Mitu Gulati

Mitu Gulati is a professor at Duke University. He and Lee Buchheit, from Cleary Gottlieb, wrote a paper in May 2010 on « How to restructure Greek debt ». It was their ideas that were eventually implemented in 2012.

Interview given in the french newspaper Les Echos, published 20 May 2012.

After Greece, do you think other Eurozone countries should restructure their debts ?
Yes, it would help Southern countries, like Portugal, Spain and Italy. I think Portugal – though the government is strongly against it – will eventually go through a restructuring. But that won’t be enough to solve all its problems. Italy is actually the country for which it would be the most useful : Italy still runs a primary surplus, so a debt rescheduling could give the government a breathing space. The country will still function. It’s always better to proceed with a restructuring before a country becomes too weak. The problem we’re facing now is that most peripheral debt is held by domestic banks. It makes things far more complicated because reducing the face value – as was done for Greece – will hurt domestic investors first, and that will be even more damaging on their economies. Markets have adjusted to the Greek process : foreign investors have exited the weak local law bonds in the Eurozone. Only local banks don’t have an incentive to care about the contract terms.

How can we be sure that foreign investors have exited peripheral debt ?
Since the crisis started, the Eurozone periphery countries have been largely issuing local law bonds, as best we know from the data. That suggests that foreign investors are not the buyers anymore, because foreign investors are not going to get caught with their pants down (holding local law bonds) as many of them did with Greece.

So what kind of restructuring process would you recommend ?
That is the question that formed the final assignment for my debt restructuring class at Duke University last semester. And the students came up with some creative proposals. The best scenarios recognized that the only real option (assuming that things like Eurobonds, high inflation, unlimited ECB funding, are not going to happen) was to try to do a Uruguay style extension of maturities (after the country got impacted by the Argentine crisis, in 2003). This can only work if a country has borrowed at a low rate in the past and now faces a high rate on the markets. And for the most part, countries in financial distress do not have this advantage. Uruguay was an exception. Its financial crisis was caused not by its internal problems, but by contagion from Argentina. Italy is a good example of a Uruguay types situation, because it should not be facing the type of interest rates it is – the reason its rates are so high probably has to do with contagion and uncertainty relating to the rest of the Eurozone. Put differently, the country has a funding problem – borrowing costs for it are too high right now. However, it also has an advantage. It has a huge debt stock, where much of it was borrowed at much lower rates than what Italy is facing today. Much of its debt stock is sitting at rates in the 1-5% range – significantly under current market rates. Those bonds are almost all under local law (around 94%). Stretching out those maturities could help avoid the need to borrow at market rates. For Spain and Portugal, the strategy of stretching out maturities could probably work too. But, the effect of using the strategy – from the perspective of solving the Eurozone crisis without needing more bailouts – would be the greatest if it is used with Italy because Italy has the largest debt stock.

How could it be done ?
There are a couple of ways to do this. My preferred scenario would be to do this in two stages. Stage one uses an idea from my colleague Jeromin Zettelmeyer. It would deal with the foreign investors still holding local law bonds. This, I acknowledge is a smaller and smaller number of investors these days. That is why we will also need a stage two. Stage one would be completely voluntary. Here, investors would be offered the opportunity to exchange their highly vulnerable local law bonds (remember Greece) for stronger foreign law bonds. In exchange, however, they would have to take a 20-30% face value haircut. I suspect that many of the foreign investors still holding local law bonds (that they purchased in the good old days ; before the crisis hit) would find such a deal attractive. After all, we have seen that the local law bonds got a severe haircut in Greece (nearly 70% of NPV) whereas the foreign law bonds that were holdouts were able to recover 100% (so far at least). After stage one, the remaining investor base of those holding local law sovereign bonds would likely be largely comprised of local financial institutions. If a face value haircut is forced on these investors, it will cause a banking crisis and that would not be good. So, what they could be offered is a zero face haircut, but a stretching out of maturities for three to five years (that would effectively produce an NPV haircut). This stretched maturity option would probably be more attractive to local banks, who would not want to take a face haircut for capital adequacy reasons.

But why would anyone take the second offer since it involves a real value reduction ? Many banks presumably would, with some persuasion (arm twisting) from their sovereign. But to make sure that there were no holdouts, one could use a retrofit CAC (Collective action clauses) of the type Greece used with its local law bonds. Like with Greece, if more than 67% of the holdings are with local banks, then that means that they will all vote for the stretching out and, therefore, the stretching out could be achieved for the entire local law bond stock. If done quickly, this would help eliminate the funding needs of these sovereigns for some years to come. There is also a less market friendly to do stage two.

Which is ? This is the idea my students came up with : it would be to use the fact that many of these bonds are issued under local decrees. This is particularly the case with Italy. Some of the Italian decrees, according to my students, potentially allow for the government (the Ministry of Finance or Treasury Department) to simply extend the maturities of the bonds. So long as there are no delays in payment, maturities can arguably be extended. If the government did this, it would make many investors unhappy, but it would be easier than using the retrofit CACs that Greece used (that required legislative approval, that can take time and add complications). But this was simply a hypothetical exercise to see how far the local law advantage that countries like Italy have could be pushed. In a sense, it is the same idea as issuing perpetual bonds when rates are low – as UK did last year.

You designed the restructuring pattern for Greece. How do you judge its implementation ?
Credit for the Greek restructuring should go to Lee Buchheit and the teams from Lazard and Cleary that assisted him. I just worked on an academic article about the basic idea – the real magic was in the implementation of the idea and I had little to do with that. But to get to your question about judging the implementation, the process it took to get to the point of recognizing the need for a restructuring was far too long. The restructuring should have been implemented as early as mid 2010. I believe the markets would have understood that a Greek restructuring then would avoid a worsening of the situation in the rest of the Eurozone. If it had been done then, it could have been done with relatively little expenditure on the part of the other Eurozone governments. And that, in turn, would have meant that the amount of austerity that was demanded from the Greeks would have been less as well. Indeed, market confidence might have actually increased if the Greek crisis had been fixed early through a restructuring. But the ECB was strongly against the idea of any restructuring, fearing contagion. In hindsight, one might argue that it was that reluctance to restructure early that arguably caused the contagion. There was also a bizarre fear of CDS contracts being triggered.

What was the Greek governement’s position ?
The Greek government did not have any control of the debt negotiation process, as best I can tell from the press reports. Usually, when a country is in such a distress, the government decides to stop paying their creditors, then negotiate with them. In that situation, creditors have an incentive to come to an agreement quickly, so that payments can resume as soon as possible. In Greece’s case, the opposite happened. Greece was negotiating while also continuing to pay the creditors. Therefore, creditors had every incentive to delay, as long as possible. After all, they were getting paid in full during the period of delay. It probably meant a waste of 60 to 80 billion euros. That is money that Greece could use now.

European leaders also insisted that the debt exchange should be voluntary…
European leaders put forward the strategy of asking for « voluntary participation » for many months. That made no sense. A bank could easily say yes, in theory, to a voluntary debt exchange and then, before the exchange, sell those distressed bonds to some hedge fund.

Don’t you believe that delaying the deal was good for banks ?
I doubt there was a real strategy behind it. In restructurings that were done in Latin American in the 1980s crisis, it is true that the idea was to give banks enough time to reduce their debt exposures. That was the whole idea behind the Baker plan. In the Eurozone, one can only notice that banks are not in good health today. Instead of banks divesting themselves of weak sovereign debt over the past two years, they have been buying more of this bad stuff. That was put us in a worse situation than we were in two years ago.

Are there any litigations risks towards Athens ?
Not much : those who tendered their Greek bonds committed themselves to give up any litigations. Those who held-out are now being paid. So there could be a case if Greece stopped paying out the hold-outs : then, those investors could complain for “inequal treatment”, if they hold foreign law bonds that include “equal treatment” clauses. We’ll also have to see what happens with state guaranteed bonds. All of them were not included in the debt exchange, so they must be redeemed.

ISABELLE COUET

http://blogs.lesechos.fr/by-les-echos/mitu-gulati-portugal-spain-and-italy-should-also-restructure-their-debts-a10752.html

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