forks burning with matches

Greek debt restructuring constitutes one of the most ominous obstacles for the eurozone debt crisis right now, as private holders of Greek debt and the government bicker over a deal to extend the maturiies on Greek bonds.

No surprise here, as Greece has until mid-March to figure out the debt swap deal in order to receive its next round of aid from the EU and IMF. But the mere lack of an agreement could just be being blown out of proportion.

Greek PM Lukas Papademos is scheduled to resume talks with representatives of bondholders tomorrow, after a five-day break. So far, talks have appeared to hit a dead end, as the government struggles to convince private sector creditors to stomach 50% losses on Greek debt holdings in what would constitute the first developed market default in more than 60 years.

According to a source cited by Bloomberg, bondholders are pressing for coupon payments—essentially, interest received on their bond holdings over time—to grow from the 4% EU, IMF, and Greek officials are suggesting to higher interest rates as the Greek economy improves over time. Government officials are evidently rejecting this idea, as it would impinge on Greek efforts at debt sustainability.

Troubles in negotiations between private sector holders of Greek debt and the government do admittedly pose some hurdles to the euro area. The European Central Bank has been particularly vehement that debtholders accept losses voluntarily and avoid provoking a credit event that would trigger payouts of credit default swaps, insurance contracts on Greek bonds. The effects of a credit event are difficult to trace, and could potentially be widespread.

However, there are signs that an involuntary deal—and the subsequent credit event—is already being priced into the market. Walter Kurtz at Pragmatic Capitalism explains:
Unlike bonds held in banking books or loans, derivatives contract get marked to markets daily.  All the banks have to do is look at their Bloomberg monitors and mark the contracts – it’s a transparent market (in spite of what many believe).  The losses associated with Greek CDS have already been taken by banks who wrote this protection – a while back.

True, a credit event could have unintended consequences beyond those that investors are already pricing in. But the size of the Greek CDS market is relatively small—$74 billion net and $4 billion gross, according to Citi's Willem Buiter—and the effects of not provoking a credit event could compromise faith that EU leaders will play by market rules.

The bigger problem is not really the credit event, but the fact that Greece's debt will remain unsustainable for the foreseeable future. Officials' unwillingness to give into creditors demands for increasing coupons supports the reality of this dismal future. It constitutes a tacit admission that things are not going to get better anytime soon.
Add that to some depressing facts about the government's failure to institute the austerity measures it has promised and comments from ECB President Mario Draghi that EU officials will have to assess whether the current agreement on a selective default in Greece are "realistic," and angst over private sector involvement appears to be just a symptom of a larger sovereign debt problem.