How a Debt Exchange Could Ease Europe’s Crisis: Luigi Zingales
The political response to the European crisis so far has been denial and temporary patches. But policy makers are facing more than just a liquidity crunch; they also need to tackle a solvency crisis and possibly a structural one. One of the most pressing issues is addressing the over-leverage of the southern European nations.
Economic theory tells us that in situations of over- leverage there are multiple equilibrium points. If all parties expect a sovereign borrower to be able to pay, the market will refinance that creditor at low rates, ensuring it won’t default. Conversely, if lenders expect a default, it will happen. The enormous volatility we are witnessing is the result of the impossibility of knowing which of these outcomes will prevail.
How can this uncertainty be eliminated?
Corporate finance provides an answer. When companies are over-leveraged, they respond either with a debt-for-equity swap or with a debt exchange offer that reduces the face value of the bonds. While these reorganizations are difficult to negotiate, they have the potential to make both creditors and debtors better off. Even the most conservative estimates put the cost of such financial distress at 15 percent of a company’s value. If we were to apply similar figures to countries, the results would be more than enough to satisfy both bondholders and issuers.
Transforming debt into equity is easier for companies than for countries. While it is possible to convert part of a sovereign debt into claims that would pay creditors according to a country’s gross-domestic-product growth, such arrangements can’t be put in place on a voluntary basis. By contrast, debt- exchange offers can be achieved by mutual consent, if they offer some securities with higher seniority.
To illustrate how this can be done, I will rely on a proposal by the Brussels-based research institute Bruegel for a two-tier euro bond. Bruegel advocated the creation of senior “blue bonds,” which could amount to no more than 60 percent of a debtor nation’s GDP and would be jointly guaranteed by the European countries, along with junior “red bonds,” which would be guaranteed by the issuing country.
Applied to sovereign debt, a package of blue and red bonds that has lower face value, but higher seniority than existing obligations, could achieve the dual goal of reducing the amount of debt while making the creditors better off.
Here is how it would work:
Take an Italian bond with a remaining maturity of six years and a coupon payment of 3.5 percent. With a current spread vis- à-vis the German bund of 340 basis points, this bond today trades at 90.50 cents, which implies an annual probability of default of 8.2 percent and an assumed recovery rate in case of default of 60 percent. This price, however, is artificial. If the European Central Bank weren’t supporting this market, the spread would easily reach 500 basis points, causing the price to drop to 83.30 cents.
Suppose that for each 100 euros of face value, Italian bondholders were offered a package of blue bonds valued at 50 euros, with a coupon of 4.5 percent, plus a 35 euro red bond, with a coupon of 3.5 percent. Since the blue bond would be very liquid and safe, it would trade at a yield equal to or even slightly below the German bund. With a coupon of 4.5 percent, it would trade above par for a valuation of 57 euros.
It is more difficult to estimate the trading value of the red bond, because it is junior (and thus paid back after the rest of the debt), and its recovery rate in case of default would probably be very low. When all the debt had equal priority, it was reasonable to assume a recovery rate of 60 percent. Now that 50 percent of the debt would be senior, in case of default there would be only 10 euros left to repay the 35 euros of debt, a 29 percent recovery rate.
Probability of Default
It also is more difficult to calculate the probability of default on the red debt. On the one hand, it should be lower than before because part of the debt is secured. On the other hand, it wouldn’t have the support of the ECB, which adds to the risk. It is reasonable, then, to keep it the same, which would produce a valuation of 27.50 euros for the 35 euros of red debt. Thus, holders of Italian bonds would receive a package worth 84.50 euros in exchange for assets with a true market value of 83.30 euros.
To ensure that bondholders are willing to make the exchange, however, we need to compare the value of the offer with the value of the claim of a bondholder who holds out. In this case, the asset that creditors would retain is a de facto red bond, junior to the blue one, with a coupon of 3.5 percent.
Under the best-case scenario for the holdouts, the probability of default would be about the same as for red bonds, as would the recovery rate. This would price the holdout debt at 78.70 euros, which is below the exchange-offer value. This depreciation would be an incentive for bondholders to convert.
That means the exchange offer would succeed and Italy would cut its debt by 15 percent, greatly reducing the probability of the bad equilibrium. The same principle, with different numbers, applies to the other periphery countries.
This solution doesn’t address the rescue of the banks that hold the converted debt. In a previous article, Roberto Perotti and I argued that most would have to be recapitalized in any case and offered a proposal for doing so.
(Luigi Zingales is a professor of entrepreneurship and finance at the University of Chicago Booth School of Business and a contributor to Business Class. The opinions expressed are his own.)
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