It has been argued that the LDC debt problem could be significantly alleviated if debt to private sector creditors could be wholly or partly securitized. Securitization would provide market valuations of existing debt, enabling the development of secondary markets in debt. This would expand the range of investors willing to hold LDC debt, thereby increasing the supply and reducing the price of funds to debtors. Market valuation of the debts would also reassure bank shareholders and provide LDCs with incentives to maximize the value of their securities, in order to obtain new issues on favourable terms.

A major obstacle to securitizing LDC debt has been sovereign risk: if debtors choose to stop payments due, creditors have little leverage to enforce resumption of debt service. In Discussion Paper No. 295, Ronald Anderson, Research Fellow Christopher Gilbert and Andrew Powell propose a means to overcome this obstacle. The authors adapt a game-theoretic model of default and rescheduling used by Eaton, Gersovitz and Stiglitz, taking account of the characteristics that distinguish sovereign debt from private financial contracts. A sovereign debtor decides whether to threaten default by comparing the cost of honouring the contract with the penalties resulting from default. If the repayments are greater than the penalties, the borrower threatens default; the lender may then declare default or propose a rescheduling of the debt. Both parties usually prefer rescheduling, because it results in the lender receiving a sum greater than could have been obtained in the case of default, while the borrower does not lose future access to credit.

Anderson, Gilbert and Powell propose, first, separating sovereign risk from other components of risk attached to the debt, so that the default risk could be insured with a third party. This unbundling of risk would eliminate the need for investors to form their own judgement of the risk of sovereign default. Second, to ensure that the premiums set for insuring the default risk are not too high, the likelihood of default must be reduced. As this likelihood is usually greatest when the borrower faces an adverse economic environment, for example if export revenues are low, the authors argue that debt repayments should be made contingent on commodity prices.
In the 1980s, high real interest rates have raised debt service obligations at the same time as recessions and low real commodity prices have substantially reduced the benefits to debtors from having continued access to financial markets. This combination increases the risk of default and would raise the cost of default insurance. Anderson et al. therefore propose financial instruments in which there is a positive correlation between the borrower's repayment schedule and current and expected export earnings. To remove the temptation for debtors to under-report export revenues, and to ensure standardization across countries, repayments should be correlated with internationally quoted commodity prices and exchange rates, rather than with each country's export earnings, Anderson, Gilbert and Powell suggest.
Though an adverse economic environment tends to encourage many debtors to default at the same time, exposing an insurance system to unacceptable levels of risk, the authors argue that this high correlation reflects the heavy dependence of all LDCs on relatively few commodities. Splitting off LDCs' exposure to commodity price movements would therefore ensure that the probability of default is more affected by factors that vary across debtors

Securitization and Commodity Contingency in International Lending
Ronald W Anderson, Christopher L Gilbert and Andrew Powell

Discussion Paper No. 295, March 1989 (IT)