Collective action clauses in eurozone sovereign debt.
What if they don’t work?
The spectre of CACs has been haunting investors in euro government bonds, ever since the EU proposed revising its current mechanisms for bailing out sovereigns. They’ll allow more bondholder bail-ins and are thus very popular with those balking at eurozone fiscal moral hazard.
This revision would involve implanting collective action clauses in bonds issued after 2013, in order to get majorities of investors to agree to this burden-sharing as smoothly as possible.
We already know about some problems here — the lack of applicability to any pre-2013 debt means that it would take a long time for any sovereign to actually derive much benefit from restructuring the CACed bonds. But it’s the start of something big. Above all, CACs would prevent individual investors with large holdings in any one bond from holding up restructuring across different bonds. It’s burden-sharing inside burden-sharing.
Markets clearly know that very well, having heavily repriced credit risk around the 2013 cut-off date and considered various legal strategies for the CAC era. (CACs have, of course, been features of sovereign bonds in emerging markets for a while, so this is mere catch-up.)
But what if CACs instead made all investors dig their heels in during a sovereign debt restructuring, by creating a wholly separate collective action problem?
It’s a question asked in a recent NBER paper by Rohan Pitchford and Mark L. Wright, Australia National University and UCLA economists respectively. As they write:
In this paper, we develop a theory of sovereign debt restructuring negotiations based on the observation that it takes place in a weak contractual environment, where the sovereign cannot commit to making identical settlement offers to all creditors. Delay then arises endogenously due to a strategic holdout effect whereby creditors delay entering into a settlement in the expectation of better terms at a later date.
…we use the theory to examine whether strategic holdout is overcome by collective action mechanisms, i.e. policies which bind holdout creditors to agreements negotiated by a group of earlier settling creditors.
They find that it does indeed. But (emphasis ours) …
In our most striking result, we show that the introduction of a collective action mechanism can increase delay, as the imposition of common settlement terms across creditors intensifies the incentive for creditors to free ride.
Basically, put yourself in the shoes of that individual investor who’d preferred to have held out. (You’d be a vulture fund specialising in distressed debt litigation, or whatever). Under the CAC regime, you couldn’t hold out, but neither would you likely bother to pay for those costs of negotiating the actual CAC vote alongside everyone else. Alternatively, you might actually be pro-restructuring but would prefer to leave the cost of negotiation to others all the same.
The problem here, then, is what happens if pro-restructuring voters who do bear the costs actually begin to find them too large and start stalling the sovereign in order to get a more remunerative outcome overall from the restructuring. Say smaller haircuts or shorter-dated maturity swaps , and so on.
This is quite theoretical. It really depends on negotiation costs versus haircut cost. Moreover, Pitchford and Wright couch their argument in examples taken from emerging markets, not the current euro crisis.
However, their conclusion is worth considering amid the CACs trend:
When the model is calibrated to the range of negotiation costs observed in practice, we find that free riding is quantitatively relevant, with the introduction of a collective action mechanism more than doubling delay in complicated and costly restructuring operations. For simpler restructuring operations, where costs are low, we find that collective mechanisms reduce delay by more than 60%.
So it really would depend how complicated and costly the restructuring of debt would be, and the negotiation costs. That’s a good reason to think through the implications of their thesis for future eurozone debt swaps and haircuts. They’d be very complicated, likely beyond any previous sovereign debt restructuring.
Let’s consider (in what would be highly hypothetical examples) Ireland or Greece restructuring some time after 2013.
They’re actually odd cases from the point of view of their creditors. Holdings of Greek debt have become increasingly consolidated and domestic over the crisis. Conversely, Ireland’s bonds have largely been held by foreign investors. You’d conclude that negotiation costs regarding Greece restructuring would thus be easier, but there is another problem — many of Greece’s biggest creditors, its banks, probably would need to restructure their own debt especially if the haircuts on their government bond holdings wiped out their capital. Discussions on that double problem would be pretty tricky.
Although if you’re thinking Ireland might then have it easier — the negotiation cost of bringing all those foreign creditors in one place is potentially going to be large and vulnerable to free-riding as well.
At the same time, at least almost all Irish and Greek debt should be subject to domestic law. Some do think a Greek burden-sharing may take mere months, not years, on this basis.
The point is, we don’t know. The problem is, you’d want a eurozone restructuring to proceed much faster than (for instance) Argentina’s which has taken the best part of a decade already, given the size and interconnectedness of eurozone debt holdings versus emerging debt.
Investors are rightly focused for now on the subordination problems of Europe’s coming CAC-ed debts. But it’s worth asking what value they’d have for actual restructuring, if they are to be the future of sovereign debt.
Full paper in the usual place.
Related links:
Battles loom between creditors and borrowers - FT
Bondholders will sue every sovereign – FT Alphaville
That tricky ESM seniority – FT Alphaville
Eurobonds are among us – FT Alphaville