EU sovereign debt: Bondholders should bite restructuring bullet

SINCE GERMANY FIRST proposed a permanent replacement for the European Financial Stability Facility just over two months ago, the eurozone government bond market has been in a state of flux. Sovereign bond investors have been spooked by a largely German-led initiative to create a debt resolution mechanism that will make private creditors bear some of the costs of any bailout of a sovereign state within the eurozone.

Although bond markets already knew that many of Europe’s peripheral sovereigns had debt burdens verging on the unsustainable, the prospect of mandatory debt restructuring or, at the very least, an exchange of haircuts for financial assistance, has been the catalyst for a worrying rise in bond yields across the eurozone, creating a momentum of its own in the push and pull of debt sustainability. It has prompted calls for the EFSF to be increased from its €440 billion limit to meet emergency funding needs for sovereigns as rising yields have made peripheral sovereign debt burdens less sustainable by the day.

Germany has resisted such demands.

As the eurozone’s biggest financial sponsor in this sovereign crisis, Germany has made its own demands as a matter of principle and law. Market sentiment has been a mere inconvenient truth. Germany is no longer prepared to continue to underwrite profligate eurozone members, while also being adamant that the existing bailout regime, cobbled together in the early summer of 2009, was in contravention of the no bailout clause as laid down in the Maastricht treaty, and would therefore be challenged by the German Constitutional Court as unlawful. And so, after months of lobbying fellow EU members, it managed, on December 16, to get EU leaders to amend the bloc’s treaties and create the permanent resolution mechanism. A new regime that shared the burden with taxpayers was also an electoral necessity.

The two-sentence amendment to the treaty read: "The member states whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality."

In keeping with the trend of this developing debt crisis, EU leaders were playing catch-up, since Ireland had already become the first casualty. In November it had been forced to accept an €85 billion aid package from the EU and the IMF after its government bond yields soared more than 200 basis points through November, making its access to the capital markets untenable. Markets then began turning their attention to southern Europe, and the looming refinancing risks EU members there face this year. The ratings agencies joined the party. Moody’s said in December that it might cut Spain’s credit rating in 2011, citing "substantial funding requirements", while Standard & Poor’s said it would review its ratings on Ireland, Portugal and Greece. This calendar year, Portugal needs to borrow €38 billion, Belgium €85 billion, Spain €210 billion and Italy €374 billion, according to estimates from Goldman Sachs. Even France suffered from the negative market mood. Its banks are the biggest holders of government debt issued by the peripheral countries. While the ratings agencies maintain that France should retain its AAA credit rating, credit default swap markets are now starting to signal that it could be in question, implying a rating seven notches lower. It can now be safely argued that the crisis of peripheral Europe is becoming a problem of systemic proportions.

While Ireland’s demise was sealed by market concerns that the EU would impose mandatory restructuring under the guise of a Sovereign Debt Restructuring Mechanism (SDRM), an IMF-proposed mechanism from a decade ago, what finally transpired, with the approval of the European Council in December, was the European Stability Mechanism (ESM). This will provide financial assistance to member states in distress, conditional on the implementation of strict economic and fiscal adjustment programmes in line with existing arrangements. The rules will be adapted to provide for a case-by-case participation of private-sector creditors, fully consistent with IMF policies. However, private-sector creditors will have their claims subordinated to those of the official sector, that is, the EU and the IMF. The proposals, which are still lacking in detail, have done little to alleviate market concerns, and prompted S&P into its review of the ratings of Portugal and Greece.

"As the market has made abundantly clear, the current stage of the global sovereign debt crisis is not, and never was an ‘Irish crisis’," says Arnaud Mares, a former analyst at Moody’s now with Morgan Stanley. It "is the consequence of a demotion of government bonds in the liability structure of governments".

The ESM proposals also stress the importance of collective action clauses (CACs) in eurozone bond contracts that will take effect in 2013. Such clauses, first implemented in Mexico in 2002, are designed to make debt restructurings proceed more smoothly and over a shorter time frame by preventing hold-outs from minority bondholders, forcing them to accept the terms agreed to by a majority of creditors. While these are an important part of any restructuring process, they are not a panacea. Indeed financial stability is undermined by the fact that new debt issued with CACs will likely have to be subordinated to existing debt if the EU’s ambition remains to grandfather existing debt and isolate it from the risk of restructuring via CACs, says Ralf Preusser, head of rates strategy at Bank of America Merrill Lynch in London. "This implies considerably higher refinancing costs, and therefore actually leads to an increase in default probabilities (over and above the restructuring risk posed by the CACs)," he says.

Streamlining

Historically the sovereign debt restructuring process had compromised a hotchpotch of solutions but after numerous debt crises in Latin America in the 1980s and 1990s, efforts were made to streamline it in the early 2000s. This was defined by a three-pillar approach: contractual – through the use of CACs – where amendments were made to the provisions in debt instruments; statutory, which was best exemplified by the IMF’s SDRM, or in Europe’s case today, with the ESM; and a code of conduct, a roadmap that guided the coordination of restructuring between the public and private sectors. It is this third pillar, known in industry parlance as "the principles", that has been omitted from the restructuring debate in Europe, says debt restructuring veteran William Rhodes. Rhodes, a senior adviser to Citi, who played an integral role in sovereign debt restructurings throughout Latin America and Asia over the past three decades, believes the EU approach has fundamental flaws that go beyond the issues of private-creditor subordination. These concern some indications by Germany that will require a restructuring of private sector creditors debt to be determined prior to any financial adjustment program, and before any official financial support.

"This is not the way it works," says Rhodes. "The private sector needs to be consulted at a very early stage, and part of the process of judging debt sustainability is a highly consultative and cooperative process for resolving a debt restructuring and determining on what terms it will take place." The lack of clarity on the level of participation of private-sector creditors will continue to unsettle bond markets, exacerbate the challenges that sovereigns face in pursuing their adjustment programmes and hinder their chances of restoring their access to private capital markets. Rhodes warns: "Contagion is always underestimated; It was underestimated in Latin America, it was in the Asian crisis, and more recently in Europe." Rhodes was, until his recent retirement, the first Vice Chairman of the board of directors of the Institute of International Finance, which acts as a secretariat of the principles. He’s also a trustee member of the IIF’s "Principles for Stable Capital Flows and Fair Debt Restructuring". Late last year the IIF deleted "emerging markets" from the end of the principles’ title to reflect the growing awareness that debt crises were no longer solely a developing-world phenomenon.

The genesis of the principles came from Jean-Claude Trichet when he was President of the Banque de France, which was then endorsed by the G20 in 2004. It provides a framework for a code for voluntary approaches to debtor-creditor relations designed to promote stable capital flows to economies through enhanced transparency, dialogue, good-faith negotiations and equal treatment. Its trustees consist of a who’s who of prominent former and present central bankers, including Trichet, who is co-chairman, as well as such luminaries as Paul Volcker and leading bankers worldwide. The principles have been successfully applied to several voluntary debt restructurings, primarily in Latin America, over the past decade.

Vexed question

How easily could the experience of Latin American debt restructurings be applied to a European context? According to Charles Dallara, the IIF’s managing director and one of the architects of the Brady Plan, which introduced collateralized Brady bonds to the emerging markets in the late 1980s, the question is complicated. He says there is firm resistance from some sovereigns to restructuring their debts because of the concern that such an action might be misinterpreted as the "easy way out to avoid making tough decisions" needed to reform and strengthen the economy. In addition, they take the view that it could damage their future access to capital markets and might put the future of the euro at risk. Germany’s insistence that any future bailout will be conditional on a restructuring, without the input of private creditors, would be folly, Dallara warns. "We don’t quarrel with the fundamental thrust that these countries with outsized fiscal deficits and large external debts are going to have to go through a challenging and difficult period of adjustment for which there is no alternative," he says. "And neither do we quarrel with the fact that at some point in the future some sovereigns may need to consider a debt restructuring, but to wield this threat now continues to generate anxiety in the markets." He adds that Latin American experience shows that such a conditional approach is not productive if you want an orderly restructuring.

Resistance to restructuring was partly resolved in Latin America through the issuance of Brady bonds. "It makes the banks willing to negotiate," says David Lubin, head of emerging markets economics at Citi in London. He adds that collateralized debt reduction could lubricate the process of cleaning up sovereign balance sheets since it gives creditors something in exchange for their agreement to write off debt.

In November, Professor Roy Smith of New York University’s Stern School of Business proposed the introduction of a European version of Brady bonds, called Trichet bonds, as a market-based solution to reduce the amount of sovereign debt among the peripheral countries. He argued that Greek bank loans could be a useful test case, where they could be exchanged for new tradable 30-year Trichet bonds backed by a zero-coupon bond issued by the European Central Bank (with the sovereign support fund as its back-up) to guarantee the principal. However, IIF’s Dallara doesn’t believe that is an option for eurozone countries, because most bank creditors are still rebuilding their balance sheets after the crisis, and are facing headwinds with new capital requirements contained in Basle III. "Brady bonds in the late 1980s/early 1990s could be sustained by the banks, but now it would be very risky and ill-advised," he says. This is an acute problem in Europe, where the scale of the indebtness dwarfs that of the Latin American experience and where bank exposures are more concentrated, both in sovereign and private-sector debt. The nature of the problem is regional and there are big implications for the contagion effect if one of these countries decides unilaterally, or through coordination, to default or apply a haircut, analysts say. For instance, German banks have international claims in Greece, Ireland, Portugal and Spain that amount to about 15% of German GDP, according to Citi. This could have disruptive implications for banks in the eurozone. Thus the creditor’s position is crucial to determining the timing for a default or a restructuring of its debt. With banks still recovering from the financial crisis, balance sheet repair is a key factor, most analysts say.

Orthodoxy not working

While Ireland comes to terms with its recent bailout and the terms and conditions are set, Greece (six months into its adjustment programme) has failed to convince the markets that its austerity measures are working. Credit default swaps still trading in excess of 900bp, indicate that a default is still likely. In November, Josef Pröll, the Austrian finance minister, threatened to withhold his country’s share of the next €6.5 billion loan tranche from the EU, although he quickly withdrew the remark. However, it underscored Greece’s weak position within the eurozone. In spite of a deeper than forecast recession, Athens is pressing ahead with ambitious budget targets for 2011, intended to reduce the deficit by another two percentage points of GDP and bring the three-year bailout programme back on track. On December 14, the Greek parliament passed a package of wage cuts for public-sector and private-sector workers as strikes and protests shut down banks and public transport across Athens. The law was passed by 156 votes to 130 after more than six hours of noisy parliamentary debate. The legislation was rushed through amid fears that payment of a €6.5 billion loan tranche, postponed by the European Commission from December to January for "technical" reasons, would again be delayed because of the government’s slow progress on pushing through reforms. Three days later the IMF said it was disbursing about €2.5 billion to Greece.

Some investors, such as Robert Koenigsberger, the founder and chief investment officer of Gramercy, a dedicated emerging markets investment manager based in Greenwich, Connecticut, aren’t optimistic that the orthodox approach to resolving the fiscal crisis is working. He says bailouts such as Greece’s €110 billion programme often fail because a country doesn’t comply, pre-emptive resources aren’t made available, or the country simply implodes because the public can’t stomach the austerity measures.

Often it’s the reaction of a nation’s people that determines the likelihood of success, he says. "In Greece the first union to go on strike was the tax collectors, so you get a pretty good indicator that their austerity package is doomed to fail." He compares that with the success of the Korean restructuring after the Asian crisis, when a picture appeared on the front page of the New York Times showing Koreans standing in line to have gold extracted from their teeth. "It tells you all you need to know about a people’s willingness to comply with austerity measures," he says.

Destructive force

Koenigsberger, whose firm was involved in the voluntary restructuring of Argentina’s debt after it defaulted in 2001, argues that private-sector creditors’ best option is to pre-empt any sort of post-default restructuring to avoid the potential of subordinated claims by the IMF and important public-sector creditors, such as the G7, which have historically been paid in full in past crises.

He explains: "They act like the angel investor who kicks the can forward and hopes the problem goes away, and when the problem doesn’t, they start to act like senior creditors, and then it becomes a zero-sum game, where there’s only so much pie and senior creditor mentality becomes a destructive force." Therefore creditors should "cut and paste" some of the pre-emptive debt restructurings that occurred in the wake of the Argentine default, where his firm acted as the architect and lead investor in the restructuring of the country’s sovereign debt. The IMF version of SDRM, or a ESM-type approach, says Koenigsberger, "seems to me to be very much a case of a what-do-we-do-after-the accident-type of mechanism. The better question to ask is how can we pre-empt the accident first?" That could involve a hybrid of bailout funds and restructuring of the debt, which could bypass the need for a post-restructuring bail-in. "Our concept is why don’t you try to marry those two things together. Do a pre-emptive reprofiling and the bailout money can be used for better purposes, by partly guaranteeing the reprofiled debt, so that it incentivizes the private sector that’s holding the paper to provide that debt relief in the form of reprofiling. It need not occur with a bail-in."

It’s a solution that mirrors what the IIF’s "Principles" are all about, with the emphasis on the participation of all stakeholders. Ultimately a pre-emptive action is the desired route for investors. As Koenigsberger points out, Argentina is a prime example. Before default it could have serviced a haircut of 35% to 50% rather than the final 66%. "Again that’s the danger the private sector should be aware of if it isn’t already. If I was running the bailout package, I would signal if you all don’t play ball with us, you should understand the range of haircuts that have been out there historically can be unnecessarily draconian." The Latin American experience, although it does not provide a perfect template to apply to Europe’s widening sovereign debt crisis, does offer instructive lessons for policymakers on the perils of mandatory debt restructuring. There can be little doubt that the sheer scale of Europe’s debt mountain means that there is a dire need for restructuring, and that European taxpayers, and particularly Germany, will no longer stomach unconditional support for peripheral countries that provide little or no economic benefit to them. But by imposing conditional mechanisms, European leaders are playing a high-stakes game that need not be played. As Rhodes sees it, the Group of Trustees of the Principles, made up of some of the most senior leaders in global finance, and who provide overall guidance for the implementation of the road map, have an important role to play.

"I really don’t understand why, when you see who’s on that board, why they don’t say we’re going to be guided in our relationships with market and the private sector along the lines of the Principles," says Rhodes. "That would reassure the markets."

see also:

EU sovereign debt: Bondholders should bite restructuring bullet
Sovereign debt: Principles and practice

Also this issue:

Market leader: Tensions run high over sovereign debt haircuts
Market news: EU bailout bonds set for debut issue
Against the tide: It’s in the eurozone’s DNA