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Why Not Convert Greek Debt to Equity?

All we are saying is give Greece a chance.

September 29, 2011

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533535_greek_flag_2Few commentators are giving Greek politicians much of a chance in turning around the country's indebtedness. Neither are Greek taxpayers. How Greece got into this mess is a 10-year odyssey. Still, there may be opportunities – to salvage something from the wreckage, or better, to profit from ship timber put to better uses.

First, let's consider a report by the New York Fed researchers Matthew Higgins and Thomas Klitgaard

"After the creation of the euro area, Greece and other periphery countries had access to financing at much lower interest rates than would otherwise have been possible. Investors knew that monetary policy for the region as a whole would be set by the European Central Bank (ECB), seen as likely to continue the strong anti-inflation policies of Germany's central bank. This essentially eliminated the risk that investments in periphery countries' debt instruments would be eroded by high inflation. Moreover, given the common currency, the possibility of depreciation or devaluation in the periphery countries was eliminated as well. The one risk that remained, of course, was credit or default risk: the prospect that the periphery sovereigns could not or would not make good on obligations as they came due—something to which the market assigned little probability."

That's not something the Europeans were thinking about at the time: sovereign default evidently was a quaint practice engaged in by the Russians and the Argentinians. Naturally, euro area governments had to specify they were meeting deficit and debt conditions … but no one told them not to use off-book accounting techniques. And no one expected a bank meltdown or a near-Depression experience.

"In retrospect, investors misjudged the risks of lending to euro area periphery countries at paper-thin spreads over rates in Germany. Indeed, the high current account deficits in the euro area periphery would likely have prompted investors to reassess the fundamental creditworthiness of those countries much earlier if not for the reassurance provided by their membership in the monetary union. However, the periphery country economies now face the prospect of diminished market access and the need to sharply reduce external borrowing."

Well, external borrowing is not only cut off, but the creditors are on the hook, now for more than a haircut. One solution being bandied about is the creation of a eurobond that would rely on the whole euro area's creditworthiness. A eurobond would mix the good, the bad and the ugly, solid sovereign credits with dodgy ones to achieve – like subprime CDOs — a triple A rating. But it has met with resistance, particularly from Germany.

As French politician Philippe Marini  put it in a recent Wall Street Journal Op-Ed,

"Euro bonds are a seductive idea, as they would replace (at least in part) the separate debt liabilities of the governments of France, Germany, Italy and so on, with a single liability for the whole euro area. This single liability would be managed by a single European agency, which would finance itself by issuing its own bonds—euro bonds. This would allow European states to fund themselves at a single rate. Even more appealing, it would let these states avoid the nasty and self-fulfilling cycle of markets panicking and demanding ever-higher interest rates from otherwise solvent governments, thus making it impossible for these governments to quickly finance themselves in the marketplace. It's this cycle that threatens to spread the crisis to Spain and Italy, whose economies are too big to be rescued by the EU's existing emergency funds.

"The difficulties in the euro-bond idea appear when we consider how such a project would actually operate in practice. First, in order for the euro-bond-issuing agency to finance itself at a low enough rate, investors would need a certain degree of confidence in the agency and thus in the European governments guaranteeing it. But if each state in the euro area were only guaranteeing a portion of the agency's debt, the euro-bond chain would only be as strong as its weakest link. We thus arrive at the notion that every euro state should guarantee the debt of every other euro state."

All the same, weren't euro zone sovereigns able to gain top credit ratings under somewhat similar auspices … by the fact that they were in the euro zone?

So using the credit facilities of the conglomerate to prop up one of its weaker subsidiaries seems like a non solution. But so is bankruptcy. Stephen Waldman, who writes the Interfluidity blog, suggests an alternative. Pay out the creditors with equity as obligations come due.

"One way to think about the European financial crisis is that it is a matter of capital structure. Countries like the United States and Great Britain are equity-financed, while countries like Greece, France, and Germany are debt-financed. There is no question that some European countries have very real problems. But there is also no question that no matter how badly a country may be arranged, nations cannot be 'liquidated.' A 'bankrupt' state must be reorganized. If Greece were a firm, a bankruptcy court would not sell critical assets at fire-sale prices, as Greece's creditors sometimes idiotically demand. Instead, a bankruptcy court would convert debt claims that are unpayable, or whose payment would impair the long-term value of the enterprise, into equity claims whose value would depend upon restoring the underlying enterprise to health."

Sort of like debtors in possession financing — their role is to keep the concern going till creditors can realize the value of their loans, or rather, their investment. It's a somewhat complex structure. Euro zone countries would issue equity, with dividends pegged to inflation, and the ECB would buy a proportion of it.

But is it a bailout? Not really, since sovereigns don't become insolvent, just illiquid.

As Waldman notes,

"Of course, a sovereign's issued equity represents a liability to the ECB, so each sovereign's overall financial position has not changed at all. But equity, redeemable at the discretion of the issuer, does not provoke distress costs, while a debt position very much does. For sovereigns as for corporates, capital structure matters in the real world. The long-term value of a distressed enterprise can increase dramatically if it is able to convert an unserviceable debt position to equity."

In financial terms, you lent it, so now you own it, one way or another.  How else are you going to get your capital out, when it's way past midnight?

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