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.

Downsides: 

• 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.

Objections:

• 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.