Greece's debt swap looks like it might work

Greek Prime Minister Lucas Papademos was appointed to negotiate the nation's second bailout. Thursday, private sector creditors will decide on a key deal that could determine whether the nation defaults or not.

NEW YORK (CNNMoney) -- For a country that has faced many moments of truth over the past few years, Greece is on the cusp of what could be a real make or break moment.

The nation's private sector creditors have until the end of the day Thursday to decide whether or not to accept a proposed restructuring of Greek government bonds.

But there were signs that a significant number of bondholders will volunteer for the debt swap, which Greece needs to avoid a default.

"I think people are feeling more confident that they will get the minimum required to make the deal go through," said Kathy Jones, a fixed-income strategist at Charles Schwab. "But we're still waiting to see how this plays out."

The terms of the restructuring are not attractive for bondholders. They have been "invited" to voluntarily take part in a writedown and debt swap that could result in losses of up to 75%.

For Greece, and the eurozone, the stakes are potentially huge.

The agreement on private sector involvement, as it is known, is the final hurdle Greece must clear to meet all the conditions of its second €130 billion bailout program from the European Union and International Monetary Fund.

Assuming the PSI process goes smoothly, EU finance ministers are expected to sign off on the final portion of the bailout after a conference call Friday.

If all does not go according to plan, however, Greece's bailout could be in jeopardy and the nation would face the prospect of a messy default within weeks.

The fallout from a disorderly Greek default would spread across the eurozone and beyond, with "contingent liabilities" in excess of €1 trillion, according to recent internal estimates from the Institute of International Finance.

The key to a successful outcome lies in the participation rate, which measures how many bondholders agree to the PSI terms voluntarily.

Greek default is essentially a given

The IIF announced Wednesday that a group of more than 30 institutions had agreed to participate in the restructuring. The banks, insurance companies and other investors own an aggregate €84 billion worth of Greek bonds, which amounts to 40.8% of the €206 billion that Greece owes the private sector.

The announcement marked an increase from the 12 members the IIF said had agreed to the deal earlier this week.

Still, the group added in a statement that all eligible bondholders "must make their own decisions on whether or not to participate in the debt exchange offers, based on their own particular interests and on the advice and assistance of their own advisers."

The IIF, a Washington, D.C.-based industry group, represented the private sector in the protracted negotiations over the terms of the restructuring. It has more than 450 members in 70 countries.

Separately, German insurance company Munich Re, which was not among the IIF members included in Wednesday's announcement, said it will restructure an estimated €1.6 billion worth of Greek government securities, according to a spokeswoman.

Another potential participant is the Bank of Greece, which has reportedly agreed to swap bonds held by Greek government pension funds.

While the list of volunteers has grown, most analysts expect the agreement will fall short of full participation.

Ideally, Greece would need 90% of bondholders to volunteer for the exchange to close its funding gap.

To ensure that the participation rate is high enough, the Greek government retroactively inserted collective action clauses (CAC) in the contracts that govern its bonds issued under domestic law.

The clauses would give Greece the authority to force bondholders who do not volunteer to take part in the restructuring to abide by the terms anyway.

However, Greece needs a sufficiently large number of investors to volunteer for the restructuring in order for it to be considered a collective action.

On Tuesday, Greece's Public Debt Management Agency suggested that if the participation rate is tool low, bondholders would be subject to restructuring under less favorable terms than the ones included in the PSI deal.

The unofficial target for the participation rate is at least 66%. Anything below that threshold might not be considered voluntary, which would make it difficult to argue that the action was collective.

On the other hand, if more than 66% of investors volunteer for the restructuring, Greece could use collective action clauses to make the terms binding for all bondholders. That could result in an effective participation rate of 100% of domestically issued Greek bonds and unlock the full amount of Greece's bailout.

The agreement involves investors volunteering to write down 53.3% of the value of the bonds and swap Greek debt for securities with lower interest rates. It would eliminate €107 billion from Greece's debt load and save the nation another €150 billion in refinancing costs over the next few years, according to the IIF.

Who's afraid of Greek credit default swaps?

To complicate matters, there is the question of credit default swaps.

Credit defaults swaps (CDS) are derivatives contracts that investors use to insure against, or profit from, a default.

In attempt to avoid triggering CDS contracts on Greek bonds, the restructuring was designed specifically to be considered voluntary.

But analysts say the contracts would be activated if Greece decides to use collective action clauses to coerce bondholders.

The promise of a CDS payout could give bondholders with CDS protection an extra incentive to hold out for a default, potentially reducing the number of investors who sign on voluntarily.