(AP Photo/DusanVranic)
(AP Photo/DusanVranic)

The Financial Times reports that, in the wake of the Greek debt exchange, concerns about the future of the European bond market are beginning to emerge. No wonder.

The socialization of the Greek debt problem means private investors’ claims that remain after the debt swap is completed will be swamped by the claims of official lenders (the EU, ECB and the International Monetary Fund). Of course, you could argue, this is just the inevitable result of the EU orchestrated rescue package and the “haircuts”, or reduction in the value of claims, on private sector bonds. Well, yes. The fact that official creditors have – or assert – preferred lender status, however, means that these official claims would subordinate private sector claims when it comes time to restructure Greece’s sovereign debt, should the bailout for Greece fail and Athens subsequently defaults.

Consider a hypothetical case of sovereign distress. Total outstanding debt is €100, which is initially all held by the private sector. Now assume that, as a result of a rescue package, the value of private claims is reduced by €50 (50% haircut) while official loans of €50 are provided in an attempt to avert default. Total claims on the sovereign remain €100.

Assume, however, the rescue effort fails and the sovereign defaults. What is the impact on private lenders?

In the unrealistic, but easy to explain, case that the sovereign can sustain the same debt-service payments of € 75 pre- and post-default, private creditors are unambiguously worse off. Had there been no rescue attempt, private bondholders would have recovered €75 on their claims with a face value of € 100, or a recovery rate of 75%. After the rescue attempt, private creditors get paid out only after official preferred creditors are compensated. This implies that private bondholders receive €25 (= € 75 - € 50), for a recovery rate of 50% (= €25/€50) of post-haircut claims; only 25% (=€25/€100) on pre-rescue package claims.

But, wait, it gets worse. (Caveat Emptor: I have no legal training; read the balance of this post at your own risk.) The 'after the fact' insertion of Collective Action Clauses (CACs), which lowers the threshold for assent to change key covenants in the bonds, in the Greek bond swap means that bondholders that do not accept the debt exchange will see the value of their investments further reduced. The use of this technique is justified by the need to provide 'inducements' for bondholders to accept the bond swap and thus could be considered necessary to facilitate a restructuring.

Nevertheless, all this leads me to ask: is the future of the sovereign lending also its past?

The point of the question is that how debt is restructured today, will influence what is restructured tomorrow. That is, the nature of sovereign lending is endogenous to the frameworks for dealing with restructuring. This has been seen very clearly in the past 30 years: because bonded debt was deemed de minimus in the sovereign restructurings of the 1980s, while banks were pulled into a concerted rollover and eventually Brady Plan workout, the lending of the 1990s was all bonded. This change in lending practice merely reflects the fact that bonded debt is more difficult to restructure because it is held at arm’s length, while bank debt is not – unless, of course, the rules of the game are changed after the fact.

But arbitrary changes to the rules of the game are not the way to foster, efficient international capital markets in which savings are effectively intermediated from where they generate low returns to fund projects, or smooth consumption, which pay higher returns.

It is too early to say with certitude, but it is fairly clear that Greece will greatly influence how capital is allocated through the global capital market. In this respect, going forward, we may be looking at a situation in which bond markets are closed to all but the most secure borrowers – and they aren’t necessarily the same players they once were. With debt structures endogenously determined by changes in the legal/contracting environment, sovereign lending may once again return to bank balance sheets, as was the case in the 1970s.

The future of sovereign lending may, indeed, be 'back to the future.' But in a world in which bank balance sheets are contracting in many countries, will there be enough lending?

Nevertheless, all this leads me to ask: is the future of the sovereign lending also its past?
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