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Addressing the EuroZone Dilemma – Lessons from the Emerging Markets - June 7 and 9, 2011

Speakers at EMTA’s Special Seminars on the EuroZone remained pessimistic about a resolution of the EuroZone crisis, while recommending that a "reprofiling" (for Greece’s debt at least) might prove the best solution. The events, hosted by Bank of America Merrill Lynch in New York on June 7, 2011, with a similar event hosted by Credit Suisse in London on June 9, 2011, drew over 300 attendees.

The New York event was moderated by Jane Brauer (Bank of America Merrill Lynch), who began the panel with a summary of her firm’s views on the crisis. "EU policymakers believe that to lend Greece more money now is to throw good money after bad; however, if they don’t, we believe that they would eventually have to provide even more funds to Greece, which would be forced to default and be denied market access for years," she stated. While welcoming speakers back to the event, originally held in June 2010, she noted that she hoped that there would not be a need for this to become an annual event again in 2012.

The other panelists (and their topics of interest) included:

Lee Buchheit (Cleary Gottlieb Steen & Hamilton) – Greek Debt - The Endgame Scenarios; CACs for EuroZone Sovereign Bonds

Anna Gelpern (American University) – Ways to Tread Water: Portugal and Greece Updates; Central Bank Drift

Robert Gray (International Capital Market Association) – Understanding the ESM; CDS, CACs and Aggregation

Adam Lerrick (American Enterprise Institute) – Europe’s Default in Credibility; Role of CDS

Lerrick admitted that he, like others, did not imagine how badly the situation would evolve. "I thought last year that Europe would muddle through with a series of larger and larger bailouts with lower and lower interest rates for longer and longer maturities," he acknowledged. "If Greece had defaulted and restructured last year while cutting its budget, it would have been back borrowing in the markets within months," he continued.

"The fundamental issue is that Greece’s productivity cannot pay for the standard of living its citizens expect," he commented, "and it will take a decade of deflation of nominal wages and prices and of productivity gains to achieve the balance." He rejected concerns that a Greek default would spark a Lehmanesque crisis, noting that "Lehman’s default did not cause the crisis. It was because the default was unexpected. Markets hate surprises; surprises cause panics. In this case, everyone expects a Greece restructuring," he reasoned. Concerns of a Selective Default Rating or losses on CDS contracts are also overblown, according to Lerrick. "A Selective Default Rating would only be in place for a small number of days. In Uruguay, it lasted 17 days; as for CDS, the net amount is small and CDS are marked to market so the losses have already gone into the accounts of the banks that have written the CDS," he stated.

The ECB has a new definition of contagion, Lerrick continued. The old definition of contagion posits that healthy, sound economies are victims or innocent bystanders of an infectious disease. The new definition encompasses any event in one EU sovereign (such as a reprofiling or Vienna Initiative in which banks voluntarily reinvest proceeds of their bonds) that results in higher interest rates for other countries even if the higher rates are justified, i.e., fears that events in Greece would result in higher rates for Portugal, Spain or Ireland. Lerrick argued that, fundamentally, policymakers "don’t understand markets, don’t like markets and think they can control markets."

Gray discussed the European Stability Mechanism (ESM), successor to the European Financial Stability Facility (EFSF) and the European Financial Stabilisation Mechanism (EFSM). There has been great concern since the ESM was put on the table last year, he acknowledged, with the suggestion that pre-2013 bonds might be exempt from any restructuring. This was likely an incorrect assumption, as a two-tiered bond market would serve no purpose and stood in contrast to principles of "fair" and "transparent" markets, as well as fair and equitable treatment of all local and international creditors. Gray argued that debtors that behave fairly and transparently (including disclosure of the terms and conditions of their bonds) were generally able to reach mutually acceptable accords with creditors.

The ESM’s status as a preferred creditor (although implicitly junior to the IMF) added a new complication. Would this be just a market convention accepted by investors, as was the status of the IMF, would there be a move to make this contractual and/or would member states be tempted to introduce it by legislation (thus diminishing confidence in local law governed bonds), he pondered.

There was also concern that standardized collective action clauses (CACs) would be introduced by decree (with the attendant concern that member states may be tempted to reduce CACs to 50%), although this would certainly raise legal challenges and would be complicated by comparable enforcement in various jurisdictions. He briefly mentioned the aggregation and disenfranchisement voting concepts related to CACs that were very esoteric and rarely used, and complicated by any ESM to- be-held bonds. And, he discussed the nexus between CACs and the CDS market, commenting that he didn’t think that the CDS market loomed too large in the ESM’s horizon (especially since voluntary exchanges would not trigger Credit Events, although use of CACs as binding on all holders may so trigger Credit Events), and that CDS holders might be incentivized to agree to such voluntary exchanges. He predicted maturity extensions as the likely outcome.

Buchheit recalled that the preferred creditor status of the IMF and regional development banks has been historically justified on the basis that only these organizations would lend to distressed sovereigns, and that such status has been implicitly accepted and not contractual or legal in nature. It remains unclear whether the self-proclaimed preferred creditor status of the ESM would work. "Will it be between the IMF and private creditors? Will it be by treaty and be binding European law?" he asked hypothetically.

Buchheit’s own prediction was that EU governments would wisely avoid spelling out exactly what they meant until possibly the outcome of certain events, and would avoid codifying the ESM’s preferred status in a treaty. Paying one creditor over another is a not a violation of the pari passu clause, he pointed out; rather, it is a matter of changing the ranking of debt, not payment, that may violate such clauses.

"The times are a-changin’," Buchheit underscored. In the past, relatively small IMF loans were employed as a catalyst to restore capital flows to distressed sovereigns; "never before has the official sector bailed out the entire private debt stock of a country before a default, which is in effect what is happening." The IMF and regional development banks should be wary of the expansion of the preferred creditor category, as should investors, as "bloating" of this category will mean deeper cuts for others, as well as possible restructuring of even the ESM’s held debt, with large official sector losses borne by taxpayers, Lerrick added.

Gelpern opened with her statement that the number one determinant of a Greek restructuring is who takes the losses and how far do they reverberate. A year, however, should be a reasonable time to come up with a loss allocation scenario. Today, there is a new financing gap and more sustainability fears; new, improved talk of a Greek restructuring; a new financing package with new, improved policy conditions; a diminished contagion fund, with promise of another two years; and jittery Central Bank balance sheets, with a first-time, severely impaired reserve asset. With limited progress on a loss allocation scenario, and sources of financial and political support scarce, the pressure on private creditors will be mounting.

She noted that legal and contractual obstacles to restructuring are not real, and that investors have often focused on CACs, which are "a distraction", as if their mere presence or absence would determine the likelihood of a restructuring; rather, CACs may help determine how a restructuring proceeds, but not whether and when it occurs. The real obstacle is the politics of loss allocation.

The "trilemma" is that a solution must be economically, politically and institutionally credible, something quite difficult to achieve, she believed. For example, economic solutions that involve a combination of transfers to Greece, recapitalization of European institutions and losses on Eurosystem Central Bank balance sheets won’t work politically, and formally involving Central Banks in an economically credible restructuring is not institutionally credible; restructuring debt through the private sector may be politically credible, but it is not economically viable because many private creditors are backed by EuroZone governments (including Greece) and much of the debt is owed to the public sector, and who pays when the Greek banking system is wiped out; and, a solution that preserves the integrity of Central Bank functions, while reducing Greek debt, might involve a restructuring of all publically and privately held debt on equitable terms, conditional on policy reform, among other scenarios, is probably not politically credible. She concluded that printing money and inflating the debt, or using "smoke and mirrors" accounting or ‘soft’ restructuring or other nomenclature will likely not solve the trilemma.

Panelists debated whether the Vienna Initiative employed for Eastern European nations could be used in the case of Greece. "If I were a shareholder in a bank or a beneficiary of a pension fund that voluntarily re-invested in Greece after miraculously escaping with full repayment on its bond, I would certainly make noise at the annual meeting," stated Lerrick. This initiative worked in Eastern Europe because of unique circumstances (e.g., small number of affected banks, long-term strategic interest in the countries involved) that don’t apply in the Greek case.

Banks have limited exposure to Greece and they own government bonds, not operating subsidiaries, so they have no long-term interest to reinvest in Greece, according to Lerrick. Gray disagreed, citing the rescues of South Korea and Turkey in recent decades. "A number of banks do recognize that these sorts of steps can help get to a solution," he responded. Lerrick countered that in South Korea a government guarantee and a 300 bp step-up in coupon were offered to investors, which is why a Selective Default rating was not assigned since the risk was reduced and the yield increased. He believes that the only way a Vienna Initiative could succeed is if everyone were convinced that the alternative was an immediate restructuring with massive losses.

As for collateralizing Greek bonds á la EM Brady Bonds, Buchheit noted that Greece’s local law governed bonds did not have negative pledge clauses (as well as half of external bonds, "due to a drafting error"), so Greece could borrow on a collateralized basis from the EU without triggering negative pledge issues. However on a more visionary level, he wondered if the EU really wanted to send the signal that investing in Greece on an uncollateralized level was too risky. With such a "deeply insolvent" country, Buchheit believed that Greece needed a "savage" restructuring.

The use of higher taxes on holdout creditor bonds in a restructuring would be viewed as a coercive measure by ratings agencies, Gray speculated, triggering CDS and a Selective Default rating. Another measure to discourage holdouts—the ECB not accepting "holdout bonds" as collateral—would mostly affect weak Greek banks, which have a less diverse inventory than European competitors.

Panelists concurred that the Uruguayan reprofiling through extended maturities was seen as a fair solution by the market, which proved "forgiving" after an NPV loss of 5-10%. Montevideo resisted calls to default as neighboring Argentina had done, and Uruguay was viewed by investors (with whom it consulted extensively) as making maximum efforts to meet its obligations. The country was rewarded by being able to tap voluntary markets within 30 days after the deal closed, Buchheit noted.

Lerrick believed that Greece’s best option was a "time out" with maturities on bonds extended for seven years. During that time, Greece could privatize assets and reduce its spending, while the EU financed its deficit. Bondholders would lose only on an NPV basis, a Selective Default rating would be a short-term event, although CDS would be triggered. Structurally, the EU remained problematic because its members cannot agree on what level of assistance EuroZone states owe one another and what controls the EU should have over member deficits and debt, according to Lerrick.

EuroZone officials should support a reprofiling of Greece’s debt because of its "burden sharing," i.e., private creditors would take an NPV loss, and also because the official sector’s rising share of Greece’s debt was shifting the risk to "core" nation taxpayers. These taxpayers, not Greece’s bondholders, would pay the cost of a later restructuring. Lerrick concluded that there is no effective enforcement of sovereign debt, the "only reason to pay is that there is more to gain from paying than from not paying", that "for every bad borrower there is a bad lender", and that Greece doesn’t need to borrow more money, it needs to lock in the lenders it has. The debate on this topic continues, Buchheit believed, and the "jury is still out."

Two days later, Kasper Bartholdy of Credit Suisse moderated the event in London with David Riley of Fitch Ratings joining Buchheit, Gray and Lerrick, and with much of the discussion following the themes of the NYC event.

Buchheit began with a quick summary of the crisis, and the conflicting solutions being proposed by the European Central Bank (fill the hole by contributions from the EU and IMF) and Germany (time has come for the private sector to reprofile Greek debt). He noted that, with the IMF program for Greece up for renewal at the end of June, "the battle is being fought as we speak and must come to a conclusion soon" since the assumed return to the private markets in 2012 will not happen at this rate.

Lerrick criticized the EuroZone’s decisions as being made on geopolitical not economic grounds ("Europe wants to establish its global leadership and regain its lost status in a world where Brazil, India and China are more important than any individual European economy"). For him, the real deficit was in credibility, not in payments. He added that, "if Greece were 3000 miles away, it would have already defaulted, restructured and re-entered the markets." When the Euro was created, there was the illusion of an "homogenized" credit risk, similar to the homogenized currency risk, when, in fact, accountability was missing. A system in which the union underwrites the debt of all members is not sustainable unless the union controls the spending and borrowing of each member. Finally, chat of Greece having to leave the Euro was "perplexing" to Lerrick, noting that "Orange County and New York did not have to leave the Dollar when they defaulted and restructured their debts!"

Lerrick expressed strong disapproval of EuroZone response to the crisis. "Everything is run by arbitrary ad hoc decisions; yet the whole purpose of policy is to reduce uncertainty," he stated, continuing that "the violation of EuroZone promises has become the rule, rather than the exception." Either each EuroZone member stands on its own, or the EuroZone underwrites all losses; the EuroZone must make a decision or crises will continue. He also challenged policy makers’ unrealistic views, including the fiction that telling bondholders they may need to buy bonds in the future at grossly inflated prices will not cause the bondholders to sell their bonds today. "No one ever voluntarily takes a loss." It would be better if the interest of the private sector was forced into alignment with the interest of the EU taxpayer. A seven year extension of Greece’s bonds would provide the time to determine if Greece has a liquidity problem or an insolvency problem that requires a large scale restructuring.

Gray explained the differences between the temporary European Financial Stability Fund (EFSF) and the more permanent European Stability Mechanism (ESM), while noting that they had more similarities than differences ("no changes in conditionality; no real changes in the parameters on private sector involvement"). However, the ESM would have a different capital structure and rely more on callable capital from member states.

Riley addressed a variety of issues relating to the Greek crisis and opened with his belief that the crisis was a catalyst for the broader systemic crisis across the EuroZone, a Western (not global) financial crisis. Despite conjecture to the contrary, most of Greece’s sovereign debt is held by banks, not hedge funds or "vulture" funds, he said. This was a concern because banks remained the dominant source of credit, and cross-contamination of the sovereign and local banks could create a vicious cycle. Riley reminded participants that, in contrast to Uruguay’s $5 billion restructuring, Greece would potentially be restructuring E300 billion ("…and this is a small European economy"), so scale was an important factor to recognize. In addition, the economic linkages were "substantial and include the ECB’s balance sheet." And, Riley wondered, could Greece recover in an economy dominated by Germany?

Riley viewed the crisis from moving from a stage 1 ("default impossible") to a stage 2 ("a sovereign default only after mid-2013 and only if insolvent, rather than illiquid, and only via a special default mechanism"), and subsequently to a new stage where the IMF seemed to be moving to issue new money to fill a financing gap, and not yet concluding that Greece was insolvent. While the IMF has been criticized for "hanging on too long" in cases such as Argentina, the official sector belief used to be that sovereign defaults should be the last resort, rather than a first response; Riley is not sure that the official sector holds that view today. He remarked that there was a crisis of credibility and trust in the European political response, and he did think that contagion was a real threat.

He described his agency’s approach to the issuance of a "Restricted Default" rating (equivalent to a "Selective Default" rating) at the announcement of a debt exchange, which may be considered a default event, informing the audience that the completion of such debt exchange represents a "cure" to a default and "effectively re-starts the clock," with a new rating issued based upon the post-exchange credit profile of the debtor. While there wouldn’t be "tweaking" of other countries’ ratings just because of Greece, the agency will be looking at the relevant countries’ existing EU programs in its ratings assessments.

Following the formal presentations, the panel addressed a wide variety of audience questions in an hour-long Q&A. Speakers discussed the "hard" or specific percentages of critical mass required for a bond exchange to be completed (as in the case of Uruguay), or the more common case of a vague reference to a requirement of critical mass, or the mention that an exchange would not occur if it would not result in a sustainable debt load. Riley acknowledged that his firm would apply an "RD" rating once they receive indications from the sovereign that a deal would occur, and, if there were no "hard" percentages, the agency would seek to consult with the sovereign.

On the possibility of regulatory forbearance to allow Greek bonds to be held at par on the books of creditors, Buchheit opined that this was quite possible, citing the generous "professional allowances" and accounting fictions during the Latin debt crisis of the 1980s and 1990s. Responding to a question on Greece abandoning the Euro, Lerrick commented that a recent proposal that Greece should leave the Euro, devalue and subsequently return at a new lower exchange rate would destroy the Euro; "the Euro then is no longer a money but simply a fixed exchange rate system."

Buchheit replied to an inquiry on a potential redenomination of Greek debt into a post-Euro currency. Local law debt indeed could potentially be open for a redenomination, he acknowledged, though this could be viewed by ratings agencies as a default. Owners of English law bonds, if indeed they could be redenominated, could get an English court judgment for the debt in their original currency, making the redenomination meaningless.

What level of a debt burden was sustainable for the Hellenic Republic? Speakers had no easy answer, and suggested that some countries could be judged as insolvent with a debt to GDP ratio of 50%, while others—usually the most highly-rated countries—can support much higher debt/GDP ratios.

Instead of the option of Greece leaving the EuroZone, would a move towards deeper EuroZone integration make sense? Gray agreed with the presumption that a tighter or looser union was preferable to "one in the middle." Lerrick repeated his assertion that if the union guarantees the debt of the individual members, the union must control their spending and borrowing.

The ECB’s aversion to a triggering of CDS also was a subject of additional discussion. Buchheit observed, "there seems to be some aversion to paying ‘the speculators,’ even though the data I have seen seems to show that 60% of CDS is owned by bondholders, and it may be more disruptive to the market not to trigger the CDS, or as a CDS holder one may not participate in a voluntary exchange, thus possibly triggering a Credit Event."

As for the chance of a massive, disorderly default having ripple effects throughout international finance, Riley thought this was unlikely. Lerrick thought the only significant effect would be higher rates for other weak EuroZone states such as Portugal, Ireland and Spain. "After spending billions of Euros to try to keep things together, to bring Argentina to the belly of Europe is almost unthinkable," opined Buchheit.

New York
June 7, 2011:

  • Agenda
  • Summary of Panelist Remarks
  • Materials
  • London
    June 9, 2011:

  • Agenda
  • Summary of Panelist Remarks
  • Materials