Stuffing bondholders in Greece and Ireland

Greece and Ireland are in an existential crisis. Over-indebted, the two countries have been forced to slash spending in order to reduce deficits despite the existing shortfall in private sector demand. For Greece this is a real economic death spiral, with the attendant social and political costs. It is a foregone conclusion in global markets that Greece will default on its bonds. The potential for default in Ireland is also high.

Clearly, cutting bondholders lose and defaulting is tempting. So, let’s take a brief look at the political issues surrounding a default. I will start by highlighting two articles I read from the Irish Independent today on this issue.

Background

This first article goes to the losses that wealthy Irish investors suffered in subordinated Irish bank debt.

Hundreds of wealthy Irish individuals are nursing heavy losses after pouring millions into Irish bank bonds over the last two years. Some investors have lost millions of euro.

The bonds — known as unguaranteed subordinated bonds — were sold by some stockbrokers and the private banking arms of the main banks…

"Some investors incorrectly believed they could not lose money because they thought the bonds were covered by the government guarantee."

Although some bank bonds were guaranteed by the Government, many of those which offered the prospect of higher returns were not guaranteed…

Haircuts of up to 90 per cent have been imposed on subordinated bond-holders.

–Hundreds of wealthy Irish burnt in bond haircuts – Independent.ie

The second article goes to what would happen to Ireland were Greece to default. Note the reference to US Treasury Secretary Timothy Geithner’s veto of Ireland’s cutting bondholders loose. I will come back to that.

With the Papandreou government teetering on the brink of collapse, a Greek sovereign debt default now looks very much like a question of when rather than if…

Meanwhile, Finance Minister Michael Noonan travelled to the United States where he announced plans to "burn" the Anglo Irish and Irish Nationwide senior bondholders — a move that he must have known is anathema to the ECB, which has committed itself to a rigid policy of "no writedown" of government or senior bank debt.

It’s difficult not to suspect that neither the timing nor the location of Noonan’s statement was coincidental. While in the United States he had meetings with the IMF, which has adopted a far-less rigid policy on debt write-down than the ECB, and with treasury secretary Tim Geithner, the man accused by economist Morgan Kelly of vetoing a previous plan by the Irish Government to "burn" unguaranteed senior bank bondholders in November 2010.

Are we seeing the first signs of the emergence of an Irish Plan B? Does Noonan have a cunning plan for Ireland to hold out until Greece goes bust?

We can only hope so. Things can’t go on like this.

–What happens to us if Greece defaults? – Independent.ie

The Key Players

With those articles as a backdrop, let me outline who some of the players are and their political positions on a default. Here are seven.

1. The ECB: Headquartered in Frankfurt, Germany; widely seen as a German-dominated institution geared to strong currency and anti-inflation dogma; also with heavy French, Dutch and Italian influence; new Italian ECB head problematic for French; categorically opposed to sovereign bond default, ostensibly because it would create contagion; However, having already provided liquidity to Greek and Irish banks against Greek and Irish government bond collateral, the ECB has a vested interest in not seeing a default.
2. Greek government: Socialist government in place since Oct 2009; came aboard with potentially politically-motivated revelations of fiscal tricks by previous conservative government in Greece; revelations, rather than giving new government a clean slate, plunged country into sovereign debt crisis; engaged in austerity cuts in order to receive bailout money from the EU and IMF.
3. Irish Government: Fine Gael-led coalition government elected as a repudiation of Fianna Fail government which led Ireland into crisis.; in power since March; have cautiously moved toward Plan B of repudiating bank debt guarantees of previous government; engaged in austerity cuts in order to receive bailout money from the EU and IMF.
4. German Government: Led by Angela Merkel, first German Chancellor from former East; because of public opposition to bailouts, reluctant supporter of bailouts; Looking for bail-in of private investor losses; Finance Minister Schaeuble only minister with institutional memory of pre-Euro German political imperatives; More unilateralist and markedly less ‘pro-European’ than previous German governments.
5. Bank creditors: Domestic institutions in Ireland and Greece; Foreign exposure dominated by institutions domiciled in Germany, France, Britain, and US; shaky capital structure cannot handle writedowns after credit crisis; categorically opposed to debt haircuts or default
6. The IMF: European-led international monetary institution used to give loans to emerging markets with balance of loan problems; often lambasted as a tool of big banks as loan and bond repayment is central aim of IMF programs. Main technocrats in restructurings in LDC crises of 1980s and Asian crisis of 1990s. Added to European crisis because EU lacked institutional experience to deal with sovereign debt crises. Less concerned about full debt repayment than ECB.
7. Tim Geithner: US Treasury Secretary; Former US regulator (NY Fed chief); architect of US bailouts of Bear, AIG, Citi, BofA; proponent of Lehman Brothers collapse; opposed to US bank nationalisation; driving force behind Obama’s economic policies; main architect of US mortgage relief programs; driver of move toward deficit reduction; categorically opposed to senior debt losses; inserted himself into Irish bailout

Solvency and Liquidity

The issue in any solvency crisis is three-fold.

1. The illiquid can be rendered insolvent. “One problem with financial crises is that perfectly healthy companies, perfectly healthy financial institutions, [healthy countries] can go bankrupt just because they temporarily lack the funds to pay their creditors. This is what the lack of liquidity in our financial system can do. The real problem of crisis is that healthy institutions are often dragged down with unhealthy ones, leading to a dead weight loss and a negative feedback loop in the real economy (Solvency, Sep 2008).” The EU needs to separate liquidity and solvency by providing liquidity to the solvent and having the insolvent restructure.
2. Who is illiquid and who is insolvent is important. “When bankruptcy comes, it does so normally as a result of a liquidity crisis… creditors become spooked about longer-term insolvency. At first, they demand a higher return for their loans. Eventually, they pull in their horns altogether. Liquidity dries up and the company or country is unable to roll over its debt requirements. It literally runs out of money (Liquidity and Solvency, May 2010).” If a bank is insolvent it needs to be resolved not bailed out. If a country is insolvent it needs to do a debt restructuring not get bailed out. Bailouts conflate liquidity and solvency and bring on deadweight loss in the form of the bankruptcy of the illiquid as well as the insolvent.
3. Bailouts are used to avoid pain. Nationalisation, writedowns, defaults and other remedies are always about who gets the stick, who takes the losses. Nationalisation wipes out shareholders who share losses with taxpayers and potentially bondholders. Defaults cause bondholders to lose. Bailouts, debt guarantees and the like are ways to avoid that pain. However, they can lead to crisis if the bailout is not credible and that leaves taxpayers footing a larger part of the bill and creates deadweight loss from solvent but illiquid debtors being rendered insolvent.

What we see in Greece and Ireland fits this framework. In Ireland, for example, the Irish government has imperilled its solvency by bailing out the banks. The EU has created confusion by resorting to bailouts that have allowed the euro zone periphery to ‘re-couple’. In the end, this is just about who takes the losses: taxpayers or bondholders, the periphery or the core.

Stuffing Bondholders

So what should Greece and Ireland do? Clearly, austerity has been devastating to their economies. In Greece, the austerity will be for nought as they will likely default anyway. In Ireland, the austerity is a necessity largely because the Irish government assumed bank liabilities. So why shouldn’t they stuff the bondholders?

First, I agree with these sentiments from March 2009 about US bank bondholders:

To preferred and subordinated debt holders, Geithner is effectively saying the following: "If the bank holding company in which you hold capital instruments is in dire need of common equity capital, then come to terms with them or we will do it for you! You knew at the time that you purchased this paper that they were not FDIC insured deposits, but rather capital instruments of a bank holding company. If the company in which you invested is in dire trouble, you too should share some of the pain and not expect 100 cents on the dollar."

–Geithner to shortsellers: take your profits and go home

Bond investors made calculated capital allocation decisions, judging their investments in Ireland and Greece as likely to yield the best return for their level of risk tolerance. Unfortunately they misjudged the risk. And now they must face the consequences of that misjudgement. To bail them out is a moral hazard which encourages the misallocation of capital.

So subordinated bank bondholders have been eviscerated in Ireland. The question now goes to senior bank debt and sovereign debt.

My problem here is that the holders of bank liabilities – depositors and creditors – have other options. They can always withdraw their support from an institution that they feel will fail – creating a self-fulfilling prophecy. This means that taking too much of a haircut on bondholders, especially senior bondholders, will undermine confidence in the system. In the Swedish example from the 1990s, this was recognized and a blanket guarantee was given to all depositors and creditors of institutions deemed to be solvent…

This is a solution that was geared to address the ‘Bear Stearns problem’, where lines of credit are pulled and a firm goes under before it is clear that said firm is actually insolvent…

However unpalatable a senior debt guarantee might be, it seems a wise option to consider.

For an alternate take see Barry Ritholtz’s: Haircuts for Bond Holders.

–Stuffing bondholders, Mar 2009

That’s how I put it two years ago after wiping out shareholders via nationalisation was removed as an option. It’s not that I wanted to protect bondholders from their own mistakes but that I wanted to minimize the losses by guaranteeing the senior debt in solvent companies.

Of course, in the US not only were shareholders not wiped out, but subordinated bondholders and senior bondholders were made whole while taxpayers were forced to pony up bailouts and subsidized loans for the banks. This was the handiwork of Timothy Geithner, the same Timothy Geithner who also intervened on behalf of (American) creditors (or CDS insurers) in the Irish bailout.

I think the point still holds that a credible senior bondholder guarantee can underpin the capital structure of a solvent organization and induce those investors to roll over their debt. This is what the Swedes did in the 1990s and I suspect the Irish were following their playbook.

To my mind, this all speaks to the overriding need for policy makers to ascertain who is illiquid and who is insolvent and to as demonstrably as possible subject the insolvent and the solvent to the most differential treatment one can muster. At the end of the day, what people want to know is who is insolvent and who isn’t. Once they know, they can fight over who takes the losses. And those creditors that cannot take the losses will have to be recapitalised or resolved. Everyone else gets to live another day.

Why isn’t anyone in policy circles except Wolfgang Schaueble fighting for this solution? Clearly the bank lobbyists are winning this battle

The Politics

Unfortunately, they are winning the battle but may lose the war. The view that the EU is “Destroying the Periphery in Order to Save the Core’s Banks” is fast becoming the prevailing mindset in the euro zone periphery. And that means Nouriel Roubini’s belief that “The Eurozone Could Break Up Over a Five-Year Horizon” is very much a factor. I certainly believe the chances of a euro zone breakup are now increasing. But more than that, this destructive path doesn’t save anyone. It makes defaults, break up, depression, civil unrest, economic nationalism and xenophobia more likely. And from there, the outcome is anybody’s guess.

As I wrote in the New York Times yesterday:

Putting off the day of reckoning makes the situation politically unpredictable and, therefore, considerably worse. This would increase the likelihood of other defaults and of the euro zone coming undone. Acting now maximizes the recovery value for Greece’s creditors and allows the E.U. time to develop the institutions needed to support a single currency.

If E.U. leaders are smart, they will understand that the turmoil they fear from a Greek restructuring will be much worse if that default is a unilateral one forced by a population that has taken to the streets.