Trichet Bonds Echoing Brady Plan May Fix Debt Woes: Euro Credit

Jean-Claude Trichet, president of the ECB
Jean-Claude Trichet, president of the European Central Bank (ECB). Photographer: Hannelore Foerster/Bloomberg

Two decades after Citigroup Inc.’s William Rhodes helped Latin American nations restructure their debts, investors are telling him a similar solution may fix the euro area’s borrowing crisis.

“Some people have been talking about Brady bonds,” said Rhodes, a senior adviser to Citigroup in New York and its former senior vice chairman. “Anything is possible. There are a number of people who feel the austerity process is not going to be sufficient to carry the day and to service the debt.”

Brady bonds, named after then-U.S. Treasury Secretary Nicholas Brady, enabled 17 countries in Latin America, Africa, Asia and Eastern Europe to swap bad loans for new debt starting in 1989, some of which was backed by zero-coupon U.S. Treasuries.

The European Union has so far failed to persuade investors that it can solve the debt crisis that has roiled financial markets for more than a year, required bailouts of Greece and Ireland, and shaken confidence in the euro. Now, Goldman Sachs Group Inc. and Barclays Plc’s wealth management division say a Brady-like program may be needed to reorganize the debt of cash-strapped euro-area members.

“It’s something they should pursue,” said Erik Nielsen, chief European economist at Goldman Sachs in London who worked on the Brady plan as a World Bank employee. “So long as we don’t figure out a way of restructuring the debt, maybe this is a way of doing it.”

Old for New

The cost of insuring against default on European sovereign debt using credit-default swaps rose to a record last week. The yield premium on Greece’s 10-year debt relative to German bonds reached a record 974 basis points on Jan. 7 and Portugal’s spread reached a high of 460 on Jan. 11. Successful bond auctions by Portugal, Spain and Italy prompted a rally that nudged yields lower.

What may eventually work is an exchange of old debt for new, cheaper assets with longer maturities, said Roy Smith, a finance professor at New York University’s Stern School of Business and former partner at Goldman Sachs.

In a plan for Greece, which he says could extend to other nations, Smith suggests swapping devalued debt for new tradable 30-year securities he nicknames “Trichet Bonds” after European Central Bank President Jean-Claude Trichet, whose institution he would expect to guarantee the securities.

Under Smith’s proposal, the bonds would trade at current yields, replacing existing securities at their market value, which he calculates is now about 70 percent of face value. That would trim 30 percent from debt burdens and lengthen debt servicing to three decades, giving investors an investment that’s easier to trade and avoiding a default that wipes them out, he said.

Turn the Page

“It would be doing the same as Brady bonds, but in a European context,” Smith said in an interview. “It would be a turning of the page.”

Michael Dicks, head of research at Barclays Wealth in London, said such a plan may already be in the minds of policy makers.

“There needs to be lateral thinking for long-term solutions,” Dicks said. “Something that lengthens out the payment schedule and reduces the net present value of debt so that there’s some burden sharing from bondholders rather than just the official sector.”

Kicking the Can

Investors may even embrace such a program, said John Taylor, a former U.S. Treasury undersecretary for international affairs who now teaches at Stanford University in California. “If it’s done well, I think the markets are ultimately going to be more comfortable with something like that than just sort of continuing to kick the problem down the road,” said Taylor.

Still, European officials refuse to countenance a restructuring, which typically counts as a default and triggers credit-default swap insurance to pay out, even as economists including former Bank of England policy maker Willem Buiter, now at Citigroup, and Harvard University’s Martin Feldstein say debt rescheduling is increasingly likely for some borrowers.

“The restructuring of Greek debt or debt of any other euro-area member state would have so serious negative consequences through the contagion effect and by being perceived as an example for other cases that we do not want to go to that route and we will not have to go to that route,” EU Economic and Monetary Affairs Commissioner Olli Rehn said Jan. 12.

ECB Executive Board member Lorenzo Bini Smaghi said in a Sept. 9 speech in Frankfurt that what worked in emerging markets may flop in advanced economies. That’s because the woes of developing nations often originated in unsustainable exchange rate pegs or reliance on foreign debt. In Europe, the euro is a “super hard” peg and exiting it would create more havoc, while domestic debt purchases are more important in rich nations and so countries may find it better to focus on improving their budgets than restructuring, he said.

Fit for Purpose?

“How often do we hear that Europe should learn from the Brady bond experience to address the Greek debt problem?” Bini Smaghi said. “The risk is that solutions devised for a particular case are not applicable to other cases.”

Mohamed El-Erian, chief executive officer at Pacific Investment Management Co. in Newport Beach, California, told “Bloomberg Surveillance” with Tom Keene on Jan. 12 that Europe may be unwilling to tolerate the lost growth that Latin America suffered. Another complication is there are now “millions of bondholders,” while in the “old days you could bring five banks together in a room and tell them to cooperate,” he said.

No Panacea

A program similar to Brady bonds isn’t a panacea, and countries would still have to revamp their economies and slash spending, said Daniel Marx, Argentina’s former finance secretary who helped sell Brady bonds in 1993.

“First, you have to deal with the fundamentals of the economy, and only when worked on that can you deal with the debt terms,” said Marx, who now runs Quantum Finanzas, a Buenos Aires-based research firm.

At Citigroup, the 75-year old Rhodes, who has spoken with European officials about their crisis in recent months and says market supporters of Brady-like bonds are still in the minority, said the key is for governments to liaise with investors on how to best end the turmoil.

“Governments are pretty adamant they don’t want to get into full restructuring mode,” said Rhodes. “What’s going to end up happening is governments take a very good look at what they can and can’t do, and work with the private sector on a solution.”

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