal also receiving bailout packages of their own in recent months — and bets being taken for when or whether Spain and Italy will go the same route — the word “restructuring” does not receive the same reaction of alarm, or “paralyzing fear,” that it did a year ago, Buchheit added.

A Will and a Way

According to Buchheit and other conference participants, any scenario that does not involve Greece defaulting looks less and less realistic. For one thing, Buchheit noted, if Greece hobbles to 2013 without restructuring, it can’t expect to be embraced by the public markets as it once was — back when investors “to their regret today, failed to conceive of any credit differences between Germany and Greece” and piled into Greek sovereign debt. Forecasters predict that Greece’s public sector debt-to-GDP ratio in 2013 will be between 150% and 170%, compared with 143% at the end of 2010 — which at the time was the highest in the EU and more than double the 60% ceiling EU members have agreed to maintain under the Maastricht Treaty.

In 2013, Buchheit said, more than half of that debt will be held by the so-called “official” sector — the EU, the IMF and the European Central Bank (ECB), which has been buying big chunks of the eurozone’s “peripheral” countries’ debt on the secondary markets. The official sector will be able to claim “preferred creditor status” ahead of other creditors, Buchheit noted, leaving investors in private capital markets out in the cold should Greece’s economy teeter again.

“So is it cheaper to have Greece default, or hand Greece the money?” asked panelist Arnoud Boot, corporate finance and financial markets professor at the University of Amsterdam. Ultimately, he added, “these are political questions” that have more to do with the wherewithal of Greece’s politicians than with finance and economics.

Franklin Allen, Wharton finance professor and co-chair of the conference, agreed. “Projections [suggesting] that [Greece is] going to spend 5% to 10% of GDP on interest payments alone are just not going to happen,” he said in an interview after the event. “I just don’t think they have the political will to go out and tax people and cut expenditure in a way that would generate 5% to 10% of GDP,” not least because Greece’s economy has been contracting since 2008, and a -3% GDP is forecasted for 2011. At some point over the next few years, he predicted, Greece’s debt will climb to around 340 billion euros, and the country will have to restructure its debt by either writing off a portion of it or rescheduling repayments, potentially forcing banks to accept heavy losses and triggering a larger crisis across the region’s financial sector.

Therein lies the rub. “This isn’t a debt problem,” observed Charles Calomiris, professor of financial institutions at Columbia University’s Graduate School of Business in New York. “This is a debt problem with a banking problem — and one where a run on [Greece’s] banks will make the crisis come to a head. How do you stop that once it starts?” Were the balance sheets of Greece’s banks to crumble as investors and customers fled, “the big problem is: Who is going to put up the money to save the Greek banks?” asked Allen. “If that’s a big enough number, and no one is willing to come up with the money, then Greece will leave the eurozone. They need to be able to print money so that the banks don’t go bankrupt.”

But that’s a scenario EU politicians — the most vocal being Prime Minister Angela Merkel of Germany, one of Greece’s biggest creditor nations — refuse to acknowledge. “Politicians are very reluctant to discuss that as an option,” said Allen. “But that’s what has happened historically. With the gold standard, if you got into trouble, you got off the gold standard, sorted yourself out and then got back in. That’s what they don’t seem to understand.”

Solidarity or Bust?

It’s a perplexing situation, said Calomiris. As more and more public money is poured into the bailouts, European officials refuse to entertain the thought of any of the 17 eurozone members leaving the currency union, despite the drag on the long-term competitiveness of individual members and the growing unhappiness of their citizens living under the constraints of the euro. “And you’re doing all that because you really love this European idea,” he said. “The change to the euro is first going to happen as a redenomination of the banks’ liabilities. I predict the end of the eurozone as we know it.”

Calomiris’s comments raised some audible consternation in the audience in Florence. But he was not alone in foreseeing eurozone exits, with or without defaults. For example, in an op-ed published in December on, Elena Carletti, an economics professor at the EUI and a conference co-chair, wrote that the EU’s politicians have spent month after month debating whether to include collective action clauses in eurozone debt contracts, to the detriment of tackling the EU’s larger crisis issues. “These clauses, which make debt restructuring faster by forcing minority bondholders to accept the terms agreed to by a majority of creditors, are no doubt important to include, but are a distraction from what is likely to be the main issue, namely financial stability,”Carletti wrote. What is the best option for a country like Greece?

According to Carletti, it’s either a quick default or an exit from the eurozone, perhaps temporarily, with a market-determined exchange rate between the new currency and the euro.”The great advantage would be for the defaulting government to regain control of monetary policy and potentially be able to guarantee the banking system. There would be inflation, but this, together with the devaluation of the local currency, would help the country to grow by boosting exports,” she wrote.

Part of the challenge for the EU, if it wants to avoid the costs of future rescue funding like that of Greece — and moral hazards of making defaults too tempting for member countries — is that there is no bankruptcy framework to follow, said Skeel. “The problem in bankruptcy … when you’re dealing with sovereigns is that you don’t have the stick that we have in normal bankruptcy proceedings,” he noted. “In normal proceedings, there’s direct liquidation — you’re just going to shut everything down if bankruptcy doesn’t work. You can’t liquidate a nation.”

Skeel recommended that the EU adopt a “rules-based” bankruptcy framework, similar to what he and Patrick Bolton of Columbia Business School developed in early 2004. A key part of the framework includes a “first in time” priority system to reduce the risk of debt dilution in a restructuring based on when bonds are issued. For example, investors with bonds from 2010 would have priority over investors with bonds from 2011. Higher priority bondholders would be paid in full; others would not.

A Peso for Your Thoughts

If there’s good news for the likes of Greece, it’s that history is littered with examples of debt restructurings to learn from — thanks to as many as 60 sovereign debt defaults in recent decades, according to Buchheit. What history shows, he said, is that a country has a lot of leeway in negotiations with creditors, as long as it does not discriminate against any of the creditors through legislation and it has a good justification for the negotiations. Managed efficiently and fairly, a default can take six months from beginning to end, he added.

Throughout the conference, references were made to various debt restructurings in Latin America. One recent default that often conjures up grimaces — and is perhaps a lesson on how not to manage a default — is Argentina’s. Argentina is “a poster child for how a restructuring can be so terrible and so costly,” said G. Mitu Gulati, a law professor at Duke University in North Carolina. Many factors led to Argentina’s crisis and the government’s decision in 2001 to default on $95 billion of debt to private creditors, the largest sovereign default in history. Ten years later, the country — whose debt, like Greece’s, was largely in bonds — has struggled to return to international financial markets. “But the economists I meet with always tell me that you can’t just look at one case; you have to look at the other cases,” of which there have been as many as 60 in recent years, said Gulati.

Another example is Uruguay. When the country’s government defaulted in 2003, it was days away from running out of money to repay its creditors. So it “re-profiled” its external bonds by extending the maturity of each of its 18 series of bonds by five years. There was no “haircut” on the principal and coupons were kept the same. Unlike Argentina, Uruguay was back in the international capital markets in 31 days, and has returned frequently since, noted Buchheit, who was an adviser on the Uruguayan default program.

The Trouble with Greece

As for Greece, it could do a “Uruguay-style” re-profiling, according to a paper published in April by Buchheit and Gulati. Getting creditors — including many northern European banks — to agree to stretch out the terms might require the official sector to provide some sort of guarantee or collateral security.

According to Wharton’s Allen, however, Uruguay has “a small enough problem, and they just needed more time to cut expenditure. The trouble with Greece is that time doesn’t help them very much.” Rolling over the debt, he said, “won’t be enough to solve the problem. They need to get rid of more of the debt before they can start doing that…. But then somebody has to take the hit.”

Despite the challenges ahead, Gulati pointed out that Greece has a number of factors working in its favor that other financially distressed countries don’t have. One of those factors involves Greece’s debt contracts. As much as 90% of its debt has been issued under local law, with the rest falling under U.S., Swiss and a handful of other jurisdictions. And unlike most loan instruments in other countries, Greece’s do not have what’s known as “negative pledge clauses,” which prevent the use of assets to secure other loans. “Their contracts are actually set up to do a restructuring,” he said. Whether intentional or not at the time of bond issuance, “the Greeks negotiated for a lot of flexibility. It’s almost as if they knew as soon as they joined the eurozone, there would be restructuring,” he joked.

Using local legislation, Greece can put in an orderly mechanism for a voluntary exchange of debt, “the kind of thing politicians are saying does not exist,” Gulati said. “If that’s not what we want to do, then we have to go to other, much more painful solutions, where we’re going to creditors and saying, ‘We owe you a euro or a dollar, but we’ll pay you a fraction thereof.'” Echoing Buchheit, Gulati argued that a steep haircut, say of 50%, was legally possible.

“The story cannot be that there is no mechanism,” he said. “Greece is almost in a better position than any other country in recent memory to do a restructuring.”

Legal issues aside, the EU political machine continues to work on a different outcome. On May 7, the finance ministers of the EU’s “inner circle” of creditors initially vehemently denied press reports that they had met secretly in Luxembourg a week earlier to discuss, among other matters, Greece’s exit from the single currency. Later that weekend, however, the finance ministers issued a statement saying that they had been “called to participate for an exchange of views regarding the financial developments in Greece…. It is absolutely evident that in these talks, there was no discussion nor was any issue raised concerning Greece’s participation in the eurozone, as various foreign media outlets said irresponsibly and for their own reasons.”

In or outside the eurozone, Buchheit wondered whether it’s the term “restructuring” — “which connotes a degree of coercion on the affected creditors” — that the EU is struggling with. Calling the solution “voluntary liability transaction management” might be more acceptable if action needs to be taken on Greece’s debt before 2013. But call it what you will, Buchheit summed up his thoughts about the conundrum facing the entire EU — creditors, politicians and taxpayers — with an old joke about several people lined up before a firing squad. As the guns are drawn, one of them turns to another and asks, “Would you like to trade places?”