Form and Substance Eupdate (Updated)

After a month spent reeling from DSK whiplash, Eupdate finds the European landscape little-changed, much noise notwithstanding.

Summarizing: Greece has gone through profound political upheaval to enact austerity measures boosting the nominal credibility of its economic program; German banks have continued quietly to unload Greek debt (unto whom?); European politicians have continued loudly to bang the table about bail-ins; and the European Central Bank has continued stoutly to reject all compromise that might reflect on its mammoth holdings of peripheral debt ... that is to say, all compromise on offer. As Adam pointed out last week, the French bank fig-leaf proposal solves none of the problems at hand, though as Wolfgang Munchau pointed out yesterday, it does apply criminal amounts of structured lipstick to the EU bank-sovereign pig.  (No, not PIIG.)

The one curious thing about this slow-motion train wreck is the extent to which the public sector is embracing crude formalism as its preferred method of treading water, while some private market participants are seizing the substantive high ground. 

Take, for example, the effort to avoid triggering sovereign CDS and ratings downgrades in a voluntary, consensual, warm and loving anythingbutdebtrestructuring. The most often-cited reason for this is that European central bank rules prohibit taking defaulted debt as collateral for liquidity support to European banks. Restructuring via debt default would cut off Greek and other banks from central bank liquidity support, which would in turn destroy the Greek banking system. Restructuring via debt magic would avoid all such unpleasantness. If the French proposal is any indication, debt magic requires Greece to take on net new debt to buy a little time and liquidity. It meets the formal requirement of private sector participation, substantively saddling central banks with even more deeply unsustainable debt as collateral. But since all talk of sovereign insolvency is off the table, none of this matters under the rules.

The private sector response is revealing. First, credit rating agencies are refusing to go along with the public sector's contract arbitrage. In a letter to the FT last week, Fitch swore it would look to the economics and "spirit" of the debt operation in deciding whether to brand it a default; more recently, S&P said it would rate the French deal a default based on substance. There is even a bit of sanctimony in the message: "[i]t is surprising and unfortunate that so much effort appears to have been invested in circumventing a particular rating outcome. By far the most important and beneficial outcome for Greece and its creditors is securing a credible solution to the current crisis."

What of the CDS? Here ISDA has made a procedural move, but one that captures for itself some quasi-judicial discretion. Whether anythingbutdebtrestructuring triggers Greek sovereign CDS will likely go to an ISDA determinations committee, which will come under heavy pressure from some ISDA members to decide on substance, and equally heavy pressure from the official sector to decide on form. Recent ISDA statements suggest that market expectations will weigh on the outcome, which will affect the sovereign CDS market far beyond Greece. It is a "youthful space" indeed.

Meanwhile, market participants have wasted no time putting on a trade to arbitrage the official arbitrage, even as some hedge funds seem to have tired of gaming mainstream market politics--perhaps a good thing, except who will buy all the debt from the banks?

Never mind. Rules are Rules. UPDATED: ... are Rules.