Uncharted Territory

April 6, 2010

Scraping Greece off the Floor

Filed under: Business practices, Concepts, Economics, Risk — Tim Joslin @ 5:33 pm

Wolfgang Munchau writes very pessimistically today at the FT that “Greece will default, but not this year”.

The core of the problem is a self-fulfilling prediction. Because of the risk of Greece defaulting, the yield on its bonds, and consequently the cost of new borrowing, is 3% over Germany’s. As Munchau points out, the market implies that there is a 17% chance of losing 17% of the value of Greek bonds (1.7 is approximately the square root of 3 so 17% of 17% is approx. 3% – you could also say a 30% chance of losing 10% of value or vice versa, etc – just thought I’d point out the basis of Wolfie’s calculation). The Greek national debt would obviously become even more unmanageable after a few years of borrowing at such a premium, with debt repayments becoming an ever-increasing proportion of government expenditure. The cost of borrowing would rise even higher… Hence Munchau’s gloom.

A sacrilegious thought has occurred to me. To avoid the interest-rate death-spiral self-fulfilling prediction, why doesn’t Greece simply say that existing bonds will bear the first loss? They could then issue “New Bonds” (TM) at something close to the rate for German bunds (as they call them in the trade). Hopefully, the Greek public finances would be in better shape by the time the stock of New Bonds is large compared to the Old Bonds. Maybe it would be best practice for countries to issue long-dated junior debt when times are good, to prepare for the next financial crisis…

My cunning plan might even reduce the yield on existing bonds, free as they would be of interest-rate death-spiral risk. Everybody would be happy. Except Wolfgang Munchau, of course – he’s never happy.

Come on Greece, you’re a sovereign state. Almost. You can do what you like! Why borrow at +3% (that was yesterday, it’s +4% today, apparently) when you don’t have to?

And did I say the idea is sacrilegious? For starters, corporates can and do reorganise their capital by buying back their own debt below its nominal value and issuing more under different terms. And in fact many governments have reduced the cost of paying down the national debt by increasing the risk of existing borrowing. They do it simply by selling assets, up to and including the right to raise taxes. Buyers purchasing an income stream – for example, in the UK, the right to collect tolls on the Dartford Crossing is apparently for sale – are logically the same as bond investors. The difference is that asset purchasers don’t have to worry about the rest of the national debt – which, of course, becomes more difficult to fund without the income stream. Essentially, asset sales or privatisations are a conspiracy between governments and the asset purchasers against existing bond holders. In stark contrast to asset purchasers, new bond purchasers only rank pari passu with existing lenders. At least, until Papandreou reads this…

If the interest-rate death-spiral trap can be avoided by selling off income streams anyway, why bother with the pretence? Simply issue “New Bonds”.


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