The debate surrounding the debt overhang faced by Greece is focussing on two different types of debt restructuring:
- A “haircut” (i.e. partial debt repayment) applied to the face value and/or to interest payments.
- A rescheduling of maturities (i.e. stretching out the repayment period).
But both these options are likely to have quite negative effects on financial markets for a number of reasons:
- Financial institutions would be forced to lower the value of Greek bonds in their balance sheets;
- other governments would be exposed to spillover effects; and
- the market for credit default swaps (CDS) would be hit by a “credit event”, triggering payments by CDS sellers and making them bear heavy losses.
These negative effects can be avoided, or at least mitigated, by a “market-based” solution to the debt overhang problem. Such a solution, based on voluntary participation by bondholders, is not new (Sinn 2011) but I believe it would work. In particular, a buyback of some of its own outstanding debt by the Greek government should be considered. Actually this solution was considered earlier this year, but it was dismissed. This column argues that it should be taken seriously, giving an active role to the European Financial Stability Facility (EFSF), which should lend the Greek government the funds needed for the deal.1
The buyback solution was proposed by Krugman (1988) for emerging countries affected by the debt-overhang problem. It relies on the ability of the government to purchase its own debt traded in financial markets at a discount. If the sovereign debt of a country trades at 0.75 (this is the case for long term Greek bonds), the government can spend 75 cents to purchase €1 of its own debt, thus reducing its liabilities by the same amount. This sounds a good deal for the debtor country.2
However, Bulow and Rogoff (1988) have shown that the matter is more complex. If we look carefully at the effects of the deal, the debtor country may end up losing money to the benefit of its bondholders. Their point can be made through an example. Consider a country whose future wealth can take up two values, either 150 or 50, with equal probabilities. The face value of its outstanding debt is 100. So the expected value of the creditors’ claim as a group is 0.5*100+0.5*50=75, and the market price of its debt is 75/100=0.75. The government decides to spend 10 to purchase some of its debt. It can be shown that the announcement of the deal makes the price of the bonds go up to 0.786. At this price, the government can buy 10/0.786=12.72. However, the expected liability of the country is reduced only by 0.5*12.72=6.36, since the face value of debt is repaid only if the country is solvent. In case of insolvency, the country will continue to repay 50 (which, together with a lower face value of debt (87.28), make the recovery rate and the market price of debt go up). The bottom line is that the country pays 10 and it gains 6.36, so the deal turns out to be a net transfer of wealth to its lenders (equal to 3.64).
New proposal: Leveraged buyback
If we should stop there, the buyback solution would not be so attractive for a sovereign borrower. But we can do better by considering a “leveraged buyback”, provided the institution lending the money for the deal is senior to existing bondholders. Imagine that the EFSF lends the country 10 to finance the purchase of its own sovereign debt. The seniority means that, in case of insolvency, the EFSF is repaid before other lenders; in our example, the EFSF is repaid in full and the holders of outstanding bonds are repaid only 40. This in turn implies that the EFSF holds a riskless asset, so it should be ready to lend at the riskless rate (which here is assumed to be zero for simplicity). It also implies that the market price of bonds goes down to 0.73, since their recovery rate in the default state has been reduced. At this price, the government is able to purchase 13.7 of its own debt. What is the outcome of the deal? The nominal liability of the country has declined from 100 to 96.3 (100–13.7+10), so its expected liability has been reduced by 1.85 (0.5*3.7). This is a net gain for the debtor country. Note that nothing changes in the default state, where the country continues to pay out 50 to its lenders (EFSF included).
The example shows a crucial principle. If the buyback is funded by a senior lender, the money used in the deal is subtracted from the resources available to repay the existing creditors in the default state. This implies a transfer of wealth from them to the debtor country. The debtor country benefits as it can substitute some outstanding debt for another form of debt with a lower face value (since it is less risky). This principle should be exploited by Greece, as well as by other debtor countries whose debt trades at a significant discount in financial markets. The EFSF should lend the money to fund the buyback and it should be given the seniority status. This would anticipate the application of the rule governing the European Stability Mechanism which will replace the current EFSF in 2013.3 Thanks to this status, the EFSF could lend at interest rates much lower than those paid at present by Greece in the open market. Note that this lower rate would not be a “concession”, but it would just reflect the lower riskiness of the EFSF’s claim relative to the bonds traded in the market. Greece would then be able to significantly lower its debt burden.
Credibility is key
A caveat is needed. The seniority status of the EFSF must be credible. Otherwise the outcome of the leveraged buyback is quite different from above. Imagine that the EFSF turns out to be junior to private lenders, and this is anticipated by market participants. In such a case the resources left to repay the existing bondholders would be unaffected by the buyback, as they were in the Bulow and Rogoff case. Then the price of bonds would go up and the deal would be a gift to the existing lenders. The debtor country would lose, since it would substitute some outstanding debt with another more risky debt with a higher face value (unless the EFSF were willing to lend at a concessionary rate). Finally, it can be shown that the deal is neutral if the EFSF is given the same creditor status as private lenders. No transfer of wealth between the debtor country and its creditors arises in this case.
In conclusion, a credible priority structure is crucial in determining the outcome of a leveraged buyback.
Baglioni A (2011), Leveraged buybacks of sovereign debt, mimeo.
Bulow J, K Rogoff (1988), “The buyback boondoggle”, Brookings Papers on Economic Activity, 2:675-704.
Krugman P (1988), Market-based debt-reduction schemes, NBER Working Paper 2587.
Sinn, H-W (2011), “Why the rescue fund is large enough”, VoxEU.org, 19 February.
1 The exposition here is simplified by the aid of a numerical example. A formal model is provided in Baglioni (2011).
2 The argument made by Krugman (1988) is not so naïve. I am oversimplifying here to keep things very simple and intuitive. Similarly, the case made by Bulow and Rogoff (1988) is more general than the example reported below.
3 The Conclusions of the European Council of March 24/25, 2011 state that “the ESM will enjoy preferred creditor status” (page 32).