The biggest news in the sovereign debt world this week has come from Greece, which managed to sell some €3 billion in new 5-year bonds at a yield of just 4.95%. This is not what you might expect, given the macroeconomic situation:
Greece’s debt currently stands at about 320 billion euros, or 175 percent of GDP. It is rated nine notches below investment grade at Caa3 by Moody’s. Standard and Poor’s and Fitch rank Greece six notches below investment grade at B-.
So, how does one explain investors’ appetite to buy this debt at such low yields? Here are the top five reasons:
1. This is just part of a momentum trade.
The Greece trade has been astonishingly lucrative for the past two years. Here’s the chart, from the WSJ:
You could have bought post-restructuring Greek debt in May 2012 at a yield of 30%; it’s now down to 5%, and there’s no particular reason to believe that the trend is over. After all, Portugal, which hasn’t even had a restructuring (yet), has five-year bonds trading at a yield of 2.6%. As a result, so long as the “go long Greece and make lots of money” trade is working, there are going to be investors who are happy to jump on the bandwagon.
2. The yield is reasonably juicy.
4.95% might not seem like a lot on its face, but Greece has been suffering from deflation for the past year. Right now the inflation rate in Greece is about -1.5%, which means the real yield on this bond, for a Greek investor, is actually closer to 6.5%. Given that Europe is going to have a zero interest rate environment for the foreseeable future, that kind of real yield is undeniably attractive.
3. There’s potential for significant price appreciation.
With a coupon of 4.75% and a yield of 4.95%, you can buy €1,000 face value of bonds today for €991. Let’s assume that you hold this bond for 18 months, and that at the end of that period the yield has dropped to Portugal’s 2.6%. In that case, you would get three coupons along the way, totaling €71.25, even as the value of the bond itself would have risen to $1,071. If you sell the bond at that point, you’re not just getting your €71.25 in coupon payments, and you’re also getting €80 in capital gains — for a total profit of €151.25. Which is a 15.3% return in 18 months. Not too shabby, in a world of zero interest rates.
4. The chance of default is slim.
Greece has an unsustainable debt load, and will certainly default again in the future. But the key question for anybody buying this bond isn’t whether Greece will default. Rather it’s when Greece will default, and what instruments Greece will choose to default on. So long as Greece continues to pay the modest coupons on this modestly-sized bond for the next five years, it can prove to be a perfectly good investment even if the country is defaulting elsewhere. Similarly, if Greece defaults on its public bonded debt but does so after April 2019, again this bond will be unscathed.
The degree of pain inflicted on Greece’s private-sector bondholders in 2012 was so enormous, and the amount of privately-held debt which is still outstanding is so small, that it’s going to be the official sector’s turn to take a big haircut next time round. In other words, buying this bond does not constitute a bet that Greece, as a sovereign, will not default. It’s just a bet that this particular bond will not default. And that’s actually a bet I’d be willing to take.
5. Mario Draghi is going to do QE.
The worst thing that can befall Mario Draghi, the ECB president, would be deflation across the eurozone. And the German constitutional court notwithstanding, the markets are now convinced that if Draghi needs to implement some kind of quantitative easing in order to prevent eurozone-wide deflation, he will do so. And that no one, including the German constitutional court, will be willing or able to stop him.
Quantitative easing, of course, means buying bonds. And while no one can know exactly which bonds the ECB would buy, one easy and obvious option would be to simply buy the sovereign debt of all eurozone member governments. Including Greek debt. if that happens, Greek bond prices would surely rise, possibly quite substantially. After all, there’s not much point in Draghi doing QE unless he’s going to do it at serious scale.
I’m at the INET conference in Toronto this week, where there’s a lot of talk about “overt monetary financing” in the eurozone. Basically, the euro crisis isn’t over, and there are only three ways to resolve it. One is a pan-European fiscal authority; the second is a breakup of the eurozone. Since neither of those two things is politically possible, the third option becomes a necessity. Which, essentially, is that the ECB swoops in to save the day by printing money. Most of the people I’ve talked to here thinks that Draghi is bound to do that at some point. Which in turn helps explain those low bond yields in peripheral Europe.
None of these reasons, individually or collectively, are particularly good reasons to buy Greek bonds at 4.95%. It has always been very easy to lose a lot of money buying junk-rated sovereign debt at low single-digit yields; that hasn’t changed. But if you’re a bond investor, there’s a surprisingly large number of ways that you could end up making money after buying Greek debt at these yields. Which in turn explains why Greece found it so easy to sell €3 billion in bonds.
Now that Russia seems to have formally annexed Crimea, no one can possibly expect Ukraine to repay Russia the $3 billion it borrowed back in December. The money was given directly to kleptocratic Ukrainian president Viktor Yanukovych in order to buy his fealty; now that Yanukovych is an international pariah and Russia has seized Crimea instead, in what you might call the geopolitical equivalent of a debt-for-equity swap, Ukraine has no legitimate reason to make its payments on the loan.
But there’s a problem here: the loan was not, technically, a bilateral loan from Russia to Ukraine. Instead, it was structured as a private-sector eurobond. As Stephen Gandel says:
There are a lot of other Ukrainian eurobonds out there that look similar to the ones Russia is holding, so not paying the ones Russia is holding will have larger implications for all of Ukraine’s debt, causing prices to fall and interest rates to rise. What’s more, Russia could sell its bonds to the market… That may make a court less likely to invalidate the debt, and Ukraine less willing to do so, if it is held by a private investor, especially a non-Russian one.
This is a notorious vulture-fund move: a hedge fund buys bilateral debt from a sovereign, and then sues not as a sovereign but rather as a private-sector creditor. I can think of a few hedge funds which would be interested in Russia’s debt, if they could buy it at a discount to where the rest of Ukraine’s debt is trading. After all, to use a term you might have seen on this blog in the past, this loan is, legally, pari passu with all the rest of Ukraine’s bonded debt.
(In fact, this bond is arguably senior to the rest of Ukraine’s bonds, thanks to a very unusual provision which allows Russia to accelerate the debt if Ukraine’s GDP falls. But since there now seems to be no chance that Ukraine will pay the coupon on this bond, it’s going to be in default very soon anyhow.)
So, if Ukraine defaults on its $3 billion Russian eurobond, how can Ukraine’s allies prevent that default from having massive negative repercussions on the Ukrainian economy? Anna Gelpern has the answer: The United Kingdom, she says, should make the bonds unenforceable under English law.
Yanukovych’s good-bye bonds would not have to get bogged down in the doctrinal mess of Odious Debt precisely because they took the form of simple English-law contracts, freely tradable in the capital markets and enforceable in English courts… English courts may not have much sympathy for Russia. They may decide that invading a country, bankrupting it, and trying to collect would be too distasteful with or without Odious Debt. Supreme Court Chief Justice (and former President) William Howard Taft offered similar reasons when he refused to enforce claims by private creditors complicit in the escape of another kleptocrat in an international arbitration against Costa Rica in 1923…
To stop the debt from migrating to private hands and showing up in court, now is the time for the UK government to make the Yanukovych bonds unenforceable under English law.
If the UK parliament passes this kind of a law now, before Russia can sell its debt to a vulture fund, that would severely reduce any fund’s appetite for the bond, and therefore minimize the likelihood of the default getting litigated in London.
Gelpern adds — quite rightly — that now is also the perfect time to implement a general ban on countries selling their bilateral debt into the private markets. I’m unclear on what form such a ban would take, or how it would ever be enforced, but as a principle it’s a really good idea.
Even if the UK passes a non-enforcability law, however, the problem of the Russian bond is not going to go away for Ukraine. I’m sure there are cross-default provisions in the rest of Ukraine’s debt, which means that Ukraine’s existing bondholders are likely to be able to accelerate whenever they feel like it. Again, think vulture funds here: a small group of aggressive funds could quite easily buy up 25% of one of Ukraine’s other bond issues, and then declare the whole amount due and payable immediately. As a result, even if Russia never gets its $3 billion back, and never sells any of its bonds, the structure of the December deal could still come back to haunt Ukraine.
All of this was entirely deliberate on Russia’s part. And of course the damage that Russia caused to Ukraine by structuring its loan as a bond is pretty much nothing, compared to the damage it’s causing by seizing Crimea. But it is a reminder that wonky sovereign-debt distinctions can have real geopolitical importance. As Argentina, for one, is well aware.
Puerto Rico, which is already junk-rated and which is facing yet another downgrade to its credit rating, is in no position to call any shots when it comes to raising new debt. If it wants to borrow new money — and it looks like it wants to borrow a hefty $3.5 billion in the next few weeks — then it’s going to have to make whatever concessions its lenders want. That means paying a very hefty interest rate in the 10% range, of course. But it also means changing the governing law of the bonds, from Puerto Rico to New York.
Notably, the Puerto Rican government was very careful to ensure that it would not waive its sovereign immunity, except as regards “legal proceedings with respect to such bonds”. The result is that Puerto Rico seems, on its face, to be setting itself up for a nasty, drawn-out stalemate a la Argentina, where bondholders sue a sovereign nation in New York, trying to claim all the principal and past-due interest that they’re due, while the sovereign in question responds that all of its assets are immune from attachment. That’s definitely not the kind of fight that the hedge funds lending Puerto Rico money would ever want. So why are they insisting on New York law?
The answer is that the hedge funds lending to Puerto Rico basically look at bond contracts, and New York law, in much the same way that Argentina does. In fact, they would be very upset if Puerto Rico treated its new debt in the way that Argentina’s opponents — and a number of New York federal judges — like to think.
At stake, of course, is the fate of Puerto Rico’s bondholders if and when the territory ever defaults on its obligations. Already, some Puerto Rican lawmakers are saying that’s exactly what should happen, and there’s no obvious fiscal track to debt sustainability, so default is a very real risk, and the main thing that lenders want to protect themselves against.
Historically, default protection has come mainly in the form of asset-backed bonds. Most of Puerto Rico’s debt is backed by some revenue stream or other: even if the government defaults, the state-owned utilities and the like will still have revenues which can be attached (at least in theory) by bondholders. But here’s the problem: if I held one of those revenue bonds today, I would not feel particularly confident in my ability to continue to get my coupon payments, even in the face of a government default.
The problem is precisely that so much of Puerto Rico’s debt is collateralized in this way. If we reach the point at which Puerto Rico needs to default in order to get its fiscal house in order, then it will have to restructure (which is to say, default on) its revenue bonds. If those are untouched, then the problem doesn’t get solved, and there’s really no point in defaulting in the first place. No one knows exactly how Puerto Rico would do such a thing, but legislation would probably be involved — if Greece can do it, then there’s a decent chance that Puerto Rico can, too. The idea is to pass a law which, in effect, makes it legal to default on your debts. And since those debts are issued under domestic law, there might not be much that bondholders can do about it.
Conversely, if Puerto Rico defaults with a relatively small quantity of New York-law debt outstanding, it’s probably easier for Puerto Rico to just continue to pay the coupons on that debt, rather than try to restructure it. Again, Greece is the precedent here: while debt under Athens law was restructured, debt under London law continues to be paid in full. Puerto Rico could default on its New York-law debt, of course — but doing so would severely cripple the island’s ability to do business with the mainland; would involve paying massive legal fees for years to come; and probably wouldn’t move the needle very much when it came to debt sustainability.
The point here is that the concept of seniority doesn’t really make a lot of sense when you’re not operating in the context of a formal bankruptcy regime. A bankruptcy judge can ensure that a debtor pays senior creditors first, and junior creditors last. But in a sovereign context — which includes Puerto Rico — there is no such thing as bankruptcy. In the Argentina case, the New York courts are trying to enforce an idiosyncratic reading of the formerly-obscure pari passu clause to try to bring back some semblance of seniority into the sovereign debt world, but it’s a knock-down, drag-out fight, and no one knows how it’s going to end. The overarching principle in sovereign debt remains the principle that has governed Argentina’s behavior ever since it defaulted well over a decade ago: a sovereign government can and will pay whomever it likes, whenever it likes, wherever those people think that they might stand in terms of some theoretical seniority chart.
As a result, creditors in Puerto Rico aren’t looking for de jure seniority; they’re looking instead for de facto seniority. And the way to get that is to be part of a small group of bonds which is more trouble than it’s worth to restructure.
That strategy generally works very well. When most of Latin America was busy defaulting on its sovereign loans in the 1980s, for instance, the countries in question generally stayed current on their sovereign bonds — just because the loan stock was big, and mattered, while the bond stock was small, and didn’t. Similarly, when Russia defaulted on its debt in the late 1990s, it defaulted on its large stock of domestic bonds, but stayed current on its much smaller stock of international-law bonds, for exactly the same reason.
So when you see hedge funds demanding that their new Puerto Rico bonds be issued under New York law, don’t kid yourself that they particularly value the protections that New York law gives them, or that they think that New York courts will allow them to recover most of their money in the event of default. Rather, they’re just hoping that Puerto Rico won’t bother defaulting on those bonds in the first place. And they might well be right about that.
Argentina, as everybody knew it would, has gone to the Supreme Court to appeal the bad (and ignoble) ruling against the country by New York’s Second Circuit. The most likely final outcome, still, is that Argentina will default, for the reasons (but not with the timing) I gave last year. But, with this petition, Argentina now has three possible outs.
Call them sovereign immunity, pari passu, and the bondholders’ ransom. None of them is particularly likely to happen — but add them all together, and there’s still a glimmer of hope for Argentina.
1. Sovereign Immunity
The first one is, in a sense, the obvious one. Argentina has appealed the lower court ruling to the Supreme Court, and it is possible that the Supreme Court will accept the case, hear it, and find in favor of Argentina. (If that happens, the decision would come down some time between October 2014 and June 2015.)
The Supreme Court needs to rule on a matter of federal law, and Argentina has just such a matter: the Foreign Sovereign Immunities Act (FSIA). Sovereigns by their nature can’t be bound by US courts — and there’s federal legislation to that effect. Argentina has a long list of legal arguments surrounding FSIA, but at heart its case is simple: the judge in New York is trying to force Argentina to use its reserves to pay its holdout creditors. But the judge can’t legally do that, because Argentina’s reserves are immune assets. And if such assets can’t be attached directly, they can’t be requisitioned indirectly, either. As the petition says,
The whole point of the FSIA’s two-part immunity scheme is that a foreign sovereign may “refuse to pay” immune assets to satisfy a money judgment, even when the sovereign is subject to a court’s jurisdiction. That is the basic structure of the FSIA, not a defect that justifies an injunctive remedy.
The sovereign-immunity argument has been well rehearsed in lower courts. Elliott will say that Argentina explicitly waived sovereign immunity in its bond documentation, and that the injunctions are, on their face, quite agnostic as to where Argentina finds the money to pay the holdouts — or even whether Argentina finds the money to pay the holdouts. They just want to put the holdouts on an equal footing (pari passu, you might say) with the existing bondholders, so that if the holdouts aren’t being paid, then the bondholders won’t be paid either.
Are the finer details of sovereign immunity and district-court discretion really something the Supreme Court wants to litigate? It’s certainly possible that the Supremes will accept the case, especially since the US government supports Argentina on this narrow issue. Over the next few weeks we’ll see a series of amici file briefs for and against Argentina in this case; if the US is one of them, along with other major international powers like the IMF and France, then that might persuade the Supremes to hear the case. That said, however, there’s no very clear constitutional issue at stake — and neither has there been any disagreement between lower courts. At heart, this is a commercial issue, and the Southern District generally covers commercial issues very well. It’s not clear that the Supreme Court has any particular need or appetite to strike the Southern District down.
2. Pari passu
The second out for Argentina is a kind of backup plan, in case the Supreme Court doesn’t see anything it particularly wants to hear, but is still sympathetic to Argentina’s cause. The bond documentation being litigated here — the notorious pari passu clause — was written under New York law, but so far all the judges interpreting it have been federal judges, not New York judges.
Argentina says — rightly, I think — that the federal courts’ interpretation of the pari passu clause “is deeply flawed”. What’s more, it says, “no New York court has ever interpreted a pari passu clause in a sovereign debt contract”. The federal courts have certainly been clear about what they think the clause means, but they’re not in charge of New York law:
The New York Court of Appeals should have the final word on whether the pari passu clause prohibits a sovereign from continuing to service performing debt without servicing defaulted debt. If New York courts want New York law to upset settled expectations, impede restructurings, and endanger New York’s status as the law of choice for sovereign debt, that is their prerogative. But they should not have those consequences thrust upon them.
Argentina is therefore giving the Supremes another out: if they don’t want to hear the case themselves, they can send it down to the New York Court of Appeals, in the form of something called a certified question. (Basically, the Supreme Court would be asking the New York court to settle a question of New York law, rather than deciding the issue itself.) If the New York court then found that the federal courts’ interpretation of the clause was indeed deeply flawed, then they would have the power to overrule it, and thereby vacate the federal court order. Clever!
This seems like a good idea to me. The interpretation of the law should not be done by people who are the victims of the law — and in many ways the federal courts here are the victims of what they consider to be Argentina’s “contumacious” behavior. Basically, the federal courts have consistently awarded money judgments against Argentina, and Argentina has consistently ignored those judgments, and the federal courts have become highly annoyed and frustrated with Argentina as a result. And you don’t want annoyed and frustrated judges making law; you want the law to be interpreted dispassionately. As Argentina puts it:
In reacting to the district court’s injunctions, Argentina thus has not behaved like a contumacious litigant—it acted like a sovereign, displaying exactly the affront that Congress intended for the FSIA to prevent. Any sovereign would protest if a foreign court issued an extraterritorial order threatening its creditors and citizens and coercing it into turning over billions of dollars from its immune reserves.
By sending the case to the New York court, the Supremes would basically be appointing an impartial set of judges, who hadn’t had their noses tweaked for a decade by an affronted sovereign, to decide the meaning of the pari passu clause. It’s a clever idea, on the part of Argentina — but it’s also, sadly, by all accounts, very unlikely to happen.
3. Bondholders’ ransom
Which leaves just one other option for Argentina — and it’s an option which doesn’t involve the Supreme Court at all. The holdout creditors, led by Elliott Associates, say that they want a “negotiated settlement” — and it turns out that the bondholders want exactly the same thing. In public, they’ve called for “an inter-creditor transaction”. In practice, what that means is that they’re willing to give up some of their future coupon payments, if doing so will make the holdouts go away.
The idea is that over the next five years, Argentina is scheduled to pay its bondholders some $7.5 billion in coupon payments. The bondholders — or at least 23 of the biggest bondholders — are willing to see that number reduced by 20%, to $6 billion. And they would be willing to let the holdout creditors, led by Elliott Associates, pocket the other $1.5 billion, if it would help end this whole litigation nightmare.
I spoke to one of the bondholders last month, who said that “this is a hostage crisis, and we’re asking to pay the ransom”. And it’s easy to see why. Argentina’s bonds are trading at about 65 cents on the dollar right now. If Elliott forces a default, then those bonds will plunge in value to about 30 cents. If, on the other hand, the Elliott issue is resolved, then Argentina’s bonds would probably start trading at well over par. So whatever the bondholders lose in terms of future coupon payments, they more than gain in terms of the increased value of their bonds. As the bondholder told me, “I will pay five cents to have a hundred-cent bond rather than a thirty-cent bond”.
If you do the math on this proposal, it all makes a certain amount of sense. The bondholders, as we’ve seen, would make a substantial mark-to-market profit — while the holdout creditors would make even more. Take as an example a holdout creditor with $300 million, face value, of bonds. That creditor is asking, today, for some $700 million in principal and past-due interest. Argentina’s official offer, which is to simply reopen the terms of the old restructuring, would give that creditor bonds worth about $225 million — that’s less than face value.
But if the existing bondholders gave up 20% of their future coupons for the next five years, that would add a sweetener of about $150 million, in present value. On top of that, thanks to the rising tide of spread compression which would lift all the boats, the value of the exchange bonds would rise from $225 million to about $280 million. Add it all up, and the holdout is now being offered bonds worth $430 million or so — which is an extremely good deal, if those bonds were bought for about 25% of par, or $75 million.
The mechanics of such a deal would be complicated, to say the least. First, there would have to be a consent solicitation, where Argentina proposed a deal to all of its bondholders, asking them whether they would be willing to give 20% of their next five years’ coupon payments to the holdouts. Such a deal would be contingent, of course, on the holdouts accepting the offer. The threshold here would be 75%: under Argentina’s collective action clauses, 75% of its bondholders can, in principle, agree to do such a thing, and thereby bind everybody else.
Could Argentina, as well as Argentina’s big bondholders, persuade 75% of the existing bondholder base to accept such a coupon reduction? Nothing like it has ever been tried in the past, and the whole thing does smell of rewarding the very vultures who have made bondholders’ lives so tough for so long. So it wouldn’t be easy. What’s more, it’s not even clear that Argentina wants to attempt such a thing. The country’s powerful finance minister, Axel Kicillof, has come out against the idea, as part of his political infighting with Hernán Lorenzino, who’s nominally in charge of the restructuring, and who likes the idea.
The next step would be to get the holdouts to accept the deal — and that step would, if anything, be even harder. Elliott has said that the idea is “beyond bizarre” and “a stunt” — and even if Elliott were persuaded to change its mind, there are other holdouts, too, like Ken Dart, who might be even harder to bring around.
I suspect that a negotiated deal between the holdouts, Argentina, and the bondholders is exactly what the Second Circuit wanted all along. My impression is that they hoped that if they were very tough, that would bring the various sides together and make a negotiated resolution more likely. But when you’re dealing with individuals like Cristina Kirchner, Paul Singer, and Ken Dart, no one ever wants to budge. So even though many bondholders are willing to grease the negotiations to the tune of $1.5 billion, the chances are that a negotiated settlement is still not going to happen.
Despite the fact that there are now three ways out of this mess, then, I still reckon it’s going to end in tears — that is, in Argentina defaulting on its bonds. The only real question is when.
Ryan McCarthy has a good round-up of Puerto Rico’s debt problems, which have now been exacerbated by S&P downgrading the island’s bonds to junk status. (Moody’s and Fitch are certain to do so as well, in short order.) For a good one-stop overview of most of the big issues, I can recommend Nuveen Asset Management’s note, which includes this chart:
What you’re seeing here is a vicious cycle: as debt problems pile up, economic activity decreases, which causes even bigger debt problems, even lower economic activity, and so on. Puerto Rico is now shrinking at a 6% annual pace, and that number is probably going to get worse before it gets better. The chances of the island’s economy actually growing at any point in the foreseeable future seem remote: indeed, the country has essentially been in one long and nasty continuous recession since 2006.
Puerto Rico has $70 billion in debt outstanding, all of it needing to be repaid with interest — and the simple fact is that there’s no way it’s going to be able to do that, if its economy continues to shrink and its most talented nationals continue to decamp for the mainland, where their prospects are much brighter. Labor mobility from Puerto Rico to the rest of the US, and particularly to Florida, has never been higher, while most of the migration in the other direction comes in the form of retirees, who are not exactly going to kick-start the economy. In fact, in terms of the labor force participation rate, they’re just going to make matters worse, on an island where only 1.2 million of the 3.4 million inhabitants are employed.
In many ways, Puerto Rico is similar to those other tourist destinations, Portugal and Greece — it’s highly indebted; it’s not particularly well educated (only half of Puerto Ricans over 25 have graduated from high school, and only a quarter of high-school graduates go on to get a bachelor’s degree); and it is hobbled by being unable to devalue its currency.
All of this is a clear recipe for default: if Puerto Rico can’t repay that $70 billion in debt, then it won’t. The only alternative is a bailout — but as Martin Sullivan explains, the US government has already extended a back-door tax-code bailout worth some $2 billion per year, and even that is both insufficient and constitutionally dubious. A more explicit bailout is not going to happen — not when Detroit is being left to deal with the ravages of bankruptcy on its own.
The good news is that the increasingly-inevitable default is not hugely harmful in itself. It’s not fully priced in: the funds owning Puerto Rican debt are going to take more losses, if they don’t sell now. And the insurers who have wrapped some $15 billion in Puerto Rican debt are going to have to get used to making a lot of coupon payments for quite a long time. But that’s their job. This is the way debt markets should work: if you lend money at high rates of interest to someone who can’t pay it back, then you have to understand there’s a pretty good probability of default.
The default will be messy, however, since there’s no chapter of the US bankruptcy code which encompasses Puerto Rico. A lot of different court cases will be held in a passel of different jurisdictions, and a lot of lawyers will get rich. In the end, everybody is going to have to take a nasty hit — including the island’s retirees, whose pension fund is woefully underfunded. From a legal perspective, there will be some fascinating arguments about sovereign immunity, and whether (and how) bondholders can attempt to enforce their contractual rights, absent any kind of overarching bankruptcy regime. In the end, restructuring terms could end up simply being dictated by Congress.
Still, the important thing is not the process, it’s the final outcome. If Puerto Rico manages to emerge from default freed of its massive debt burden, it will finally have a chance to start growing again. If it doesn’t, it won’t. The problem is that there’s no easy way of herding the bondholders and bond insurers, all of whom are going to want to maximize their financial recovery, thereby making Puerto Rico’s real recovery that much more difficult.
My advice to the Puerto Rican government, then, is this: start having quiet conversations in Washington about a piece of legislation which would give the island the legal freedom and ability to restructure its debts in a clean, one-and-done manner. Such a law would not be a bailout: it would involve no money flowing from DC to PR. But it would allow Puerto Rico to default on its debt and come out the other side, without the risk of years of legal chaos. While bondholders would squeal, at least they would get certainty. And Puerto Rico would get something much more valuable still — an opportunity to finally drag itself out of its horrible recession.
JP Morgan’s Nikolaos Panigirtzoglou put a fascinating report out last week, looking at supply and demand in the global bond market in 2014. And although I consider myself something of a bond nerd, I was genuinely astonished by some of the charts he put together, starting with this one:
This chart alone suffices to explain why the markets care so much about the taper: central-bank buying accounts for $1.6 trillion — more than half — of the total demand for bonds in 2013. Meanwhile, private banks are taking the opposite side of the trade: while they were huge buyers of bonds in 2007 and 2008, they’re net sellers in 2013 and 2014, more or less completely negating the buying pressure from pension funds, insurance companies, bond funds, and retail investors. In 2014, it seems, substantially all the net demand for bonds is going to come from the official sector. So it matters a great deal when that demand is diminished.
What’s more, central-bank buying, overwhelmingly from the Fed and the Bank of Japan, accounts for the lion’s share of official-sector buying: sovereign wealth funds and other foreign official institutions will buy just $364 billion of bonds this year, according to JP Morgan’s estimates, down from $678 billion last year. So the heavy lifting is still going to have to be conducted by QE operations, in the face of a taper which JP Morgan estimates at $500 billion over the course of the year. (The assumption is that it starts in January, and is completed by September.) Between the taper and other sources of diminished demand, total bond-buying firepower is likely to be $750 billion smaller in 2014 than it was in 2013. Bad news, for bonds, right?
Not so fast! It turns out that even as demand for bonds is shrinking, the supply of new bonds is shrinking just as fast:
Again, this chart surprised me: I knew that government debt was a very important part of the total bond market, but I wouldn’t have guessed how important it was — or how fast it is shrinking.
Panigirtzoglou puts the two charts together, and you end up with this result:
In total we expect bond supply to decline by $600bn in 2014 to $1.8tr, more than offsetting the $500bn decline in bond demand due to Fed tapering. The balance between supply and demand, i.e. excess supply, looks set to widen from $140bn in 2013 to $280bn in 2014.
That number has pretty large error bars: you could pretty much cover the entire thing just by delaying the taper for three months. So let’s not worry too much about the difference between the two estimates, here. Instead, step back and look at the big picture, which is pretty simple: as a stylized fact, the bond market is dominated on both sides by the official sector. Private participants might sit in the middle as market-makers, or try to borrow money here or there, but overall what you’re looking at, when you look at the bond market, is government issuing debt and governments buying it.
The good news is that this large transfer of money from the official sector’s left hand to its right hand is slowing down, but that’s going to take a while. In any case, there doesn’t seem to be any conceivable way that the private sector could possibly be able to fund the still-substantial government deficits which have been bequeathed to us by the financial crisis. As a result, I suspect that QE is likely going to be around for a while, just as a matter of mathematical necessity. The world’s national deficits can’t get funded any other way.
In the September issue of Euromoney, Peter Lee has a huge investigation into what he calls “the great bond liquidity drought”. The landing page for the story features subscriber-only links to the whole thing, as well as free-to-access links to various sections. But it also neatly summarizes the problem a single paragraph:
Liquidity is drying up across the bond markets. Regulations designed to curtail banks’ leverage have had the unintended consequence of also sharply reducing their ability and willingness to make markets in corporate and even government debt. New regulations on the leverage ratio that will reduce banks’ repo funding books threaten to make matters even worse and to spread the drought from credit markets to rates, the underpinning of all financial markets. Secondary markets are close to a breakdown that will soon imperil the primary markets on which companies and sovereigns depend for funding. All that is masking the decay is the extraordinary actions of central banks.
Here’s a chart from Citigroup which helps show at least part of the story:
This chart doesn’t just cover Citigroup, it covers all bond broker-dealers. They massively increased their inventory of bonds during the 2000s bubble — but so did everybody else: total credit assets were raising substantially over that period. Then, after the financial crisis, came the great divergence. Broker-dealers retreated from the market, even as investors continued to seek the safety of bonds. So while broker-dealers were about half the size of the credit mutual fund industry in 2007, according to the quantity of assets they owned, today they’re only about 1/20th of the size. And those broker-dealers are still the only real liquidity providers in the market. If you want to buy or sell a bond on the secondary market, there’s really only one way to do it: phone a bunch of broker-dealers, ask them to make you a market, and either accept the best price you find, or don’t.
Lee’s article makes a very strong case that the only way out of this problem is for buy-side institutions to start trading directly with each other, since the broker-dealers have enough to be able to provide good service only to their very best clients. But neither of the two buy-side bond market giants (Blackrock and Pimco) seem to have been able to make such a system work, and although the MarketAxess system is growing fast, there isn’t going to be any fundamental change unless and until bond investors start making buy/sell markets of their own. Which is simply not going to happen: bond investors don’t tend to think in terms of opportunistic trading, precisely because their portfolios are so illiquid. What’s more, the ability to make a two-way market is contingent on the ability to buy one name when you sell another, which is not something anybody can reliably count on being able to do any more.
In other words, we’re living through a vicious cycle: the less liquid the market gets, the less ability there is for anybody to make markets, which in turn just worsens the liquidity problem. And things are only going to get worse still if and when QE goes away.
The implications, as Lee says, are enormous. The whole point of bonds is that they’re tradable: you don’t need to hold them to maturity. But increasingly you do need to hold them to maturity, since finding a buyer for your inventory is extremely difficult — especially if you’re investing in size. This is one reason why the two big bond investors arguably pose a systemic risk: if either one of them were to suffer substantial withdrawals, the selling pressure on the market would be so enormous that the entire bond market could pretty much cease to work. It’s already extremely difficult for bond funds to grow without changing their risk profile: while it’s possible to buy large positions in the primary market, it’s basically impossible to continue to add to those positions as your fund increases in size.
Part of the problem is the degree to which the market is fragmented: GE has more than 1,000 separate bond issues, while Citigroup has almost 2,000. (Both of them, of course, have only one equity security outstanding.) But there’s little incentive for companies to issuer fewer separate bonds, since the primary market is the one place where the bond market actually seems to work. And besides, if the bond market becomes harder to navigate, companies always have the option of going to the loan market instead, or raising equity instead of debt.
For sovereigns, however, the fate of the bond market is of paramount importance: they have to be able to issue debt, even as major banks are withdrawing from the markets entirely. And sovereign bonds are being hit just as badly as corporate bonds by the liquidity drought:
Traders say that without moving the price the markets might still absorb a large customer order for €250 million in German Bunds, maybe €100 million in French government bonds, perhaps €50 million in Italy and €25 million in Spain.
In Portugal, which has no direct market access of its own, Lee adds, it’s almost impossible to buy a position of any size at all without moving the market, with even the benchmark 10-year bond gapping out as much as 100 basis points on minimal underlying volume.
The result is that the bond market is going to have to contend with more than just rising rates over the next few years: it’s going to have to deal with rising illiquidity premiums as well. A bond yield will be the benchmark rate, plus the credit spread, plus the illiquidity premium, and it’s going to become impossible to disentangle the last two variables, especially when benchmark government bonds themselves are often quite illiquid. The effect on aggregate global borrowing costs could add up to trillions of dollars, and severely crimp the ability of the bond markets to finance growth.
Still, over time, those extra trillions of dollars are going to find their way into the pockets of bond investors: an illiquidity premium is still a premium. It’s never nice to see rates rise, but once they’ve risen, the extra yield will surely be very welcome to savers. And for the time being, at least, borrowing costs are not really a problem for most issuers with market access. If companies have to pay an extra 50bp to borrow money, so be it — they’ll live.
Sovereigns, however, are another story — they need to borrow in size, and they have historically relied on liquidity issues to ensure that they get the cheapest possible rate. (That’s the main reason why US Treasury bonds have the lowest yields in the world, on a swapped-into-dollars basis: it’s all about the liquidity, not the credit risk.) The great bond liquidity drought is arriving at the worst possible moment for G20 sovereigns which are already struggling with unprecedented levels of bonded debt. It’s always liquidity that kills you, not insolvency: it’s the inability to roll over your debts as they come due. Which means that the next wave of sovereign debt defaults might come even sooner than many analysts currently fear.
Bond spreads, along with their close cousin credit default swaps, are a beautifully linear measure of sovereign default risk. They go up in a straight and steady line: the higher the number, the riskier the country is perceived to be. And so they’re normally the first and last place that people look when they’re interested in the chances of any given country defaulting.
But of course the world isn’t quite as simple as that, and — as we have learned the hard way — it’s the unexpected defaults which are the most damaging. So I asked Ben Walsh to put together this chart for me, showing a different measure of risk. It’s not a better measure, by any means. Still, it’s an interesting measure all the same, and it’s almost entirely uncorrelated with credit spreads.
The red bars, in this chart, are the credit spreads we’re all familiar with. Countries like France, the UK, Canada, and Germany are considered effectively risk-free, while Spain and South Africa and Italy are riskier, India’s worse, Greece is very bad, and Argentina is truly dreadful.
And then there’s the blue bars, which are related to the concept of a “sudden stop”: when all the windows close, and a country simply can’t borrow money any more. Such things can arrive with astonishing speed: the markets, in general, will only lend if they think that everybody else is willing to lend. So it’s easy for them to shut down very quickly indeed.
The blue bars are also related to the fact that sovereign creditworthiness, at least as the markets understand it these days, is not really a measure of a country’s ability to pay off its debts in a timely fashion. Japan is a highly creditworthy country, but it also has public debt of a quadrillion yen. Which, it is safe to say, it will not be able to pay off at any point in the foreseeable future.
In order to be considered creditworthy, even to the point of being considered risk-free, all you need to be able to do is roll over your debts, as they come due. There’s something scarily self-fulfilling about this state of affairs: if it’s all one big confidence game, then the minute that a country for whatever reason becomes unable to continue to borrow money, then catastrophe is imminent. And, as we saw during the debt-ceiling debacle, there are a lot of reasons why a country might become unable to continue to borrow money.
In a forthcoming paper, Lee Buchheit, the Cleary Gottlieb partner and godfather of sovereign debt restructuring, writes this:
No purchaser of a sovereign debt instrument today does so in the hope and expectation that when the debt matures the borrower will have the money to repay it. The purchaser does so in the hope and expectation that when the instrument matures the borrower will be able to borrow the money from somebody else in order to repay it. This is a crucial distinction. If by sovereign creditworthiness we mean that a sovereign is expected to be able to generate enough revenue from taxes or other sources to repay its debts as they fall due, then most countries are utterly insolvent…
We have allowed a financial system to develop for sovereigns that assumes a more or less perpetual state of benignity — in the debtor country, in the region, in the global economic and political environment and even in the natural world. A disturbance in any of these areas, if it frightens investors sufficiently, risks interrupting the expectation of refinancing that defines sovereign creditworthiness. Many sovereign borrowers would last only a few months, some only a few weeks, if shut off from the ability to refinance their maturing debts. Denied continued market access, they would burn through their reserves with frightening speed.
This is the idea behind the “hang time” measure in the chart above. What we did was to take a country’s primary deficit — the amount it needs to borrow every year to finance its operations — and add on its total annual debt service. We then took that number and divided it into the country’s total foreign reserves, to get an idea for the length of time that sovereign reserves would be able to fund not only operations, but also all of the country’s debt service requirements.
The results are quite startling. Some countries do extremely well on this measure: Russia, for instance has a primary surplus which is higher than its annual debt service, so it could quite happily continue to service its debt in perpetuity, even in the event of a sudden stop. And Argentina looks very healthy on this measure as well: it has a hang time of 280 weeks, or well over five years. Germany and Brazil would both last about three years; even Portugal would last more than a year. But the UK would run out of money in six months, the US would go bust in 17 weeks, and France has just nine weeks’ worth of reserves. Japan would have only about 14 days.
Of course, countries like Japan and the UK borrow overwhelmingly in their own currencies, and can always, if push comes to shove, print more of it. The US is in the same boat — and, to boot, has the exorbitant privilege of printing the world’s reserve currency. Where fiscal solutions fail, monetary solutions are likely to look attractive. But the chart does show how incredibly fiscally precarious many of the world’s safest credits really are.
Last weekend, at the IMF annual meetings, I moderated an official panel with the snooze-worthy title “Sovereign Debt Restructuring: Lessons from Recent Experience”. But the room was packed, and attention was rapt: everybody wanted to know what the panelists in general, and one in particular, thought about the subject at hand. All eyes were on first deputy managing director David Lipton, who kicked off proceedings with a dry but important speech in which he praised a recent Brookings report as “excellent”.
Lipton’s speech came in the wake of a 49-page paper the IMF released in May, which tried to lay out the issues as seen from Fund headquarters. The paper raised quite a few eyebrows, since it marked the first time in a decade that the IMF has talked in public about changing the international financial architecture around debt restructuring. Its last attempt to tackle the subject, known as the Sovereign Debt Restructuring Mechanism, or SDRM, died ignominiously, bereft of any US support.
What do I think about Lipton’s idea? If you scroll down to the end of this rather long and dense post, you’ll find out. It’s OK, there won’t be a quiz, and you don’t need a detailed understanding of everything I’m going to cover in order to understand my conclusions. But for the suprisingly large number of sovereign debt nerds out there, I’m first going to lay out the issues, as they were presented during the IMF meetings.
Lipton, in his speech, said that he was worried that “official resources, including from the Fund, would be used to pay out other creditors”. He also said that “in cases where the need for debt reduction may be unclear at the outset, in our view the key is to keep creditors on board while the debtor’s adjustment program is given a chance to work”.
This idea is very close to the “standstill” that was originally proposed as part of the SDRM; another name for it is “default”. And as veteran sovereign debt advisor Rafael Molina patiently explained later on in the panel, sovereign debt managers will, as a rule, do anything to avoid defaulting on their debt. As a result, tensions are naturally very high whenever this idea is brought up, despite the upbeat spin that the IMF puts on it in its paper:
The primary objective of creditor bail-in would be designed to ensure that creditors would not exit during the period while the Fund is providing financial assistance. This would also give more time for the Fund to determine whether the problem is one of liquidity or solvency. Accordingly, the measures would typically involve a rescheduling of debt, rather than the type of debt stock reduction that is normally required in circumstances where the debt is judged to be unsustainable. Providing the member with a more comfortable debt profile would also have the additional benefit of enhancing market confidence in the feasibility of the member’s adjustment efforts, thereby reducing the risk that the debt will, in fact, become unsustainable.
Translating into English, the IMF here is essentially saying this: “Sometimes we don’t know whether a country’s debt is too high. We need time to work that out. But if we’re lending, during that period, then while we’re deciding whether or not the country’s debt is sustainable, we’re going to force it to default on its private debt.”
There are two big worries at the IMF, according to Lipton. The first is that the IMF sometimes ends up lending money to sovereigns too late, after the country in question has already racked up an unsustainable quantity of debt. The second is that when the IMF does lend money to a troubled sovereign, that money just turns around and leaves the country entirely, in the form of coupon payments to foreign bondholders. In other words, the IMF doesn’t want to be the last chump lending, even as everybody else is using an IMF program as a path for smoothing their exit out of the country.
Hence the IMF’s latest idea, which is not (yet) a fully-fledged proposal, but which is intended to become one at some point. Basically, if you’re a country with a high and possibly unsustainable debt load, then new IMF loans are going to come with the mother of all strings attached: you’re going to have to stop paying back your existing private creditors in full and on time. Instead, you’re going to have to restructure those loans, somehow — term them out, force them to be rolled over — and in doing so you’re going to see all of the ratings agencies, and all of your CDS contracts, unambiguously declare that you have defaulted on your debts.
In the private sector, such financing is extremely rare: you don’t often see lenders to a company insisting that before they lend, the borrower has to stop paying back its current debts as they come due. There’s really only one situation where that ever happens, which is the case of debtor-in-possession financing after a company files for bankruptcy. So despite the fact that the IMF is adamant that it is not attempting — second time lucky — to create a sovereign bankruptcy regime, it does look as though the Fund is steering in that general direction.
Indeed, it looks like the Fund is aiming for a kind of muddled middle — one which is the worst of both possible worlds. On the one hand, it’s going to force countries to default on their debts; on the other hand, after coming out of default, the countries in question will still have debts which are far too high. The good thing about bankruptcy proceedings is that companies emerge from them in viable form, even if doing so means that creditors are forced to take substantial losses. But if all the IMF wants is “more time for the Fund to determine whether the problem is one of liquidity or solvency” — and if it then makes the determination that the country is actually insolvent after all — then the mild restructuring will have to be followed with a much harsher one. And if defaulting once is bad, defaulting twice in short succession is much, much worse.
The official sector understands this fact about markets, although it has never much liked it. Official-sector creditors, including the IMF and its shareholders, never mark to market: when they make loans, they always keep those loans on their book at par, until such a day as the loans are officially written off. The result is the classic series of Paris Club restructurings, where loans get rescheduled, coupons get reduced, and the present value of the debt continually declines — but not where it matters, on the books of the creditors. If you’re a sovereign creditor, rescheduling debts costs you almost nothing, and so it is indeed a great way of buying time for the debtor.
But the Paris Club, just like the IMF, doesn’t like the idea that its generosity will be taken to the bank by private-sector creditors. As a result, it insists on something called “comparability of treatment”: if a country is getting a good deal from the Paris Club, then it needs to negotiate something similar with its private-sector creditors at the same time. Which might be possible when the private-sector creditors are banks, which can sit down across a negotiating table and hammer something out — especially if the banks in question are able to continue to hold the loans on their books at par, on the grounds that they’re being held to maturity.
When the private-sector creditors are bondholders, however, everything changes. The cost of restructuring bonds — a very public default — is much higher than the cost of restructuring loans. And so there’s a constant tension between the official sector and the private sector when it comes to restructurings. The official sector likes to drag things out, in a series of deals; the private sector much prefers to do a single big deal — what’s known in the trade as “one and done”.
In other words, the noises coming out of the IMF aren’t particularly new: they’re pretty standard official-sector whines. What’s new is that it’s the IMF making them, after a decade of studious silence on the subject.
The Fund is treading much more cautiously this time around than it did ten years ago. It’s listening to just about everybody with an interest in the subject, including the wide range of views represented by its own board. (While creditor countries can see where the Fund is coming from, debtor countries are generally pretty solidly opposed, since they fear that any moves in this direction will only serve to drive up their borrowing costs.) Before my panel, for instance, the Fund hosted a discussion between 20-odd experts from the private sector and academia, with a wide range of views.
I was impressed by the certainty with which the various participants expressed their views, because I have no particular dog in this fight, and generally just find myself agreeing with whoever the last person to speak was. Virtually everybody there had an extremely strong case, despite the fact that many of them were deeply opposed to each other. I’ll try to give a flavor of the full range of views here, since it was hard to do that in the public panel. Obviously, many of these views are mutually inconsistent, but they’re all held by some important constituency somewhere — which should give you an idea of how hard the IMF’s job is, if it wants to achieve any kind of consensus on this issue.
The best place to start, though, if only because the views have names attached to them, is the Brookings report. The lead authors include Lee Buchheit, the dean of sovereign debt restructuring, and lawyer who has represented debtor nations around the world. Also on the lead-author list is Jeromin Zettelmeyer of the EBRD, although he’s at pains to point out that his involvement in the report was personal, and that the report does not necessarily reflect the views of the EBRD. More interestingly still, if you look down the list of other committee members involved in putting this report together, you’ll find the name of the biggest buy-sider of them all, Mohamed El-Erian. From what I can glean, he was not an active participant in the process. But the fact that his name is here at all is noteworthy, since there’s a lot in the report to antagonize the buy side in general.
The report unapologetically uses the b-word in its title, “Revisiting Sovereign Bankruptcy”, and is a pretty radical document, if by “radical” you mean the opposite of “market-friendly”. It says that there’s now “a much stronger case for an orderly sovereign bankruptcy regime today than ten years ago”, and lays out what is referred to by critics as the “Greece and Griesa” argument. Basically, the lesson of Greece — and of the euro crisis more generally — is that sovereign overindebtedness is a much bigger problem than anybody thought it was in 2003. As such, if some kind of sovereign bankruptcy regime helped to constrain the amount that countries could borrow on the private market, well, that might be a good thing, rather than — as people thought in 2003 — a self-evidently bad thing. On top of that, Thomas Griesa, a federal judge in New York, has created a huge precedent with his rulings about the way that the pari passu clause can and should be interpreted in bond documentation. In the wake of those rulings, bondholders are more likely to hold out, rather than tendering their bonds into an exchange. As a result, bond exchanges are going to be more and more difficult to execute successfully, and therefore there needs to be some kind of alternative way to restructure a nation’s bonded debt.
The Brookings paper essentially comes up with two separate sovereign bankruptcy regimes: one for the Eurozone, and one for everybody else. This makes sense to me: a one-size-fits-all solution is never going to be optimal with respect to addressing the very specific and idiosyncratic nature of European sovereign debt problems. In both cases, however, the Brookings paper proposes major new legislative changes: an amendment of the IMF articles, as well as an amendment of the ESM treaty in Europe. And in both cases the amended treaties would set an ex ante level for debt-to-GDP ratios, over which no new official-sector money would be lent without a debt restructuring taking place.
There are obvious problems with using a blunt instrument like the debt-to-GDP ratio to determine whether a debt restructuring is necessary. In fact, the Brookings paper goes in the exact opposite direction to the IMF, which is trying to make its debt sustainability analyses increasingly sophisticated. (For instance, if you look at the debt sustainability analysis on pages 43-45 of the Italy Article IV report, you’ll see a range of scenarios, with associated probabilities, rather than just a simple projection.) Obviously, the simple debt-to-GDP ratio excludes a huge number of very important factors: Japan, with its stratospheric debt-to-GDP ratio, is still vastly more creditworthy than Argentina, whose debt-to-GDP ratio is very low. And more generally, flows tend to matter more than stocks: ceteris paribus, the market will always prefer a country with a 100% debt-to-GDP ratio which is in primary balance, on the one hand, to a country with a 50% debt-to-GDP ratio and a primary deficit of 15% of GDP, on the other.
The Brookings paper argues that trying to put together a more complex threshhold, or even coming up with a bespoke number for every country on a case-by-case basis, is an approach which is certain to be gamed, and ultimately to fail. The point of this proposal is to tie the official sector’s hands — since one of the articles of faith underlying both the current IMF project and the Brookings paper is that the official sector has been too weak when it comes to saying no to countries needing funds. The official sector faces “a simple choice,” says the Brookings paper: “to adopt simple ex-ante rules that constrain discretion when structuring rescues, or to adopt no rules. Given the biases that currently exist against any form of debt restructuring, pure discretion would lead to bigger errors than simple rules.”
This is a highly contentious statement: Much of the buy side, for one, is genuinely convinced that the system isn’t broken, and shouldn’t be fixed. Putting in place a system where official-sector funding requires debt default, they say, plausibly enough, will only make matters worse: any time that a country even thinks about approaching the IMF or the ESM for help, markets will plunge, and bondholders will rush to be the first ones out the door.
Under this view, there are many countries — Brazil in 2002, Portugal and Italy more recently — which are clear success stories thanks to official-sector support, and which would have turned into debt-default failures had this kind of a scheme been in place. Official-sector types, on the other hand, are not entirely convinced that Portugal and Italy really are successes, and they reckon that even Brazil got very lucky with booming commodity prices and extraordinarily low global interest rates.
On the other hand, default isn’t what it used to be. Bond defaults used to be rare, just because sovereign bonds were rare: until the Brady plan in the 1990s, most sovereigns with any propensity to default would simply borrow money from banks rather than attempt to tap the bond market. Once bonds replaced loans, then bond defaults started. At first, they were shocking, but each new default makes them seem less so: statistically speaking, if you have a lot of sovereigns with a lot of debt, then some of them are going to default.
As a result, there’s a significant constituency — including quite a lot of academics looking at things like market access and bond spreads — that has a rather more nuanced view of default than the black-and-white idea that it’s always and everywhere a really bad idea, to be avoided at all costs. Under this view, if you look at successful bond restructurings in the past, then countries do indeed get punished quite harshly in terms of market access and bond spreads if they impose harsh and punitive haircuts on their creditors. On the other hand, if the restructuring is market-friendly and is really more of a reprofiling than an outright haircut, then the country often suffers quite minimal adverse consequences.
Those that see default in shades of gray like to draw distinctions and invent new words: rather than “default”, they say, can’t we use the word “treatment” instead? And in any case, don’t most bondholders, in reality, tend to agree on what needs to be done? After all, the elegance of bond markets is that when a country gets into trouble, the original holders of the debt are likely to sell it at a loss to people who can make a profit, even if (especially if) the country goes through a successful restructuring. Argentina is a particularly contentious outlier: in pretty much every other restructuring, holdouts really haven’t been an issue. And even Argentina can be seen as a success story in one respect: because its default happened so slowly, and was telegraphed so clearly, it had very little in the way of spill-over effects. It’s the sudden defaults, like Russia’s, which are the most dangerous: a clearly-foretold default allows the bonds to be held in large part by speculative investors who might actually make money in the event of a restructuring. As a result, a mild default like the one proposed by the IMF could do wonders in terms of minimizing contagion risks.
This argument doesn’t persuade the more hard-minded market types, who say that if holdouts haven’t been an issue up until now, that proves that the current system is working. What’s more, if the official sector starts bigfooting into the markets and telling countries to default, then at that point you can be sure that holdouts will be an issue — especially since the hedge funds who buy sovereign debt at low prices are exactly the hedge funds which are most likely to hold out. The official sector always seems to want the private sector to take a very large haircut, and restructurings have been successful to date only because the debtor and the markets have had the ability to push back against the IMF. (See, for example, Uruguay.)
Some participants go even further, and say that the current system is already too biased against bondholders. Sure, they’ve done OK for themselves — so far — in Portugal and Italy. But look at cases like Greece, Argentina, and Russia: in those countries, bondholders had to take enormous haircuts, in part because there was so much official-sector financing which insisted on preferred-creditor status. If a country has to pay off its preferred creditors in full, then any given necessary debt reduction is going to fall all the more heavily on the private sector. And if the IMF is going to come up with some kind of system for imposing losses on the private sector, that’s a clear sign that the Fund thinks that the private sector’s losses right now are too small.
Lipton sounds at best overoptimistic and at worst downright disingenuous when he says that “providing the member with a more comfortable debt profile would also have the additional benefit of enhancing market confidence in the feasibility of the member’s adjustment efforts, thereby reducing the risk that the debt will, in fact, become unsustainable.” No bondholders are ever going to actively welcome an IMF program which includes a bond default, even if that default in practice doesn’t involve much in the way of present-value losses. Lipton seems to believe that such a program could cause bond yields to go down; that seems like wishful thinking to me.
So, where do I stand on all this? I’d make three main points.
Firstly, this whole thing looks to me a bit too much like a solution in search of a problem. Hard cases make bad law, and when your entire reason for taking action can be boiled down to Greece-and-Griesa, two cases which are highly unique and idiosyncratic, then you’re always going to run the risk of overreach. The big story in emerging markets over the past decade is that their local debt markets have become much deeper and more liquid, meaning that they’re increasingly capable of funding themselves domestically. And domestic debt is not an issue: any time a government wants to default on its domestic debt it can, or alternatively it can just print money to cover the obligations.
The main exception to this rule is the eurozone, where governments do not have control over their own currency. Which is another way of saying that at heart this is really a European problem, rather than a global one, and that it should be solved at a European level, rather than at the level of the IMF. What makes sense for Ireland is unlikely to make sense for Brazil.
What’s more, in Europe, even more than in the rest of the world, debt restructuring is a very bad way of saving money overall. Sure, you can impose losses on sovereign bondholders — but those sovereign bondholders are very likely to be domestic banks. Which means that for every euro you save in government debt, you’re going to end up spending roughly one euro in bank recapitalization.
So rather than concentrate on bond exchanges, I think the Fund — along with Europe’s technocrats — should think much more about alternative ways of retiring outstanding debt at below face value. Ecuador did this very effectively in its most recent default: it simply used cash to buy up its own debt at a deep discount. And if you look at the amount of money that the official sector ploughed into the Greek exchange, it wouldn’t have taken much more to simply buy up most of the outstanding private debt on the public markets, and get rid of it that way.
I do understand that Greece has worried the IMF — and that Griesa has worried them even more. But it’s crazy to let a single vulture fund — Elliott Associates — effectively set the agenda for the design of the entire international financial architecture. Ten years ago, Anne Krueger was prompted to propose SDRM by Elliott’s shenanigans in Peru; today, Lipton is similarly motivated by Elliott’s successes against Argentina. (Not that Elliott has actually gotten paid, yet.) But if the IMF ends up moving in the direction it’s thinking about, the result could end up being counterproductive for everybody. So let’s think seriously about Europe, first. Only then, and only if a European solution proves obviously successful, should we start considering extending something similar to the rest of the world.