David Apgar: Between the Whirlpool of Riots and the Rocks of Default – Market-Based Debt Relief after Greece

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.

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  1. Jose

    And what would prevent governments from starting the process all over again with the new bonds?

    Say the investor proposes a haircut of 60 per cent and receives a new bond with that nominal face value. Then after a couple of months the government proposes a new haircut – get 60 per cent of 60 percent, or 36 percent of the original face value. And so on.

    The proposed scheme seems to be just another clever trick that will solve nothing. The truth is the euro system is fatally damaged and only a move towards a full fiscal (transfer) union or a reversal to the old national currencies can fix its problems.

    1. David Apgar

      Most institutional investors have a fairly clear idea whether an illiquid sovereign borrower wants to put its finances on a sustainable footing or play games like the serial queuing (60% of 60%) example you give. If investors have any doubt they will treat creditor queuing as a default.

      They did not do so with Mexico in the late 1980s, however. The country famously balanced its primary budget in a fiscal correction worth two Gramm-Rudman’s. It had credibility and needed a long-term solution, which it got in the form of Brady bonds.

  2. john haskell

    Wow, it’s really hard to know where to start with this guy. A 50% haircut is “doing well.” yeah, I’d be delighted.

    Two years ago Greece was paying you a few basis points over Bunds, now you’re getting a 50% haircut and blamed for creating the problem.

    And David Apgar says that if you don’t show up at the next Italian bond auction with your checkbook, you’re a criminal.

    How to solve this problem? “Queue your creditors,” i.e. default. Okay thanks for the suggestion, but include me out. And if you think that “perfect austerity” will increase any country’s ability to service its debt, keep on smoking the hopium.

  3. George Phillies


    I propose that if you own bonds from, say Euro member Zenda, and you realize that the Greek solution exists in the Eurozone, the moment Zendan bonds start to drop significantly your reaction is to sell them.

    Thanks to modern electronics, you can do this almost instantaneously, and the Devil take the hindmost.

    Those rate curves start to get very steep in time.

    The other issue is that there are various ways to hedge against bond defaults, and they probably just became close to worthless for Eurozone bonds (alternatively, the trigger rewrites are going to have a new group of administrators ruling on the defaultness), meaning that folks profiting on selling them are going to find a new source of income.

  4. sleeper

    Sorry folks, I just don’t get it.

    A change in the interest offered for Itailian bonds will tip the country into default ?

    A recent press release seemed to indicate that a rate of 7% would be unsustainable for Italy.

    Odd – in recent memory (early 80s) rates for US government bonds (Federal Farm Credit Notes) were as high as 12% which while it did slow the economy it did not pitch the system to default.

    And note that consumer rates for auto loans, credit cards, pawn shops, and pay day loans are much higher than 7%.

    I can’t help but think that the constant meme of deadbeat borrowers and default concern is an artificial construct.

    Are the bond markets being gamed ?

    1. marc fleury

      does a bear sh*t in the woods? about the only thing that holds water in OP is the fact that funds are taking out sovereign one by one. The tantrums of miss market are being richly rewarded

      1. ReaderOfTeaLeaves

        And since it is becoming evident that the electeds are letting their nation states get rolled by bankers and bond markets, I expect growing political instability.

        Time for some new economic thinking; the current system appears looted into rigor mortis.

  5. marc fleury

    I don’t get it at all. As in WTF?

    If all of this mumbojumbo is to avoid default and writing down to market then why not stay at “market” and just not pay. There is going to be litigation anyway.
    t. Does the author thinks he is helping avoid naked CDS triggers with that suggestion?

    What a giant exercise in intellectual wanking.

    1. marc fleury

      And then I pay attention to the pedigree ‘McKinsey, the Office of the Comptroller of the Currency, and Lehman”

      Ahhh, maybe that would explain why we are in such a mess, if the folks who should know better talk to you and you are left with your face frozen, with your eyes darting left and right, thinking “what the f*ck did he just say, that made no sense at all” but you really can’t say anything because you are too polite anything in person. And you mumble a vague “I see… ” Looking for the exit. But of course behind my keyboard I am not such a coward and I can call a spade a spade.

      You sir, just got the prize for the most nonsensical post in the history of NC (rest easy you have serious competition).

  6. Jim the Evil Bondholder

    I really don’t see why bondholders should get burned at all. This isn’t a dodgy Irish bank with bad mortgages. Nor is it piece of subprime trash from your local branch of Goldman Sachs. Investors were led into European bond markets because they assumed they were safe. They assumed they were backed by a functioning EU.

    Very few saw or could have seen the political chicanery and outrageous lack of responsibility coming down the tunnel (a few MMTers did, but that was about it). They thought that a major power like the EU was responsible enough to repay its debts. And instead they get burned on Greek debt… and you want them to get burned even more.

    They don’t deserve this. And even from a practical point-of-view, if they were further burned you’d find very few investors putting cash up for European bonds in the future.

    1. David Apgar

      Thanks for a clear statement of the other side of this argument. And it may be true that lots of institutional investors honestly thought Greek bonds were as safe as German ones.

      But plenty of institutional investors knew there was no such thing as a contractual EU guarantee and made a cynical bet that they could embarrass Germany and France into covering Greek obligations when Greece’s implausible finances hit the rocks.

      Come to think of it, I’ve never heard a money manager say: “There were risks, I liked the yield, and I lost my bet.” It’s always more like: “This Trojan horse was supposed to be risk-free.”

      1. Jim the Evil Bondholder

        That’s an oversimplification at a number of levels.

        The most obvious being that Ireland and Spain ran budget surpluses/tiny deficits until their banking sectors melted down.

        The less obvious being that I don’t think most buyers of European government securities were aware that there was no ultimate backstop. I simply don’t think that they’d thought it through. And I don’t think this is their fault.

        But morality aside, the most obvious objection to further haircuts is that it is not practical. Investors will bail out of the Eurozone governments’ bonds — Germany’s included, if they push the haircuts far enough — if they see themselves treated as disposable playthings. And rightly so. All that is stopping the ECB paying up is stupid power politics and nationalist posturing.

        To go one further, I think that the ‘burn the bondholders’ argument can be construed at this stage as a neoliberal argument in disguise. Why? Because it will further dissolve trust between the markets and governments and ultimately push the latter deeper into the abyss. Then what? More ‘markets uber alles’? Great. I’ll leave an apology note to my kids in advance of their being born!

        1. Calgacus

          Perhaps not surprising that Warren Mosler TEB largely agrees with Jim, but here is Bill Mitchell: US opinion polls expose mainstream economic theory – “It might surprise readers to know that I do not support the Euro leaders conniving – just to protect their flawed monetary union – to penalise private banks who invested in good faith in Greece (or anywhere else for that matter).”

        2. Yves Smith Post author

          I have to tell you that I am not at all sympathetic with your description of bondholder due diligence.

          Banks in all EU nations are backstopped by that state, not the EU. It was WELL KNOWN before the crisis that EU banks were more thinly capitalized than US banks and that they did much less to clean up their losses and recapitalize post the crisis than the US banks did (and we’ve regularly hectored those efforts as insufficient).

          The EU banking sector is ALSO much bigger relative to GDP than the US. Assets are 325% of GDP.

          This was a problem waiting to happen. Bonds are risk capital too. You missed an obvious risk. Tant pis.

    2. sleeper

      So I have to ask – Who are these investors that won’t put cash into European bonds ?

      Is this Ma and Pa Kettle ? The corner grocer ? The man on the street ?

      Please if we can expect the Chinese government to invest in US Treasury securities at perhaps 1% (which by the way the US government will almost certainly only pay off with more borrowing) why is it that European bonds are not a salable commodity at any price ?

      1. Jim the Evil Bondholder

        “Please if we can expect the Chinese government to invest in US Treasury securities at perhaps 1% (which by the way the US government will almost certainly only pay off with more borrowing) why is it that European bonds are not a salable commodity at any price ?”

        Because of this:


        The US pay up. The eurocrats tell you to f&%k off whenever they feel like it. I wouldn’t loan those Scrooges a red cent. And neither would any sober investor.

        (P.S. Plenty of pension funds hold sovereign debt or are tied to it in some way. So, it’s not just Gordon Gecko’s bank account that would be hit.)

        1. sleeper

          So let’s see –

          If evil bondholders or sober investors won’t lend.

          Then why would pension funds ? Are these folks not evil enough or are they just drunks ?

          Clearly the market is being gamed there is no other plausible explaination.

  7. Foppe

    So what I’m missing in this post is an explanation of why this wouldn’t be the legal equivalent of the default for those ‘last in line’.. I mean, I can see how this auction-type thing might work out well to the advantage of the state who is restructuring in this way (especially if the interest goes down more than expected because there is a smaller insolvency worry), but what I don’t really understand is what difference that makes when it comes to feasibility.

    1. David Apgar

      Thanks for the question. The main differences are that queuing gives investors an incentive to disclose what they think a borrower can afford to pay and a little control over their own fate.

      1. Foppe

        Yes, certainly, but as I understand these sovereign default things, the problem is mostly that the institutional arrangements give the lender rather a lot of power vis-a-vis the borrowers (not least because they’re usually helped by a USGovt willing to strongarm countries); so why wouldn’t they be able to sue (and win) if this were to actually happen (even apart from the fact that all of these countries are ruled by neoliberals who are in no way interested in acting for their own constituents)?

        1. David Apgar

          More good questions. Investors may even sue and (in some jurisdiction or other) win over the so-called voluntary agreement just stitched up over Greece. We’ll have to wait and see about that and whether the markets turn on obviously healthier countries.

  8. Susan the other

    Wow. Call me ignorant, but I’ve been wondering about the “moral risks” for naughty governments and naughty investment banks. This article by Apgar was spectacular in its clarity. Thank you Mr. Apgar. I loved it. I especially loved the clarity about the relative value of currencies. Currency is a valuable tool and gold is a Cyclops. Just ask any Greek.

    I think the ancient, powerful and karmic cure for crazy debt – to queue your creditors – is pure genius. Far cleaner than all the flying buttresses holding up the EFSF, temporarily that is, the failure of which could condemn Europe to the equivalent of a cluster default which will never be sorted out.

    As we wring out the inflated value of currencies, each denomination is worth more. Isn’t this honoring debt in reverse? And shouldn’t debt go both forward and backward?

    Market based debt relief. Now that is democratic.

  9. Hugh

    Creditor queuing is an interesting idea because it shows that that the options flogged by the PTB are really not the only ones available.

    For the rest, the problems in Europe far from being solved have not yet been addressed. Burning the bondholders is only part of the answer. Major structural changes still would need to occur in European finance, politics, trade, and monetary policy. It is rather like the Titanic. A few new officers (PMs in Italy and Greece) have been named, but rather than address the issue of the iceberg and that the ship is sinking, they are rushing around making sure the glasses of the first class passengers stay full.

  10. Fiver

    I find it more than a bit strange that while pretty much everyone who is not personally interest conflicted will acknowledge that banksters et al have run riot, have captured pretty much the gamut of political/regulatory/legal/financial/media etc. institutions in the US and much of the Western world, yet there remains this compulsion to insist that markets somehow are the idealized, disinterested behavior-in-aggregate “markets” of theoretical yesteryear – as if, for example, an entity like Blackrock did not quintuple its assets under management to $3.5 trillion since the financial crisis hit. Or as if the Fed didn’t toss the law out the window and into the next county. Or as if Wall Street banks had not loaded up on European debt and CDS AFTER it was clear to everyone the crisis in Europe was far more grave than had been widely perceived (though many were aware of it back in early 2009 – I recall reading John Mauldin on this subject at length). Or that they had already unloaded Greek debt before it blew. Or that the CDS “surprise” for some odd reason caught only the hapless MFG. Or that banks have dumped $300 billion in Italian debt as of a couple days ago. To WHO one might ask.

    Point is, we will admit to a tree full of truth-challenged very powerful bad apples, but cannot stomach the idea that they ever talk to each other, that they would ever coordinate their moves, that what we are witnessing is not some diffuse “attack” by thousands, or even hundreds of high-risk, independent “bond vigilantes”, but rather deliberate, winner-take-all financial war. Look past the immediacy of who makes money in the very near-term, and consider where it’s all headed. Who ultimately is going to win this? German and French banks? HA! Germany? How? Democracy or sovereignty Ha! Ha! Ha! I for one have no doubt that once the dust settles (and Merkel is pushing hard for an early 2012 commitment to Treaty changes that shred what’s left of accountability to peoples) it will be crystal clear that the hands-down winner of this war – oops, I mean “crisis” – was the Wall Street/Washington complex, and the domestic elite that supports it. Oligarchs, and oligarchies cannibalize when conditions warrant or the opportunity presents itself. The US is going to dine on Europe for the next 5 years minimum.

    Note that it does not matter if this is good or bad for the majority in any of the real economies affected, though I believe the stage is close to set for a final Wall Street asset bubble that trickles down enough crapola jobs for Obama and Bernanke to be widely hailed by, say, late 2015 just before it blows one last time.

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