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.
The big question in Washington this week is whether, in the words of the NYT, we’re going to see “a legislative failure and an economic catastrophe that could ripple through financial markets, foreign capitals, corporate boardrooms, state budget offices and the bank accounts of everyday investors”. In this conception — and I have subscribed to it just as much as anybody else — the sequester is bad, the shutdown is worse, and the default associated with hitting the debt ceiling is so catastrophic as to be unthinkable.
This frame is a useful one, not least for the politicians in Washington, who seem to have become inured to the suffering caused by the shutdown, and downright blasé about the negative consequences of the sequester. Both of them could last more or less indefinitely were it not for the debt ceiling, which is helpfully providing a hard-and-fast deadline: Congress is going to have to come up with a deal before the ceiling is reached, because the alternative is, well, the zombie apocalypse.
There’s more than a little truth here: I’m a firm believer, for instance, that the president both can and should prioritize debt repayments in the event that the debt ceiling is reached. If we’re going to be so stupid as to hit the ceiling, then prioritizing debt service is the least-worst outcome. But at the same time, the situation is less binary than it looks, not least because the US government is already in default on its obligations.
The best way to look at this, I think, is that there’s a spectrum of default severities. At one end, you have the outright repudiation of sovereign debt, a laEcuador in 2008; at the other end, you have the sequester, which involves telling a large number of government employees that the resources which were promised them will not, in fact, arrive. Both of them involve the government going back on its promises, but some promises are far more binding, and far more important, than others.
Right now, with the shutdown, we’ve already reached the point at which the government is breaking very important promises indeed: we promised to pay hundreds of thousands of government employees a certain amount on certain dates, in return for their honest work. We have broken that promise. Indeed, by Treasury’s own definition, it’s reasonable to say that we have already defaulted: surely, by any sensible conception, the salaries of government employees constitute “legal obligations of the US“.
Conversely, if you really do expect zombies to start roaming the streets the minute that the US misses a payment on its Treasury obligations, you’re likely to be disappointed. Yes, the stock market would fall. But the price of Treasury bonds would remain in the general vicinity of par, and it might even go up if Treasury announced that past-due interest would be paid on all debt at a statutory rate of 8% per annum. Even when it’s Treasury bonds themselves which are the instruments in default, Treasury bonds remain the world’s flight-to-quality trade, and the expected recovery on all defaulted Treasury obligations would be 100 cents on the dollar — or more.
The harm done to the global financial system by a Treasury debt default would not be caused by cash losses to bond investors. If you needed that interest payment, you could always just sell your Treasury bill instead, for an amount extremely close to the total principal and interest due. Rather, the harm done would be a function of the way in which the Treasury market is the risk-free vaseline which greases the entire financial system. If Treasury payments can’t be trusted entirely, then not only do all risk instruments need to be repriced, but so does the most basic counterparty risk of all. The US government, in one form or another, is a counterparty to every single financial player in the world. Its payments have to be certain, or else the whole house of cards risks collapsing — starting with the multi-trillion-dollar interest-rate derivatives market, and moving rapidly from there.
And here’s the problem: we’re already well past the point at which that certainty has been called into question. Fidelity, for instance, has no US debt coming due in October or early November, and neither does Reich & Tang:
While he doesn’t believe the U.S. will default, Tom Nelson, chief investment officer at Reich & Tang, which oversees $35 billion including $17 billion in money-market funds, said that the firm isn’t holding any U.S. securities that pay interest at the end of October through mid-November because if a default does take place, “we’d be criticized for stepping in front of that train.”
The vaseline, in other words, already has sand in it. The global faith in US institutions has already been undermined. The mechanism by which catastrophe would arise has already been set into motion. And as a result, economic growth in both the US and the rest of the world will be lower than it should be. Unemployment will be higher. Social unrest will be more destructive. These things aren’t as bad now as they would be if we actually got to a point of payment default. But even a payment default wouldn’t cause mass overnight failures: the catastrophe would be slower and nastier than that, less visible, less spectacular. We’re not talking the final scene of Fight Club, we’re talking more about another global credit crisis — where “credit” means “trust”, and “trust” means “trust in the US government as the one institution which cannot fail”.
While debt default is undoubtedly the worst of all possible worlds, then, the bonkers level of Washington dysfunction on display right now is nearly as bad. Every day that goes past is a day where trust and faith in the US government is evaporating — and once it has evaporated, it will never return. The Republicans in the House have already managed to inflict significant, lasting damage to the US and the global economy — even if they were to pass a completely clean bill tomorrow morning, which they won’t. The default has already started, and is already causing real harm. The only question is how much worse it’s going to get.
Neil Irwin isn’t mincing words. “What’s happening in the Treasury bill market today should terrify you” is the headline, and this is the accompanying chart:
That is indeed a nasty spike! But it isn’t remotely as terrifying as Irwin says.
For one thing, let’s put the instrument in question into context. Here’s the chart that I get, when I bring up the same instrument on my Thomson Reuters Eikon terminal. It shows more clearly just how few data points we’re really talking about here: these things are spiky. Here’s another reason not to take these charts too seriously: if you take a second look at Irwin’s chart, it shows that the bill was trading at a negative yield in mid July; I would deduce nothing from that datapoint except for that the data is noisy, and it’s hard to draw too many conclusions from it.
Here’s another version of the same chart, showing the price action just for the past five days. Again, this isn’t terrifying, so much as it’s just plain noisy:
Wait, did I say price action? Scratch that, I meant yield action. The price action shows you the simple truth of the matter — and it’s so boring I can’t even work out how to make a chart of it. Still, I can give you the numbers: the Treasury bill maturing on 10/31/2013, with a coupon of 0.25%, is bid at 99 253/256, to yield 0.446%, and is offered at 100 1/256, to yield 0.184%.
So, here’s Irwin’s dystopian fantasy:
If, for example, investors were only willing to pay $950 for a 90-day, $1,000 bill (about a 20 percent annualized interest rate), then the government would run into its legal debt limit even faster than it is now scheduled to.
And here’s the reality: let’s say the yield on your $1,000 bill soars to a terrifying 0.446% from a relatively benign 0.184%. That means the price of your bill has plunged from $1,000.04 all the way to $999.88. You’ve lost a whole 16 cents — or 0.016%. If the price of your bond continues to dive at that rate every day, then after a couple of months you might start approaching a full 1% drop in paper wealth!
If you look at the actual price action in Treasury bills, then, it isn’t terrifying in the slightest; what’s more, it’s very difficult to separate signal from noise. There’s no indication whatsoever that it’s significantly raising the US government’s cost of borrowing, and there’s not even any real evidence that what we’re looking at here reflects credit risk being abruptly inserted into the interest-rate market.
For the fact is that Treasury bills trade far too close to par, far too predictably, for them to really trade at all. If you want to buy Treasury bills, you buy them at a Treasury auction, you hold them to maturity, and then — most likely — you roll them over into a new series of Treasury bills. On the other hand, if you want to trade day-to-day movements in short-term interest rates, you don’t go to the Treasury bill market at all: instead, you go to Chicago, and use the eurodollar futures market, or something like that.
The Treasury-bill market, then, is a bit like the market in US CDS: it’s a thin market which is being asked to support much more rhetorical weight than it can reasonably bear. In the real world, Treasury bills remain an absolutely safe market — and I fully expect them to continue to trade at (or extremely close to) par even if we hit the debt ceiling. The world will get much riskier, if that happens — and in a risky world, US government debt is still going to be the safest possible asset.
On Thursday I said that the US is not going to default on its bonded debt, even if the debt ceiling is reached: “with Jack Lew (or anybody else, really) as Treasury secretary, you can be sure that debt service payments would be priority number one”.
This is not a popular view within the blogosphere, maybe because it’s generally associated with Republicans trying to say that hitting the debt ceiling wouldn’t be that bad. Both Cardiff Garcia and Dylan Matthews have come out with sterling attempts to answer the question of whether debt prioritization is even possible; Danny Vinik, for one, says that there’s “pretty good evidence to demonstrate that prioritizing debt payments is not possible”. The problem, however, as Garcia says, is that most of the primary sources you’d want to go to on a question like this “are vague and unhelpful”.
It’s worth stipulating up front that hitting the debt ceiling would be disastrous even with prioritization: Garcia calls it “breaking the economy’s knees with a fiscal crowbar”, while Paul Krugman says that it would be “a catastrophe”. But it would be much better than the truly apocalyptic state of affairs that we would see in the event of a Treasury bond default. Deutsche Bank says that in that event, the S&P 500 would fall some 45% — and, boldly, puts a 0% probability on that actually happening.
It’s also worth stipulating that before the debt ceiling is hit, a lot of very sensible politicians want to make prioritization seem as unlikely as possible, because that maximizes the incentive to avoid hitting the ceiling at all. On the other hand, after the debt ceiling is hit, the very same politicians should be willing to move heaven and earth to ensure those bond coupons get paid.
So, why is Matt Yglesias so convinced that prioritization is impossible? He gives four reasons.
The first is that prioritization is illegal: “Treasury is not authorized to unilaterally decide to pay certain bills and not others”. This is true — but also a bit irrelevant. Treasury is under unambiguous Congressional orders to pay lots of bills — all of them, in fact. If it fails to pay those bills, it will be violating the law as laid down by Congress. Hence the 14th Amendment argument that the president should simply ignore the debt ceiling entirely, if it comes to that. But underneath it all, it’s hard to credit any argument which says “Treasury isn’t allowed to pay its own bonds”. If that’s what Treasury wants to do, then surely it can do so. Besides, who would even have standing to sue?
Yglesias’s second reason is that prioritization is just not feasible: it can’t be done in the real world. Both he and Matthews cite the Treasury inspector general, who does indeed say what they say he says:
Because Congress has never provided guidance to the contrary, Treasury’s systems are designed to make each payment in the order it comes due.
It’s worth reading the whole letter, however, because the inspector general says a lot more than that. And while the systems are designed to make payments in the order they come due, they have also been designed so as to effectively insulate bond repayments from all other payments. Bond repayments are made through a system called Fedwire, while all other payments are made through the standard banking ACH system. Logistically, it’s entirely possible to keep up to date on all Fedwire payments without making any ACH payments at all.
And the inspector general was very careful to keep all options open:
Ultimately, the decision of how Treasury would have operated if the U.S. had exhausted its borrowing authority would have been made by the President in consultation with the Secretary of the Treasury.
What’s more, the inspector general does rather fudge the central issue of prioritization, which is whether debt repayments can carry a higher priority than everything else. “Treasury officials determined that there is no fair or sensible way to pick and choose among the many bills that come due every day,” he said — but that’s false on its face: prioritizing debt repayments is very sensible, since defaulting on Treasury bonds would be much more harmful than simply paying all bills as they come due, whether they’re a bond coupon or a fighter jet.
There is an argument from the left that prioritization constitutes “paying China first”, and would “require the government to cut large checks to foreign countries, and major financial institutions, before paying off its obligations to Social Security beneficiaries and other citizens owed money by the Treasury”. Well, yes. But I don’t think anybody in Treasury is swayed by such arguments: they know that in the grand scheme of things, all Social Security beneficiaries would be much better off receiving their money in arrears than they would be if Treasury defaulted on US sovereign bonds.
Yglesias then rolls out the timing argument, which is further developed by Zero Hedge: debt repayments are lumpy things, and it would be hard to “save up” enough money before the big repayments were due, if you were paying any other bills at all. Zero Hedge improbably says that “Treasury will simply halt new Bill issuance” if the debt ceiling is reached, but I don’t buy it: no one’s requiring that the national debt go down. And investors generally want to be able to roll over their short term debt: failure to be able to do so would be better than default, but not much.
Could Treasury decide to prioritize Fedwire payments, and then turn on the ACH payments sporadically, only insofar as they didn’t eat up enough cash to endanger bond repayments? I don’t see why not. Treasury wouldn’t like it, of course. And as Yglesias says in his final point, such a scheme might well be so messy that the markets would have to end up assigning some kind of credit risk to Treasury bonds anyway. Still, doing so would send a very clear message to markets, that Treasury cares about them more than it cares about the sick, the elderly, or any other recipients of government funds. And the markets, in return, would probably reward Treasury with lower interest rates on Treasury bonds. After all, in a crisis, money always flows into Treasuries — even when it’s a Treasury-bond crisis.
I spent all of yesterday at a fascinating and wonky conference in London, on the economics and law of sovereign debt. I gave a short talk on the latest developments in Elliott vs Argentina (a/k/a NML vs Argentina), and specifically on the decision which was handed down by the Second Circuit court of appeals on August 23. These are the notes I drew up for the talk.
And now abide faith, hope, love, these three; but the greatest of these is love.
We’ve all heard these words at weddings, and even sometimes at funerals. But I’ve written my own version, just for pari passu geeks. It goes something like this:
And now abide secured, unsecured, judgments, these three; but the greatest of these is a judgment.
I am not a lawyer. But maybe because I’m not a lawyer, I feel like I can look at what’s going on in the NML vs Argentina case from a little bit of a distance. And when I do that, what I see is a series of court decisions which have undermined the very way in which debt is understood to work.
Remember that pari passu, at heart, is all about ranking; it’s about seniority of payment. And the way I see it, seniority works in a pretty well-established way. First of all, there’s unsecured debt. Mitu lends me money, and now I owe him a certain sum on a certain date. It’s pretty simple. If I pay him, he’s happy; if I don’t pay him, he’s sad.
Next up, there’s secured debt. Henrik lends me money, but he’s worried that I might not be able to pay him back. So he insists on a lien: he wants me to put up my country house as collateral. As with Mitu, I still owe Henrik a certain sum on a certain date. And as with Mitu, if I pay him, he’s happy. But if I don’t pay him, he goes straight to plan B: he seizes my country house, sells it, and uses the proceeds to ensure that he’s repaid in full. Still, Henrik can still end up unhappy. If I don’t pay him, and if my country house has burned down, then there’s nothing to seize, and he ends up where Mitu was, holding a defaulted obligation.
This is where the courts come in. Once I’m in default, any of my creditors — Mitu, Henrik, Joseph, it doesn’t matter — can go along to a court and reduce their obligation to a judgment. And judgments are very powerful things. Because once you’re armed with a judgment, you basically become an ultra-secured creditor. If I own a country house, you can forcibly attach that, and sell it, and pay yourself from the proceeds. But if my country house has burned down, you can attach any of my other possessions instead — you can attach my stock portfolio, or my wine cellar, or even, most simply, my bank account. Anything I own, if it can be reached by the long arm of the law, is now within your grasp.
There are only two ways for me to foil you, if I have assets and you have a judgment. The first is for me to declare bankruptcy. But for the sake of argument, let’s say that bankruptcy isn’t an option. Maybe my assets vastly exceed my liabilities. The second is for me to somehow move my assets to where they can’t be touched by your courts. Maybe I smuggle my stamp collection into a safety deposit box in Iran. It’s not going to do you much good there, because your judicial system isn’t going to be able to extract it from that box and sell it.
Still, even if you have a judgment, you can’t attach what isn’t mine. For instance, let’s say that Joseph has a bank account. If I owe Mitu money, even if he’s armed with a judgment, he can’t barge in and attach Joseph’s bank account. Just mine.
Now it’s true that I borrowed money from Mitu and from Henrik, and that I defaulted on both of those loans. I borrowed money from Joseph, as well. Joseph has something weird — he has something called subordinated debt. In his loan documentation, it explicitly says: “I will not pay you any money unless and until I’ve paid Mitu first. Mitu is senior, and you, Joseph, are junior.”
So when I default on my obligation to Mitu, Joseph is also sad: he knows that he’s junior to Mitu, which means that I’m not going to be paying my subordinated creditors any time soon.
But when Joseph’s coupon date rolls around, guess what? I walk into his bank, take out a wad of cash, and tell the bank to deposit into Joseph’s account every penny that he’s owed. Now, Joseph is happy: he’s just received an unexpected windfall. And Mitu is furious, because he knows what I promised Joseph.
Mitu has been patient with me, so far, but now his patience has run out, and finally he decides to go to court. “I have a piece of paper here which clearly says that I’m a senior creditor,” he tells the judge. “And Felix is going and paying his junior creditors, without paying me!”
The judge is sympathetic, and wants to help out Mitu in any way he can. “I’ll tell you what,” he says. “I’ll give you a judgment, that’s what judges do. And then, armed with that judgment, you can attach anything that Felix owns, and use those assets to pay yourself everything you’re owed.” This mollifies Mitu, because he knows that judgments are the best thing you can have. But it takes time to locate and attach assets, and when Joseph’s next coupon date rolls around, I go and do exactly the same thing: I walk into Joseph’s bank, and tell them to deposit a bunch of money into Joseph’s account.
Now Mitu is really hopping mad, and he goes back to the judge, who is still sympathetic. But then Mitu goes too far. He asks the judge to bring down a judgment not on me, but rather on Joseph. “Tell Joseph that he owes me the money,” says Mitu. The judge is a bit puzzled. “Does Joseph owe you money?” he asks. “Where do you have a contract with Joseph?”
“Oh,” says Mitu. “Good point. I don’t have a contract with Joseph, I only have a contract with Felix. So you can’t tell Joseph that he owes me money. But hang on, I have another idea. I can see what Felix is doing now: he’s paying Joseph, without paying me. So I want you to go to Joseph’s bank, and tell them that the next time Felix deposits money into Joseph’s account, they should refuse to do that.”
Now the judge is really puzzled. “Joseph’s bank?” he says. What have they got to do with anything? They’re just the institution which looks after Joseph’s money. And in fact, they have a very clear contract of their own, with Joseph, and they don’t have any kind of contract with you. Felix promised to pay you money, and he broke that promise, and I’ve given you a powerful judgment saying that Felix owes you money. But neither Joseph nor Joseph’s bank owes you money, so I’m not going to start slapping injunctions on them.”
Mitu is unimpressed. “But Felix promised that he wouldn’t pay Joseph without having paid me first!” The judge, on the other hand, is equally unimpressed. “Yes, Felix broke his promise. Felix broke his promise the minute that he defaulted on his payment obligation to you. He has since broken another promise. And he can go head and break a thousand more. When Felix breaks his promise, I enter a judgment against Felix. I’ve done that. But I’m not going to start handing down judgments on Joseph, or on Joseph’s bank, just because Felix has broken a promise. Those guys are independent actors, and have no control over what Felix does. So leave them alone.”
Most of the time, this story works out quite well for Mitu. Because my assets exceed my liabilities, and because Mitu has a judgment against me, it’s not hard for him to get satisfaction. But regardless of whether Mitu ends up being satisfied or not, the principle is clear. The remedy, if I break my contractual promise, is that my creditor can get a judgment against me. And a judgment is to all intents and purposes the most senior claim that anybody can have.
This is why I find the behavior of the judges in New York to be so bizarre. Firstly, they have turned the natural order of creditors on its head. Secured, unsecured, judgments, these three; now the greatest of these is, bizarrely, unsecured, with a pari passu clause. It’s the unsecured creditors who are being able to get remedies which — at least so far — have proven unavailable to either secured creditors or judgment creditors.
Secondly, there’s no real logic to how this new system of jurisprudence should be enforced. It seems to me that if Joseph has explicitly subordinated debt, and Mitu goes to court, then Mitu is going to come away empty-handed, because the explicit subordination is in Joseph’s bond documentation rather than in Mitu’s. But if Mitu manages to find the right flavor of pari passu clause in his own documentation, then suddenly everything changes, and the nuclear remedy becomes magically available.
Thirdly, the judges have created a new class of activity, for debtors, which is Worse Than Default. It used to be that when it came to debt contracts, defaulting was the worst thing you could do. That’s no longer the case: now, the worst thing you can do is to selectively default. In other words, if I pay Joseph and don’t pay Mitu, that’s considered worse than if I don’t pay Joseph and don’t pay Mitu. Because only in the first case — only when I’m in partial default — will New York’s judges roll out their brand-new thermonuclear remedy.
Fourthly, it is now entirely acceptable, under New York’s system of jurisprudence, for judges to punish the innocent, rather than the guilty. Neither Bank of New York nor the exchange bondholders have done anything wrong. All they’re doing is collecting the money they are rightfully owed. But if these rulings stand, they won’t be allowed to do that any more.
This is the bit which annoys me most about the Second Circuit’s ruling. The courts are clearly punishing the innocent, with these rulings, and yet are bending over backwards to pretend that they’re not. If you’re going to do something as unintuitive as this — if you’re going to make unsecured non-judgment creditors effectively the most senior, and create a brand-new nuclear remedy, and punish the innocent, and violate a whole bunch of sovereign-immunity precedent while doing so — then at the very least you should be open and honest about what you’re doing and why you’re doing it.
Instead, the rulings of both Judge Griesa and the Second Circuit are run through with pinched and disingenuous legal reasoning. They refuse to step back and take responsibility for the big-picture consequences of their actions, and it’s that, to me, which is by far the worst thing they’ve done. I have precious little sympathy for Argentina, in this case, and not much for Elliott Associates either — but at least both of them are openly and honestly making the best case they possibly can for their actions. The New York courts, by contrast, are just being poltroons, and it’s their ignoble cowardice which really drives me up the wall and which is the main reason the Supreme Court should accpet this case and decide it head on.
I can understand the pique and frustration which led Judge Griesa to enter his original judgment against Argentina. When an actor in your court is being as consistently and unapologetically contumacious as Argentina, eventually you reach breaking point. But when that kind of thing happens, it’s the job of the appeals court to provide cooler heads, and to say hang on a minute, what are we doing here, are we sure we really want to go down this road. Especially when you’re the court which has for decades looked after the New York payments system and the US financial architecture.
But that’s not what the Second Circuit did. Instead, they ducked all the big questions, and decided this case as narrowly and pedantically as they conceivably could. Which is why they — much more than Elliott Associates, or Argentina, or anybody else — are the biggest villains of this story. Of all the actors on stage, it’s the Second Circuit which has acted in the worst faith. I hope — against hope — that the Supreme Court will hold them to account for their actions.
Today’s tale of hedge fund / Hamptons excess comes from Mitchell Freedman at Newsday; if that story is paywalled, you can find pickups in all the usualplaces. But it’s the Daily Mail which has the best map:
For most readers, this story is just another glimpse into the hedge-fund lifestyle, where one man will spend $120,000 for a one-foot-wide strip of land — not so that he can get beach access (he already has that) but rather to ensure that his next-door neighbor loses his beach access. As the Daily Mail puts it, Kyle Cruz, who owns the house behind Marc Helie, is now “hemmed in”, and can no longer reach the beach directly from his home. Here’s Freedman:
The auction “caused quite a stir,” Thompson said.
Based on reports from staffers who ran the auction, he said, “I gathered one guy really did not want the other one walking over his property to the water.”
Helie’s purchase effectively gives him narrow slivers of property on both the east and west sides of Cruz, who would have to walk on Helie’s property to reach the ocean beach a few hundred feet away.
To a small set of sovereign-debt geeks with long memories, however, it’s not the beach-access politics which jumps out from this story — it’s the name Marc Helie. For back in 1999, Helie was the man who loved to take credit for forcing what was in many ways the first ever sovereign bond default. And Helie’s actions 14 years ago are actually rather similar to what he’s doing now, in the Hamptons.
Sovereign bond defaults are relatively commonplace these days — even Greece got in on the game. But back in 1999, there was something special about sovereign foreign-law bonds (as opposed to loans): they always managed to avoid being restructured when a country defaulted on its debt. Even Russia, in its catastrophic 1998 sovereign default, always remained current on its Eurobonds.
When Ecuador got into fiscal trouble in 1999, then, its first instinct was not to default on its bonds — even though the IMF was rumored to be pushing it to do exactly that. The bonds in questions were Brady bonds — restructured loans — which included various guarantees, in the form of built-in Treasury bond collateral, which could be used to make payments if and when Ecuador got into trouble. So Ecuador proposed that it would pay the coupons on the bonds without collateral in full, and it would dip into collateral to make payments on its other bonds, while trying to work out a longer-term solution.
But Ecuador’s tactics were atrocious: the country’s announcement came right in the middle of the IMF annual meetings, the one time of the year when all the world’s emerging-market bond investors converge on the same city at the same time. Those investors were not happy, and it wasn’t long before a vocal group of them, led most visibly by Helie, started agitating for highly aggressive action against the country.
Normally, of course, bondholders don’t want borrowers to default — and Ecuador was hoping that this case would be no different. But rather than accept Ecuador’s deal, which treated different classes of bonds differently, and which was very vague, Helie and other bondholders decided that they would rather force the matter. They discovered that if they could organize 25% of the holders of the affected bonds, and get them to write a very specific letter to the bonds’ fiscal agent in New York, they could accelerate those bonds. Rather than just owing a single coupon payment, Ecuador would then owe the entire principal amount, plus all future coupon payments, immediately.
No one expected that Ecuador could pay such a sum, but Helie and the other bondholders just wanted to make things simple. If Ecuador was going to effectively default on certain bondholders, then they would make it official, and force the country into a full-scale bond restructuring, the likes of which the world had never seen. Brady bonds were specifically designed to be very difficult to restructure: any change in the payment terms needed the unanimous consent of bondholders, and there were so many bondholders that unanimous consent was always going to be impossible to find.
Finding 25% of bondholders, however, to block what Ecuador wanted to do, was much easier — and that’s exactly what Helie did. Essentially, Ecuador expected that it could just walk down to the beach and do its bond exchange relatively easily. Instead, it found that hedge fund managers like Helie bought up property which would prevent it from doing that. When Helie et al accelerated Ecuador’s bonds, they forced it to enter into a far more elaborate and convoluted restructuring, in much the same way that Kyle Cruz now needs to walk much further to get to the beach.
Helie worked very hard and spent a lot of money on making life as difficult for Ecuador as he possibly could — in violation of the general assumption that bondholders tend to want what’s best for any given debtor nation. His plan worked, too: the exchange that Ecuador eventually unveiled was much more generous than the market expected, and Helie made a lot of money on his bonds. He was also lionized on the front cover of Institutional Investor magazine, under the headline “The Man Who Broke Ecuador”. It was all very welcome publicity for a man who was punching well above his weight: his hedge fund managed only about $10 million, and behind the scenes other, much more established (and much more publicity-shy) hedge funds had done most of the hard work of organizing the acceleration.
Helie was flying high, enjoying all the stories about the young hedge-fund manager with a ponytail and an office above a modeling agency, who was shaking up the world of sovereign debt. But while his hedge fund, Gramercy Advisors, went on to much bigger things, moving out of the small offices in Manhattan and into much larger digs in Connecticut, Helie didn’t last long. He was spending too much time at his beach house, and eventually his partners decided that he wasn’t doing enough work, and effectively kicked him out of the business.
Evidently, however, old habits die hard; Helie was so adamant that he didn’t want Cruz walking past his house to the beach that he spent $120,000 to make Cruz’s life as difficult as possible. It might even be enough to make a hardened hedge-fund manager start to feel a bit of sympathy for the government of Ecuador.
Back in February, when I made my prediction for how the Argentina endgame would play out, I got the date wrong. I did, however, get the substance right:
One likely scenario is that the appeals court will uphold Griesa’s decision at some point in April or May, forcing a big default in June. At that point, Argentina will probably launch an exchange offer under Argentine law, under which anybody holding currently-performing bonds would be able to swap them into bonds with substantially identical terms, just payable in Buenos Aires rather than New York. Given that Argentine-law bonds have been trading at tighter spreads then US-law bonds for some months now, one can assume that nearly all bondholders would jump at the opportunity to keep on getting their coupons.
Argentina might even take the opportunity to give its holdouts a third bite at the cherry, offering them some kind of option to take a haircut and get performing Argentine-law bonds in exchange for their defaulted debt. But many holdouts would still remain, and will surely continue to pester New York courts for the foreseeable future.
Timing aside, this is exactly what has now happened. Argentina might still be in the midst of its Supreme Court appeals, but given the choice between working within the US legal system and blatantly working against it, the country seems to have decided that it wants to do both at once.
For if Argentina does indeed open up this new exchange offer to existing New York-law bondholders, as the president said today that it would, that would might* be in clear and outright violation of Judge Griesa’s existing court order — the one which has not been stayed, which prevents Argentina, or its agents, from doing anything which would re-route payments on restructured debt. Doing so would pretty much guarantee that a loss for Argentina at the Supreme Court level, and might well give the appeals court all the excuse that it needs to lift the current stay.
From a tactical perspective, then, this doesn’t make a huge amount of sense: Argentina wants to delay proceedings as much as possible, and this action risks speeding them up very quickly indeed. And from a practical perspective there are massive obstacles in Argentina’s way as well. Argentina can’t do this alone: it’s going to need the help of bankers and lawyers and payment agents and trustees and the whole panoply of the international capital markets, if it’s going to come up with a way in which existing bondholders, with bonds registered in New York, can take those bonds and exchange them for new bonds which are registered in Buenos Aires.
Now Argentina has some very clever and very expensive legal minds working for it at the venerable firm of Cleary, Gottlieb, Steen and Hamilton — and maybe they’ve come up with a genius way of doing just that. But on its face, it’s going to be very difficult indeed for Argentina to find any companies in America which will help it blatantly and directly violate an existing court order — since the court order explicitly includes not only Argentina but also anybody aiding and abetting it.
If Argentina does manage to find a way to jerry-rig a bond exchange, however, then that exchange is likely to be taken up with great alacrity. Reuters poses the question well:
Fernandez’s proposal of a new bond swap raised questions about whether investors would be interested in taking Argentine bonds in lieu of foreign debt, given strict currency and capital controls that the left-leaning Fernandez government has imposed.
The answer to that question is hell yes, investors would be very interested in taking Argentine bonds in lieu of foreign debt. Here’s where I part company with the Associated Press:
Analysts have predicted that any attempt to pay bondholders in Buenos Aires rather than comply with the U.S. courts will fail, reasoning that few bondholders who now can turn to courts in New York in any dispute with Argentina’s government will be willing to risk a change that makes Argentine courts the final arbiter.
This, I think, is completely wrong. As we’ve seen time and time again over the past ten years, the ability to turn to New York courts in a dispute with Argentina is worth, to a first approximation, zero. On top of that, local-law bonds are trading inside foreign-law bonds — which is another way of saying that you get an immediate price boost to your debt as soon as you change the jurisdiction from New York to Buenos Aires. So give bondholders half a chance, and they will jump at the opportunity to change the jurisdiction and receive, in return, much more certainty that they’ll be paid in future. Sure, there are worries about exchange controls and the like. But being paid in Argentina is always better than not being paid at all.
If this exchange offer does go ahead, expect an extremely high acceptance rate — somewhere well north of 90%. And then, expect whatever New York law bonds remain to go into default shortly thereafter. That will trigger Argentina’s credit default swaps, which will pay out at a very high rate, since the value of defaulted New York law debt will at that point be extremely low. Remember that Elliott Associates is reported to own a large quantity of Argentine CDS; that means a big payday for Elliott, even if it doesn’t receive the $1.3 billion that the New York courts have ordered it be paid. Elliott, it seems, wins either way.
But frankly I have my doubts that the exchange offer will simply appear, as the Argentine president seemed to say that it would. An anonymous Argentine government official told Bloomberg that the exchange offer would only be opened up to existing New York bondholders “depending on the nation’s request for the Supreme Court to take their case” — so Kirchner might just be telegraphing what she intends to do if and when Argentina loses in Washington.
If that’s the case, she’s crazy: you might intend to do such a thing, but you don’t say that you intend to do such a thing, since that only damages your chances with Plan A, which is to get the Supreme Court to overturn the current ruling. But of course we all know that Cristina Kirchner is crazy.
All of which is to say: Kirchner has now dragged this whole saga deep into the land of the weird and irrational. Maybe we will soon see an illegal exchange offer targeted at existing New York bondholders; maybe we won’t. Either way, the rhetoric in this case will only get louder and less constructive. Expect much more heat than light going forwards.
*Update: Mark Weidemaier has found what seems to be a loophole. There were two original orders from Judge Griesa; the first implemented the draconian remedy for breaching the pari passu clause, and that was the one which was stayed pending appeal. Then there was a second “no workaround” order, which was not stayed, preventing Argentina from attempting anything clever like the exchange offer Kirchner just announced. When the Second Circuit stayed its ruling pending appeal to the Supreme Court, however, it seems to have stayed “the November 21, 2012 orders.” Which seems to include not only Griesa’s remedy, but also the no-workaround order. If that’s the case, Argentina now has a very short window of time to get an exchange done, before the Second Circuit realizes what it has done and reinstates the no-workaround order.