By David Apgar, who just launched GoalScreen, a web app still in trials that lets investors test alternative price drivers of specific securities (free though the end of the year at www.goalscreen.com. He has been a manager at the Corporate Executive Board, McKinsey, the Office of the Comptroller of the Currency, and Lehman, and writes at www.goalscreen.com/blog.
So now we can all breathe easily again. After all, the bond markets have rid the world of a dynasty of prevaricating Greek prime ministers and a modern-day Il Duce reincarnated as a trousers-around-the-ankles buffoon. There is just one fly in the ointment. Investors may start serially mugging healthy countries. Sovereign borrowers have a defense, fortunately, if only they dare use it.
Bond markets have already started tilting at France. French public debt is a manageable four fifths of annual product, its fiscal deficit low for a country recovering from a credit collapse, its banking sector moderately sized and domestically oriented, and its voters pragmatic about paying taxes for services the private sector cannot provide. It’s no surprise France has a higher credit rating than the US. Why would France make bond investors nervous?
The answer is that investors have done reasonably well by boycotting the bonds of successive euro zone governments. They’re getting at least half their money back from Greece, a country that could have repudiated its debt rather than shoulder a burden still greater than GDP. Portugal and Ireland are paying up. And Italy, a country whose ex-leader wanted to plunge his nation into crisis rather than tax his own business interests, is grinding out austerity and payment in full. Indeed, bond investors have come close to securing guarantees from the whole euro zone without having to pay for them.
Wait, it gets better. In the case of most sovereign borrowers, investors strike an implicit bargain with the borrower’s central bank. The upside is that the central bank will step in to refinance government debt if enough investors get nervous. The downside is that the central bank can unilaterally reduce the value of that debt through inflation.
In the case of euro zone borrowers, however, investors face little of the bargain’s usual downside since the European Central Bank (ECB) is fastidious about inflation. For a while, it looked as if investors would get little of the upside, as well. They had reason to fear the ECB would not buy Italian bonds, for example, when investors staged their latest tantrum and stopped buying the stuff.
The tantrum nevertheless scared the ECB into action and Berlusconi out of office. So investors are getting the best of both worlds and the real question is why they would not try their luck with other euro zone members. In Europe today we have moral hazard on the part of not just a few feckless governments but investors, too. Euro zone bailouts are tempting investors into a life of serial crime.
If investors stage strikes over the bonds of other sovereign borrowers who lack a central bank of their own to defend them, however, the euro zone may disintegrate. Rather than watch their grand monetary experiment go up in smoke, euro zone members may reach for an ancient and powerful cure not often mentioned in polite company. They may choose to queue their creditors.
Here’s how it might work. Suppose the bond markets ran rates on Spanish debt to unaffordable levels and put a refinancing at risk despite perfect austerity on the part of the incoming government. Spain could react by asking all investors – whether public or private – to propose haircuts on maturing bonds they expect to redeem. The government would then redeem those bonds for new ones with a face value lower by the amount of the haircut. An investor offering a haircut of 40%, for example, might exchange 20 million euros of maturing bonds for 12 million of new debt.
The catch is that the government would exchange debt with investors in the order of the haircuts they propose. Once the total amount of new debt issued by the government reaches the maximum it claims it can afford – it would exchange no further bonds. This poses a risk to investors who propose little or no discount. They may get no new bonds. In fact, they may not get paid at all.
This may sound like a conventional default. The difference is that investors who propose haircuts reflecting market values may end up with new bonds worth as much as their old ones. Suppose the market value of old debt is 60%, for example, and the new debt is worth 100% (which is possible if the exchange cleans up the country’s balance sheet enough). Then a haircut of 40% would leave an investor with a loss no worse than marking the old debt to market.
Conversely, this may sound like a form of market discipline for investors, not too different from the discipline that the secondary market already metes out. The difference here is that the borrower actually benefits from the losses that investors suffer. Come to think of it, investor losses on a solvent but illiquid borrower are wasted when they don’t help restore its liquidity.
It’s unclear whether creditor queuing would trigger payments on credit default swaps. Satyajit Das points out that it differs from typical CDS triggers like non-payment, debt moratoria, repudiations, and restructuring. New debt would be issued only to retire old debt and participation would be partly voluntary. It’s true, however, that nonparticipating investors would have a battle with their CDS insurers. After all, the insurers would argue, those investors had the power to avoid a full loss.
In sum, creditor queuing shares features of restructurings and routine market discipline. You might call it market-based debt relief – but more useful than market discipline and more credible than restructuring. Such credibility could be important in the case of euro zone borrowers lacking their own central banks if investors start holding healthy ones hostage. Creditor queuing evens the playing field like a bankruptcy procedure. Investors may want to keep it in mind before dumping good bonds.