Tuesday, November 23, 2010

How To Restructure PIGS Debt - A Modest Proposal

With Ireland in political turmoil over its application to receive bailout funds, it is becoming obvious that we are getting caught between a rock and a hard place: on one side, markets (a euphemism for the unholy alliance of public pension money and the private money of the ultra-rich) are no longer willing to roll over the existing debt of the over-indebted, never mind increasing their exposure, at anything approaching reasonable interest rates.  On the other, austerity programs attached to bailouts are causing  high unemployment, pay and benefit cuts, tax increases and service cuts.  

How long can this go on before things get seriously crushed, resulting in one or more massive unplanned defaults by sovereign borrowers, or massive social upheavals? Or both?  It is my opinion that time is running out.

A solution must be found, and the sooner the better.

Let's lay some ground rules:

          1.  A solution should include structural reforms, where appropriate.  For example, Greece must radically reform its public governance which is shot through with graft, corruption and ridiculous inefficiencies and raise the competitiveness of its economy so that it can produce goods and services attractive and attractively priced to the global marketplace.  Ireland should re-think its corporate tax policy and start generating significant domestic savings to fund itself locally, instead of relying on foreign portfolio investors who can - and do - disappear at the first hint of trouble (Ireland sports an external debt of 1,000% of GDP).

          2.  A solution should not trigger a credit event for credit default swaps (CDS).  Apart from not rewarding vulture speculators who bear significant onus for the current mess in sovereign bond markets, there is a systemic reason for avoiding a credit event.  Before the explosion of the CDS market a default would result in well-defined losses: debt outstanding minus recoveries.  For example, a "haircut" of 50% meant that lenders lost half  their capital.

Today, however, there is at least $2.4 trillion outstanding in sovereign CDS,  $2.2 trillion of which  is sold by dealers, i.e. big global banks.  If a credit event is triggered no one knows who will be pushed over the cliff by the tumbling dominoes, all happening in a matter of days (remember AIG?).  Most positions are "offset" in dealers' books, of course, but no one gives a damn about offsetting  when counterparty risk enters the equation in times of crisis (remember Lehman? or Bear? or Merrill? or Citi?).  Here's what it is: under no circumstances is Goldman going to offset positions with Deutsche today if it thinks there's a risk of the latter filing for bankruptcy tomorrow, and vice versa.

CDS Prices For PIIGS 

By allowing unrestricted CDS activity on sovereign debt we have increased credit exposure (more "debt" outstanding) and we also included more participants on the possible default list (the issuers of CDS).  Oh, and if sovereign CDS comes second in amounts outstanding with $2.4 trillion, guess who is first?  Oh yes, financial institutions, with $3.3 trillion.  The systemic collapse that will follow a large sovereign default is too scary to contemplate.

          3.  A solution should provide for meaningful debt relief, i.e. result in the cancellation of 30% to 50% of debt outstanding and, soon thereafter, resumption of borrowing from free markets at reasonable rates.

How is this to be accomplished?

Step One: The European Central Bank (ECB) purchases in the open market sovereign bonds of the countries most at risk.  Right now, this means Greece and probably Ireland.  Depending on maturity, Greek Government Bonds (GGBs) are trading around 55 to 75 cents on the euro.

Step Two: ECB returns the bonds to the issuing country at cost and accepts as replacement new bonds of face amount equal to the ECB's cost.  Maturity and interest rates remain the same.

Example: ECB buys 10 billion face amount of 30 year GGBs with a coupon of 4.60% at the current market price of 53, for a cost of 5.3 billion euro.  It returns them to the Greek state and gets 5.3 billion face of new 30 year bonds bearing a coupon of 4.6%.  Resulting debt reduction: 4.7 billion euro.

The operation is entirely voluntary for original bond holders, who don't have to sell.  However, given that the ECB is going to be in the market all the time, bond dealers will have to sell, or raise their offers in order not to be lifted.  Either way, the market will achieve a balance consisting of part debt reduction, part higher bond prices.

Benefits: debt reduction, bond market stabilization, CDS market coming back to earth, lower borrowing costs (eventually) for troubled countries, minimum political wrangling amongst EU nations, fast action.

  • Troubled countries may rely on ECB interventions and not implement needed structural reforms.  That's why the ECB should act only in conjunction with requirements already in place, moving deliberately and stepwise as reforms are enacted. 
  • Bond prices may jump inordinately under ECB's buying program.  If this happens then ECB just doesn't buy, leaving the market to function on its own. Some patience and lots of market savvy are definite requirements for this plan (but not much money!).
  • The ECB's balance sheet will expand, at least initially.  But it already boasts 1.9 trillion euro in assets, so even if it bought half of all GGBs and Irish Government bonds outstanding at a discount, it would only have to spend some 100 billion euro.  With markets being what they are, I doubt it would even have to be that much.
  • It's not ECB's business to bail out nations.  Oh really? Is it its business to bail out only financial institutions, then?  Let's keep in mind that central banks are, above all else, public institutions working for the benefit of the people.  And in such a plan the ECB is not really performing a bailout but a financial intermediation.
  • ECB may be stuck with too many sovereign bonds for too long.  This will happen only if nations themselves don't quickly put their finances in order.  Reforms being a necessary condition for participation in the solution, this should not be a serious problem.  Once primary budgets are balanced and markets work smoothly, ECB will be able to sell the bonds - perhaps even at a profit.
One final point from the market-participants' point of view: CDSs are wasting assets, i.e. if a credit event doesn't happen within the period specified in the contract (typically 5 years) holders will lose their entire investment.  By today's prices of Greek sovereign CDSs, that's $5,000,000 (five annual $1 million payments), paid for covering $10 million face amount of bonds.  If ECB adopts this plan it is certain that CDS prices will collapse as dealers try to get out of positions as quickly as possible, further normalizing bond markets.


  1. Way to reasonable to be accepted right now. . . Come back when the wheels are really coming off. Maybe I'm being paranoid, but there are probably too many people "making" money on CDS roulette to shut the casino down just now.

    Is it utterly callous of me to think that there are players who don't want the problems solved? Where is Major Strasser when you need him?

  2. Hell,

    May I copy + paste your article on to Irisheconomy.ie.? Or maybe you would prefer to do the job yourself.

    Your proposals will be critiqued by some (allegedly) sophisticated financial and economic folk. Would be very interesting.

    Thanks, and best wishes.


  3. Just trying to get a sense of scale here.

    You suggest the ECB could buy about half the outstanding Greek & Irish bonds for around 100 Billion Euro.

    Assuming for simplicity that the bonds are trading at half face value, that means the ECB buys 200 Billion worth of bonds.

    If the coupon is (for simplicity) 5%, the original bonds are paying interest of 10 Billion Euro per year. The reissued bonds at the lower current value would be paying 5 Billion Euro per year -- a saving to the issuing govt of 5 Bill Euro per year.

    A quick check of some newspapers suggests that the Greek govt annual deficit has been reduced to about 20 Billion Euro per year. A further 5 Billion Euro reduction in interest payments would still leave the Greek govt 15 Bill Euro in the hole -- if these back of the envelope calculations are in the ballpark.

    Bottom line - the Modest Proposal would help, but it would be far from being enough. Or am I missing something?

  4. To: Brian Woods Go ahead and paste..

    As for the savings. Yes. it would "only" be 5 billion. But the debt load, the debt/GDP ratios would be cut in half. That's enormous. I don't think such a massive cut is possible under such a plan.

    Instead what could happen is a normalization of the bond market plus some debt reduction.

    Also, if you think about it, your "Only 5 billion" statement reveals that the problem is indeed very small in money terms. The media have made a mountain out of this molehill.

    Why? Because there's a ton of money to be made in the CDS market.

    More on that in the next post.

  5. Hell,

    Many thanks.

    Some questions.

    1. Multipliers: These are some class of 'thing' that are supposed to amplify, or de-amplify, aggregate economic activity. Are these 'real' entities, or 'virtual' attributes? I have asked, and all I get by way of an answer is that they must exist because aggregate economic activity does respond in a manner which suggests that they do exist! What are they? Credit + debt?

    2. The 1930s downturn (an excess of productive capacity and involuntary inventory accumulation) was slowly cured (as in very slow) by a rundown in accumulated inventory. Eventually some idled productive capacity was brought back on-line - more persons employed, more wages, more demand ... ...

    This downturn is due to an excess of credit + debt? But debt GROWS! - unlike inventory in a warehouse.

    How does one cure an exponentially growing debt-weed? Financial herbicide?


  6. Dear Brian,

    Your question of growth multipliers includes several sub-questions, the most difficult of which is "what constitutes growth"? But let's stick to the "classical" interpretation, i.e. growth is the increase of GDP, as defined decades ago.

    There's no question that debt, particularly if it grows much faster than the economy's underlying potential to generate activity without excess inflation, does act as a multiplier, a booster.

    It usually does this through asset inflation. the wealth effect (people feel richer so they spend more), and through asset-backed loans that are used to increase consumption.

    Other multipliers are technological innovations. There's no question that the steam engine, the electricity grid, petroleum, PCs, the Web, even such mundane things as the shipping container have acted as activity multipliers.

    I hate to say it, but the excess capacity that was put into place in the 1920s was, for the most part, only put back into use because of WWII.

    So there you have it: WAR is also an economic activity multiplier.

  7. You offer a very interesting and informative analysis of the current debt crisis. I look forward to reading more from you. I found you by accident whilst surfing the internet for financial news. Do you know about the Russian-Chinese agreement Wednesday (24 Nov. 2010) to stop using U.S. Dollars in their business transactions? Big news. I hope you will write about it in future articles on this site. Thank you

  8. Thanks Roland.

    Yes I saw the news. Russia and China have agreed to use their national currencies for bilateral trade, instead of using the dollar. I don't know how much they were using dollars in their trade to begin with, but the move has quite a bit of symbolic importance, given US pressure on Beijing to let the yuan float.

    But, what's the REAL difference, anyway. The yuan is firmly pegged on the dollar anyway! Now, if the yuan were to float AND be used for international trade...that WOULD be news.


  9. Hell,

    Many thanks for your thoughtful reply. A lot wiser now.

    GDP as a proxy for 'growth'? It is quite frightning how many believe this as an absolute truth. Hope you are completely wrong about the 'war' bit.

    Maybe you might re-publish Albert Bartlett's little warning about exponents.

    Best regards, Brian

  10. (sorry for late comment, just back)
    Brilliant indeed, but ....
    what if the bond holders just ride the issue knowing that the ECB has a bid underneath and wait till maturity, forcing the binary thing: repayment or default?
    Okay, one would still get a good effect in the CDS market but is it more than a good bluff to gain time ?
    Would it not be a good solution for the ECB to slowly drop the bid for the bonds: say today 60 nest month 59, than 58 and so on, to create some urgency to sell by the holders?

  11. Sorry late hour, stupid typos making it harder to understand:
    ... say today 60, next month 59, then 58 and so on .. to create some urgency to sell for the bondholders?

  12. "ECB may be stuck with too many sovereign bonds for too long." -> This will happen only if nations themselves don't quickly put their finances in order.

    As I see it, nations won't quickly put their finances in order. If they could, they wouldn't be having these problems now, would they?

    I guess this will be the major point of discussions, if some will happen.

  13. Hey Thanks a lot for sharing this with us.

  14. this may trigger restructuring clauses in CDS, as there is a reduction in the face amount of the bonds should the ECB do an exchange. Obviously a question for the lawyers, but the solution may be more complex if CDS is not to be triggered. Good overall idea, though.

  15. re: a modest proposal

    is there really too much a difference between the proposal of Mr. Swift and the loads of future obligations we put on our childrens future?