Thursday, July 24, 2014
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A Greek Catch-22

BUENOS AIRES – Desperate times bring desperate measures. The latest package to cope with Greece’s insolvency offers a bond buyback to lighten the country’s debt burden. In essence, this is a back-door debt restructuring: Europe’s bailout fund, the European Financial Stability Facility (EFSF) would lend the money for Greece to buy back its own debt in the secondary market at deep discounts, thereby imposing a loss on private bondholders without the need to declare a default.

A recurrent characteristic of Europe’s debt-crisis debate is a Latin American precedent. Indeed, many highly indebted countries in Latin America conducted similar debt buybacks in the late 1980’s. Bolivia’s 1988 buyback of close to half of its defaulted sovereign debt, an operation funded by international donors, is a classic example. But the most relevant Latin American experience with debt buybacks is a more recent and far less studied case: Ecuador in 2008.

President Rafael Correa had been toying with default since the 2006 presidential campaign (debt repudiation was part of his platform), and quickly earned a CCC rating from Fitch. The reasons invoked by Correa (legal concerns about how the bonds were issued in the 2000 debt exchange) were beside the point. The default threat was a way to depress bond prices in secondary markets, only to buy them back at a discount through the back door. That task was outsourced to Banco del Pacífico, which bought the soon-to-be-defaulted Ecuadorian paper at 20 cents on the dollar and above – a level low enough for a deep haircut but high enough to fend off “vulture” investors.

To speed things up, after the default was declared in December 2008, Ecuador completed the buyback with an inverse auction for the remaining bondholders, to be settled in cash – rather than a regular exchange in which the legality of undercover purchases was likely to be questioned. With the larger part of the outstanding stock in friendly hands, and institutional bondholders pressed to liquidate their positions in the midst of the post-Lehman Brothers selloff, the operation was a success.

This episode offers a few preliminary lessons on debt buybacks. The first concerns the market response. Judging from the recent evolution of Ecuadorian bond yields, it appears that markets have not punished Ecuador’s behavior: Ecuador, an oil exporter blessed by the 2009 recovery in oil prices, could have returned to the capital markets shortly after the exchange. This is particularly notable, given that Ecuador’s was perhaps the first opportunistic default (triggered by unwillingness, rather than inability, to pay) in recent history.

The second lesson, and the one most pertinent to Europe now, concerns the crucial role played by the default scenario. Indeed, almost two years of default threats by Correa were not enough to elicit a deep discount. Ecuador needed to go all the way to a “credit event” in December 2008 to be able to purchase the bonds at bargain prices.

The premise that only a credible default ensures significant private-sector involvement (that is, that private bondholders take a real hit) is apparent when we compare the market-friendly Uruguayan debt exchange in 2003 with the draconian Argentine restructuring of 2005. In Uruguay, what the authorities presented as a voluntary transaction produced no nominal haircuts and only minor debt relief; in Argentina, a four-year debt moratorium was essential to achieving nominal haircuts above 50%.

So the question arises: how are private bondholders to be convinced to get rid of their Greek bonds at a loss if there is a credible buyer of last resort? If Europe credibly volunteered funds to buy back all Greek debt, the Greek risk premium would disappear and private investors would be fully bailed out. Only the probability of a default – and the goal of avoiding even deeper haircuts – can induce investors to liquidate their positions at a discount. But the buyback can succeed only if the market perceives it as the last chance before a unilateral debt restructuring. In other words, a successful buyback is a preamble to default.

Can Greece, with the EFSF’s help, obtain debt relief while avoiding default? Small purchases at current panic prices, vulture-fund style, are always possible, but they do not promise substantial debt relief. Large purchases would drive up prices in the secondary market, defeating the point of the whole operation. And the opaque Ecuadorian methods are not possible in Europe, both for legal reasons and because a transaction of this size could hardly be disguised or outsourced.

But what if the EFSF were to mimic Banco del Pacífico in a transparent way, say, by setting a threshold spread level above which it would fund buy-backs of any Greek bond in the market? Naturally, the spread would automatically converge to the threshold, but how much would be sold? Would the EFSF be retiring Greek debt at bargain prices or would it be providing insurance to current bondholders?

If the threshold spread is set reasonably high in order to achieve a significant discount, the stock of debt retired by the buyback would be marginal. After all, by capping spreads, the buyback facility would limit the downside risk while providing incentives to hold the bonds and wait for the upside – a good reason, perhaps, to make the facility a temporary offer. By contrast, if the threshold is set low enough to bring spreads down from panic levels, purchases will be more substantive, but at the expense of reducing considerably the effective haircut on private holders.

A debt buyback is something of a Catch 22: to succeed in inducing a haircut, it needs to profit from the default fears that it intends to alleviate. Without Ecuador’s gimmicks, buybacks do not seem to be the solution to Greece’s debt overhang.

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