Ignore the angry bleating of aggrieved creditors

When a country hits a rough patch and its lenders start worrying about default, there are usually lots of warnings of near-eternal financial damnation.

The cries are particularly shrill when the country looks like it is plotting a sweeping or aggressive restructuring. “You’ll be locked out of the bond market for a generation!” etc etc, bondholders will protest.

But an interesting new paper by Patrick Bolton, Xuewen Fu, Mitu Gulati and Ugo Panizza examines the long-term impact of the legal ju-jitsu that Greece used to ram through its €200bn debt restructuring. And it provides a timely reminder that these warnings are often just gamesmanship that countries should discount or ignore.

Some background: In 2012, Greece managed to pull off the world’s biggest sovereign debt restructuring in a relatively smooth fashion. It was able to do this because most of its bonds were issued under local law, rather than in New York or London. That meant Greece had a nuclear weapon at its disposal that most countries in debt distress do not: It could pass laws to fiddle with its bonds — terms, value, maturities, or whatever really.

Using an act of parliament to decree a massive haircut in the bonds’ values was considered too aggressive, so Greece instead retroactively inserted “collective action clauses” that bound all creditors to any restructuring agreement struck by a large majority. Most of its bonds were held by European banks that could be browbeaten into signing on to a “voluntary” but tough restructuring, which would then be binding on all of the local-law-bond creditors.

This was great for Greece, but triggered howls of indignation and gloomy predictions from many investors at the time. Here’s Bill Gross talking to Bloomberg in March 2012:

The “sanctity” of bondholders’ contracts has been diminished by Greece’s pushing through the biggest sovereign restructuring in history, according to Bill Gross of Pacific Investment Management Co.

“The rules have been changed here,” Gross, co-chief investment officer at Pimco, said in a radio interview on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt. “The sanctity of their contracts is certainly lessened. Bondholders have that to look forward to going into the future.”

And Cumberland’s David Kotok:

This Greek government invoked the collective action clause (CAC). It retroactively inserted provisions in a debt contract and then imposed them. No sovereign-debt contract is now immune from the same action. All sovereign-debt contracts will carry a risk premium. Buyers of European sovereign debt now act at their own peril.

. . . At Cumberland, we did not own and we will not own debt where a legal system can rewrite a contract, unless disputes (bankruptcy) can be adjudicated by a neutral court . . . We still believe in English law and American courts. If we lose those, we are all doomed.

. . . As for the Greeks, they are headed for a period of sleeping on the “bed of straw.” They will have to get used to it. 

As the paper’s authors also highlight, even Lachlan Burn — a prominent lawyer at Linklaters in London — was horrified:

Retroactive legislation of this sort runs counter to one of the most fundamental cornerstones of any civilised, free society — namely the rule of law. Investors acquired bonds in the belief that whatever contractual rights were embodied in them would be upheld by the courts and could only be altered with their agreement. So, when the debtor altered those rights unilaterally and to its own advantage . . . it is hardly surprising that the confidence of investors was badly shaken. And the fact that the perpetrator of this act was a European sovereign, and part of the European Union, who might be expected above all others to understand and uphold the principal of the rule of law, made the shock all the more palpable. It is easy to protest . . . that this was an isolated incident, and would not be repeated. Dogs that bite once tend to do so again.

One reason Greece’s restructuring took ages is that even European potentates — such as the ECB’s Jean-Claude Trichet — were deeply sceptical about this tactic. They feared it would ruin Europe’s sovereign debt markets forever.

But did it?

While the paper is a great recap of those hairy days, it also looks at the ultimate fallout of the retrofit. The authors examined different bonds of different countries issued under different jurisdictions, and how they each reacted to a series of events before and after Greece’s debt restructuring.

Surprise surprise, the authors found that:

. . . The markets did not view the Greek restructuring of 2012 as having fundamentally weakened their contractual rights. Neither what was done by the Greek legislature, nor what the courts decided subsequently, was viewed by the markets as a big negative event as was predicted by many. The implications are significant, if we think that European policymakers delayed putting in place a debt restructuring for Greece because of a fear of a negative market reaction. If that fear was unjustified, it means that Greece — for almost two years — was unnecessarily paying creditors on time and in full with money it did not have and was later going to be extracted from European taxpayers.

Some caveats are necessary though. While the retrofit in isolation might not have spooked investors much, Europe’s belated willingness to restructure Greece’s debts — and the message that sent — certainly did rattle them.

Basically, the shock of Greece’s tactics was arguably overwhelmed by the implications of the broader strategy. As a result, it took Mario Draghi’s “whatever it takes” speech in July 2012 to begin to ameliorate the crisis.

And as the authors note, while Greece has made a full return to the bond market much earlier than most people would have predicted a decade ago (it’s not an apples-to-apples comparison, but the 10-year Greek bond does yield less than 10-year Treasuries . . . ), there is one hint of residual damage: Greece’s bond sales since then have been issued under foreign jurisdictions, rather than local law.

That said, there is a much broader takeaway here beyond Greece: bondholders will often scream blue murder and whisper darkly about “systemic risks”, but most of the time this is baloney.

It is far better (often for investors as well) if countries in financial distress stop screwing about and act decisively — restructuring sooner rather than later, restructuring deeper rather than lighter, and using all the tools at their disposal to do so.

CC Pakistan et al.