Even as the ECB heads back into the market to punish the peripheral bond shorts, there’s still much talk on longer-term ways to fix what’s really the problem in markets for this kind of debt.
To recap — mass illiquidity, vanishing investor bases, and (not least) plenty of opaque default risks. Peripheral debt is a dead asset class.
One niche but appealing substitute at the moment: a common eurobond for governments to issue in place of national debt — gaining its proceeds according to their particular national weights within the issue.
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Eurobonds are here!
The ECB’s Ewald Nowotny gave some support on Thursday, but the idea has long been on the back-burner based on German objections over whether it would just encourage more deficit financing by peripheral governments.
But actually, in a weird way we already do have eurobonds now, and few have realised it. But with huge implications for future debt restructuring.
More in the legal than credit sense, but still — eurobonds de facto. And ironically enough, it’s thanks to Germany and its insistence on haircuts alongside future peripheral bailouts, now embodied in a new mechanism to replace the current bailout funds after 2013.
It basically comes back to the way in which the post-EFSF European Stability Mechanism will implant aggregate collective action clauses (CACs) for new eurozone government bonds issued after 2013, as the main means for activating haircuts. Also, as we currently understand the process — the CACs will be enforced via EU directive. That could turn out to be critical in making these new bonds ‘eurobonds’ in a key way.
We’ll go back to this legal basis in second. But first, the ESM’s aggregate CACs are not simply a route to restructuring peripheral bonds overall. They are also a route away from a particular type of restructuring at the national level. To demonstrate this — we want you to think of Uruguay.
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A Uruguayan example
After all, Uruguay pioneered aggregate CACs during a restructuring episode in 2003. The context of this very restructuring itself is also important in its lessons for Europe, however, and perhaps suggests a weakness for the ESM — unless of course, we do start to see its likely appeal to markets as a eurobond regime in all but name.
Here’s what Uruguay did, at any rate.
The little South American republic built its CAC effectively out of thin air (few of its bonds had contractual CACs, much like Europe today) during a very severe crisis for its debt, both in terms of the overall burden and the time available to avoid complete, catastrophic default.
Nevertheless, Uruguay managed to get 93 per cent of its bondholders to volunteer for a new-for-old bond swap that paved the way to aggregate clauses in those new bonds in turn. There was no automatic mechanism or even a legal process for restructuring.
Or in the words of an IMF paper of the time:
A primary consideration for the authorities was to avoid default. In this context their strategy aimed at a collaborative process and a voluntary exchange. Since time was of the essence, the authorities relied on informal contacts with creditors. As near-term debt-service relief was a major consideration, bondholders were offered to swap existing bonds for new longer maturity [five more years] instruments with broadly the same face value and coupons as the old bonds, implying a NPV reduction. To encourage high participation rates, the authorities established a commitment to complete the offer if participation exceeded 90 percent, maintaining discretion if participation levels fell between 80 and 90 percent. They also announced that the exchange would not go ahead if participation fell below 80 percent.
Waiting for the investors were those new bonds, with both vanilla and aggregate CACs inserted. The point is that Uruguay had to go about restructuring without an ‘orderly’ legal process, and did it quite well, however.
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From Uruguay to the eurozone
Fast forward to Europe, 2010. We wonder if a similar dynamic might be playing out here. There’s no ‘orderly’ legal process for a Greek or Irish restructuring in the sense that CACs do not exist for their bonds either (excepting some foreign-law bonds). However, Greece in particular has one advantage over Uruguay. Greek bonds really are overwhelmingly governed by local law (not foreign law, and not — yet — by EU law).
This was a point about Greece made back in May, in a paper by Lee C. Buchheit and Gaurang Mitu Gulati. They used this advantage to argue that Greece could consider applying a ‘mopping-up law’ throughout its local-law bonds. Usually changing the law would be anathema for the reputation risk it would incur in future, however.
On the other hand, perhaps not, thanks to CACs. As the authors noted (emphasis ours):
One legislative measure that might be perceived as balanced and proportional in these circumstances, however, would be to enact what amounts to a statutory collective action clause. It could operate in this way: local law would be changed to say that if the overall exchange offer is supported by a supermajority of affected debtholders (say, 75%, to use the conventional CAC threshold), then the terms of any untendered local law bonds would automatically be amended so that their payment terms (maturity profile and interest rate) match those of one of the new instruments being issued in the exchange.
Assuming some version of a Mopping-Up Law could survive any legal challenge… it could have significant tactical implications for a Greek debt restructuring. More than 90% of Greek bonds are governed by local law. If, to use our example, holders of 75% of all eligible bonds (local law and foreign law) were to support a restructuring, our version of a Mopping-Up Law should operate to ensure that more than 90% of the debt stock will be covered by the restructuring…
Quite a temptation, if the current rescue programme for Greece turns sour. However, Greece would not have long to act. Complicating matters further, it would have to plan for a restructuring even while it’s still borrowing rescue loans from the IMF and EU (which cease in 2013).
That’s because the ESM at least ensures that a sudden restructuring after the Uruguayan model (with or without the lubrication of legal ‘mopping-up’) becomes complicated after 2013, with its new class of legally-protected bonds. The first eurobonds, if you want.
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Whose haircuts?
There’s a real irony in the way investors sold off peripheral paper after hearing about German proposals to make new issues of those bonds far more amenable to restructuring, therefore. First — the proposals were only intended to apply to new issues, not old debt stock.
Second, the ESM which resulted from those proposals would at least provide investors with definite rights and a definite timetable over CACs and other features — effective creditor consultation, for instance. Above all, investors would come under the shield of EU law. Contrast that with how a national restructuring would proceed.
We’ll admit it’s a strange, and possibly untenable, way of looking at the ESM — so much remains to be nailed down by policymakers (such as the seniority of ESM bailout loans themselves, for example) that the details could quickly change.
But still, eurobonds or not, it’s interesting to ponder whether the ‘pro-restructuring’ ESM is, actually, going to turn out anything but.
Related links:
More bad news for Greece - FT Alphaville
Et in Arcadia ego – FT Alphaville
Creditor discrimination during sovereign debt restructurings (PDF) – Bank of Spain