The euro zone edged closer on Wednesday to a compromise on a second Greek bailout package under which private creditors would be asked to swap their sovereign debt holdings for bonds with longer maturities.
Several euro zone bankers, including the head of French heavyweight Credit Agricole
The European Central Bank, which has argued loudly against any form of debt restructuring, may also be warming to the idea of private sector involvement if a cut in the principal of Greece's debt -- a haircut -- can be avoided.
Greece sealed a 110 billion euro aid-for-austerity deal a year ago but has failed to restore confidence in its finances and a new package is in the works which could total 80-100 billion euros to cover Athens' funding needs through 2014.
Whether and how to involve the banks, hedge funds and other private holders of Greek debt in the new package has been hotly debated for weeks, with some officials worrying such a step could unleash contagion that envelops new countries like Spain, with disastrous consequences for the currency bloc.
On Wednesday, France said it rejected any restructuring of Greece's debt and would not change its stance.
But the German government, worried about a backlash from angry taxpayers and a possible rebellion in parliament, has been pushing hard for some form of private creditor involvement.
In a June 6 letter sent to the heads of the European Central Bank, International Monetary Fund and his euro zone counterparts, German Finance Minister Wolfgang Schaeuble demanded a quantified and substantial contribution from bondholders as part of any new Greek package.
Such a result can best be reached through a bond swap leading to a prolongation of the outstanding Greek sovereign bonds by seven years, Schaeuble wrote in the letter, a copy of which was seen by Reuters.
It was sent two weeks before a June 23-24 EU summit, at which the bloc's leaders are expected to put the finishing touches on the new deal for Greece.
Such a swap would amount to a restructuring of Greece's privately held debt, even if it was done on a voluntary basis, and ratings agencies have warned that they would view it as coercive and classify it as a default.
If they do anything like Schaeuble is suggesting then the ratings agencies will smash (Greece) and then they will move on and smash Portugal and Ireland, one trader said, naming the other two countries that have required EU/IMF bailouts.
Reflecting those fears, the cost of insuring Greek debt against default rose as did the premiums investors demand to hold Greek, Irish and Portuguese debt instead of German benchmarks.
But David Geen, general counsel of derivatives industry body ISDA, said a debt exchange that pushed out maturities would typically not trigger payment of credit default swaps and that could make it palatable for policymakers.
The stance of the ECB on private sector involvement will be crucial in any deal.
The central bank is believed to be examining a debt swap scenario in which credit rating agencies would declare Greece in limited or selective default for a short period of time.
That would probably force it to impose a ban on the use of Greek debt as collateral in its money market operations, but the impact on the Greek banking system could be minimized through emergency liquidity measures until Greece was taken off limited default status.
The ECB could give investors an incentive to participate in a swap by removing the old Greek bonds from its list of eligible collateral. Other sweeteners are also under discussion by EU officials.
Jean-Paul Chifflet, the head of French bank Credit Agricole, told Reuters in Milan that he expected authorities to broach the possibility of a maturity extension with him soon and voiced support for the idea.
If we lighten Greece's sovereign debt load it should benefit the Greek economy and therefore the actors of the Greek economy, Chifflet said. I am very much in favor of this.
Several bankers at a conference in Koenigstein, Germany also said they expected a deal of this sort.
Banks and creditors must participate, said Karl-Georg Altenburg, JP Morgan's senior country officer for Germany.
A large number of the big German banks that hold Greek debt are partly owned by the government, meaning Berlin would have direct influence over their decisions on a debt swap.
Bank for International Settlements (BIS) data published this week showed German and French banks hold the most Greek sovereign debt of all foreign institutions, with exposure of 23 billion and 15 billion euros, respectively, at the end of 2010.
During a visit to Washington by Merkel on Tuesday, U.S. President Barack Obama urged European countries and bondholders to prevent a disastrous default by Greece and stressed the importance of German leadership on the issue -- a thinly veiled message that he expects Berlin to help.
A German government spokesman said on Wednesday that Merkel had been informed about Schaeuble's letter before it was sent. And a spokesman for the finance ministry said private bond holders still held enough Greek debt to make a big contribution to a solution for the country.
Beyond domestic considerations, Berlin may also be worried that if private creditors do not participate in the new bailout, the share of debt owned by official creditors -- euro zone governments, the ECB and IMF -- will rise to the point where a future restructuring of the private sector accomplishes little in terms of returning Greece to a sustainable debt path.
Greece's debt burden stands close to 340 billion euros -- or roughly 150 percent of its gross domestic product (GDP).
(Additional reporting by Annika Breidthardt in Berlin, Marc Jones in Frankfurt, William James in London)
(Writing by Noah Barkin, editing by Mike Peacock)