Brendan Moynihan: Debt restructure key to saving euro


The late Walter Wriston, a former chief executive officer of what is now Citigroup, was noted for saying that countries don't go bankrupt.

Nations can default, of course, and many did so in the 1980s. Today's European leaders and bankers could learn from those experiences.

While countries don't liquidate assets to pay off creditors, they can restructure their debt when the cost of servicing it becomes prohibitive, as Wriston learned when several emerging market countries defaulted a few decades ago.

Little has changed since then. The catalyst for those events was so-called rollover risk, which occurred when certain lesser developed countries borrowed in foreign currencies, often at short-term interest rates, then failed to find new lenders when the debt came due.

A sovereign nation faced with crushing debt can print money to pay it off, default on its obligations or both. For example, in 2008 Iceland reneged on deposit insurance for foreign depositors and depreciated its currency while Russia and Argentina defaulted and devalued their currencies in 1998 and 2001, respectively.

The European Union's sovereign debt crisis has markets predicting another default. Credit default swaps for Ireland, Portugal and Spain resemble those for Greece this year. The problem is that European countries can't depreciate their way out of debt problems - they forfeited that option when they joined the euro.

The EU is doing its best to avoid defaults, mainly with a €750 billion ($1.3 billion) financial lifeline it set up with the International Monetary Fund to protect the euro region after Greece's near default this year.

The Irish rescue package announced over the weekend, like the modified Greek plan, involves seven years of emergency financing designed to help the Government avoid the soaring borrowing costs being demanded in the markets. But these so-called rescues are misguided because they merely postpone the day of reckoning.

The problem in Europe is too much debt, whose principal must be reduced.

"Is it better to extend and pretend, or to hand out some pain and some upside potential?" said Michael Shaoul, chief executive at Oscar Gruss & Son. "If you accept the premise that these peripheral countries have too much debt, then debt repayments must be reduced and not merely postponed."

Default followed by restructuring is the best option. Russia travelled that path, and has since returned to borrow in international bond markets. Iceland credit default swaps are now lower than for Greece, Ireland, Portugal and Spain.

One solution to the European debt crisis requires only a little financial engineering. The term I prefer is financial origami, the process of folding the attributes of stocks, bonds or derivatives into new securities.

The days of sacrosanct debt covenants are over. This is especially true for sovereign debt because assets aren't liquidated to pay off creditors at some per cent of face amount.

European countries should reduce the principal amount they owe by issuing gross domestic product-linked sovereign bonds as an incentive to creditors to take a haircut on the debt.

Bondholders would accept, say, 70c on the dollar on their bonds and receive new debt paying the German bund rate and with a warrant that pays a coupon tied to the amount each country's respective GDP exceeds, say, 2 per cent.

The warrants could have an assigned value at inception - based on a long-term call option on GDP - and be detachable and traded separately.

Such a move isn't without precedent. Argentina created this type of incentive to win over creditors in the 2005 restructuring of US$95 billion of defaulted debt - the largest sovereign debt default in history.

Argentina's annual payment on the GDP warrants is triggered when economic growth is more than 3 per cent and the inflation-adjusted value of the country's GDP is above the level laid out in the warrants.

This GDP-linked approach has numerous benefits. First, it aligns the economic interests of bondholders with the fortunes of the country.

Second, it enables governments to make payments when its coffers are flush and reduce them when its economy slows. Third, it largely avoids a gutting of social services or a grabbing of pensions. The success of the Argentina model is shown in how the warrants have performed since their issuance.

This should become a model for all sovereign debt issues. It would force creditors to look more closely at where they invest in the first place.

* Brendan Moynihan is an editor-at-large at Bloomberg News and the author of Financial Origami, a forthcoming book on the Wall St business model.

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