14 May 2013

The Name is Bondholder, Senior Bondholder

My friends have been telling me that my Eurozone commentary suggests that I might be a tad too critical of capitalist institutions and not critical enough of those periphery countries. You know, those notoriously lazy and irresponsible PIIGS.

As a contrarian, I am rather sensitive to polite accusations. Disagree with me violently, I am almost giddy. Insinuate slight bias, I am concerned. I stand for incontrovertible prejudice.

So, I thought the best way to figure this out would be to see the terms of successive bailouts in these countries and see who lost and who won. That would be a simple and straightforward way of prosecuting my case, right?

Let's start with Ireland.


A while ago, I related in some detail how the Irish government was duped by senior bondholders to guarantee the private debt of Irish banks. But that was only part of the story. Since I wrote those lines I discovered that, at the time, European authorities were adamant that unsecured senior bond holders were to be paid in full. To put it differently, they wanted poor Irish peasants to bailout TBTF banks like Société Générale and Goldman Sachs.

We all know what happened.

What about Greece?


For Greece, I maintained from early on that they should default on their debt and leave the Eurozone.

European leaders had a different view. They told them they should stay put and implement austerity measures. Which meant a vicious cycle that would ensure that Greece would remain indebted for the foreseeable future. The ensuing Greek bailout was presented as a serious haircut for senior bondholders. In case you don't remember, this was a contemporaneous observation:
A myth is developing that private creditors have accepted significant losses in the restructuring of Greece’s debt; while the official sector gets off scot free. International Monetary Fund claims have traditional seniority, but bonds held by the European Central Bank and other eurozone central banks are also escaping a haircut, as are loans from the eurozone’s rescue funds with the same legal status as private claims. So, the argument runs, private claims have been “subordinated” to official ones in a breach of accepted legal practice.
Do you think that this was indeed the case?

If you were getting your information from corporate media sources, you had probably retained that impression. Well, that's not what the celebrated economist Nouriel Roubini retained:
The reality is that private creditors got a very sweet deal while most actual and future losses have been transferred to the official creditors. 
Even after private sector involvement, Greece’s public debt will be unsustainable at close to 140 per cent of gross domestic product: at best, it will fall to 120 per cent by 2020 and could rise as high as 160 per cent of GDP. Why? A “haircut” of €110bn on privately held bonds is matched by an increase of €130bn in the debt Greece owes to official creditors. A significant part of this increase in Greece’s official debt goes to bail out private creditors: €30bn for upfront cash sweeteners on the new bonds that effectively guarantee much of their face value. Any future further haircuts to make Greek debt sustainable will therefore fall disproportionately on the growing claims of the official sector. [emphasis mine]
More importantly,
The new bonds will also be subject to English law, where the old bonds fell under Greek jurisdiction. So if Greece were to leave the eurozone, it could no longer pass legislation to convert euro-denominated debt into new drachma debt. This is an amazing sweetener for creditors.
Remember my recommendation about defaulting and leaving the Eurozone? Now they are stuck with a much larger debt and absolutely no way of fixing their problems. They cannot devalue their currency, stimulate the economy or even print money to reduce their debt through inflation.

And they owe a lot more to senior bondholders.

Let's take a look at Spain.


As I wrote recently, Spain was doing reasonably well with a modern and diversified economy. Their main problem was (like everywhere else) in the banking sector. Their banks made risky real estate bets and lost a bundle when the bubble burst.  Just like banks in Iceland, Ireland, Greece, Italy (and of course the US).

The only difference, in Spain, the source of funding was somewhat different. Banks sold subordinated bonds (the ones designed to take the first hit in a liquidation) mostly to retail investors. Meaning, mostly regular folks and their retirement funds. Interestingly, in the case of Spain, European authorities rediscovered the concept of risk for these bonds and insisted that these bondholders should be subjected to a deep haircut.

You might say, okay, it is never too late to go back to a principled stance. Capitalism equals risks and rewards. Right? So, good for them.

Well, not quite. That principled stance did not cover the senior bondholders.

You see, under normal circumstances, senior bondholders should be bailed in, i.e. the debt they are holding should be converted into equity in the bailed out institutions. In fact, this is an integral part of the new banking regulation framework of the EU. Except, it was not applicable for the Spanish case. For one thing, European authorities postponed its implementation until 2018.  For another, the finance ministers overruled the ECB and refused to let senior bondholders to be bailed in or to get a serious haircut.
In July, when the euro zone negotiated a bailout for Spain’s banks, the European Central Bank argued that they should be “bailed in” in cases where a bank is so sick it needs to be closed. At the time, the European Commission insisted senior bondholders would remain protected and the euro zone’s commitment to do so wasn’t tested, since none of the Spanish cajas were ultimately wound down.
In other words, if the bondholders were you and me and our retirement funds, too bad, we knew the risks: Haircut.

If the bondholders are the usual suspects, the senior bondholders, sorry, we have to make them whole, because, well, you know, they are senior bondholders.

I am guessing that by now you are noticing a pattern.

Let's take a look at the unusual Cyprus bailout.


The Cypriot case was similar to the previous ones, except for two key differences. Their banks, besides the usual reckless credit extension to dubious real estate projects, made a second bet on Greek debt, after Greece became a clear candidate for bankruptcy. When the final deal was decided upon the island banks were not among the senior bondholders that got the sweet deal. They were in the same category as Spanish retail investors.

The second difference was that since the early 2000's, Russian companies have been using Cypriot banks as a way of not paying taxes at home.

When the EU officials began to look for a bailout formula, they had this very controversial and dangerous idea. They thought that they should make the depositors pay for the funds to be raised. Originally, they wanted both the insured (up to €100,000) and uninsured (over that amount) depositors to take part in the scheme.

It is hard to emphasize how radical an idea it is to levy a fee on insured deposits. As far as I know, it is a first anywhere. Given the shaky foundations of the Euro it soon became apparent that touching insured deposits might lead to a run on the banks.

They eventually dropped the idea but since the uninsured depositors were mostly Russian, they focused on them instead. And they are the ones footing the bill.

If you read this far, you must be asking "what about the senior bondholders?"

Well, you'll be happy to know that even as they burned depositors, the EU authorities saved senior bondholders:
In the bailout deal that the euro zone and the International Monetary Fund hammered out for Cyprus, one class of investors once again made a lucky escape: senior bank bondholders. (...)
The euro zone has to far carefully avoided burning senior bondholders during a bank restructuring. (...)
With relatively little money to gain, officials decided that breaking two taboos — taxing depositors and burning senior bondholders — in one go, didn’t seems like a good idea.
The last sentence reads like a punchline, doesn't it?

I hope that through all this I established that I am NOT slightly biased about capitalist institutions.

It is a full-blown prejudice.

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