Standard & Poor's downgraded Spain yesterday, citing heightened risks to growth prospects. Fitch Ratings cut the long-term issuer default grades of UBS AG, Lloyds Banking Group Plc and Royal Bank of Scotland Group Plc, and put more than a dozen other lenders on watch negative.

Fresh Plan

German banks are preparing for losses of as much as 60 percent on their Greek holdings, three people with knowledge of the matter, who declined to be identified because the talks are private, said yesterday. The risk is that creditors balk at forgoing more than the 21 percent initially suggested in a plan crafted in July, forcing Greece to miss debt payments and sparking a chain-reaction across the euro area's markets involving rating downgrades and payouts on credit-default swaps.

Hatching a fresh plan for Greece would mean rewriting the package agreed to in July, which included a 21 percent voluntary reduction in repayments on some bonds. With a deepening recession in Greece pushing the nation further away from the July accord's debt-reduction targets, the price of two-year notes slid to as little as 36.79 percent of face value on Sept. 13, indicating dwindling faith in the nation's ability to repay investors even after the so-called haircut.

Brussels Talks

“A reopening of the deal is very likely,” said Patrick Armstrong, managing partner at Armstrong Investment, which has about $345 million in assets under management. “In the past, they were trying to avoid Greece defaulting and avoid recapitalizing the banks and what's going to happen now will probably be more sensible. It will allow the euro zone to move forward.”

The London-based fund manager owns a “small amount” of Greek 4.3 percent bonds due March 20, 2012, which it bought in July, Armstrong said.

Deutsche Bank AG Chief Executive Officer Josef Ackermann, who led talks on private sector involvement in Greece's rescue package in July, said yesterday that he will go to Brussels next week to discuss the potential for investors to accept deeper losses. Luxembourg's Jean-Claude Juncker, who leads the group of euro-area finance ministers, said separately yesterday that talks are under way with the Washington-based Institute of International Finance on the cost to investors of a second bailout package for Greece.

'Larger Haircut'

“You need a significantly larger haircut because what's being discussed now isn't enough to put this country back on the path of fiscal sustainability,” Pacific Investment Management Co. Chief Executive Officer Mohamed A. El-Erian said in a radio interview on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt. “We're going to see it soon because I think the politicians and policy makers understand that debt reduction is part of the solution.”

Since German Chancellor Angela Merkel and French President Nicolas Sarkozy put bank recapitalization at the top of the priority list in an Oct. 9 declaration, the Stoxx Europe 600 Index of shares has risen 1.7 percent. Yields on benchmark German bunds, perceived to be Europe's safest government bonds, rose to a six-week high yesterday, the euro rallied 2.8 percent to $1.3751 and a measure of how much European banks pay to fund in dollars slid to a five-week low today.

Bank Capabilities

Ensuring banks in Greece and the euro area are capable of withstanding greater losses on Greek debt is “imperative,” said Spyros Politis, CEO of TT-ELTA AEDAK, a Greek manager of mutual funds with 262 million euros ($360 million) of assets.

“You need this society to function in order to, at the minimum, guarantee that whatever is left after the haircuts is repaid,” Politis said. “This in turn needs a functioning domestic banking system.” TT-ELTA AEDAK values the Greek bonds in its portfolio at 50 percent of face amount, he said. An eventual haircut of around 35 percent “appears to be a solution that keeps everyone less unhappy,” he said.

The drop in Greek bond prices already means investors are going to save Greece more money through the July debt-exchange plan than previously thought, because they save it from selling securities at today's higher yields, Charles Dallara, managing director of the IIF, said on Oct. 4.

Greek CDS

Credit-default swaps on Greece signal a more than 90 percent chance the government will renege on its obligations within five years, assuming investors would recover 32 percent of their holdings in the event, according to CMA, which is owned by CME Group Inc. and compiles prices from dealers in the privately negotiated market. The swaps market is factoring in a 62 percent probability Portugal will default in that time, a 47 percent chance for Ireland and about 8 percent for Germany, all assuming a 40 percent recovery.

“A managed default in Greece may increase speculation of restructurings elsewhere, which would certainly put Portugal under pressure, also Ireland and we would see Italy and Spain under greater speculative pressure,” said Richard McGuire, a senior fixed-income strategist at Rabobank International in London. “It's a very difficult balancing act.”

S&P cut Spain's long-term sovereign credit rating to AA- from AA, the ratings company said in a statement late yesterday. The country faces high unemployment and public sector debt, tighter financial conditions and may be affected by the slowdown of trading partners, S&P said.

ECB Involvement

The European Central Bank will also need to be persuaded to allow a greater writedown on Greek bonds, potentially also including its own holdings, amassed under a previous plan to support the nation. The involvement of the private sector in euro-area bailouts through enforced investor losses is a risk to financial stability and would have “direct negative effects” on the banking sector, the central bank said yesterday in its monthly bulletin.

ECB President Jean-Claude Trichet said on June 30 that the central bank didn't expect to participate in the voluntary rollover of Greece's debt agreed to in July.

“Very likely the ECB will defend its position of taking no haircut up until the last moment but I think at the end of the day the ECB will stop being the blocking point,” said van den Heiligenberg. “If you recapitalize the banks first then you have more potential to do bigger haircuts on Greek bonds. If they mix up the order then the market would probably get very nervous.”

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