A Greek debt restructuring might not be the panacea for European bond markets that a lot of investors are expecting. Instead, it might be a case of trading an albatross for a stigma.
In a note to clients this week, Carl Weinberg, chief economist at U.S. independent research firm High Frequency Economics Ltd., argued that a forced bond haircut – which common logic suggests would instill confidence and reduce risk in the sovereign bond market – could ultimately have quite the opposite effect. His evidence to support his argument? Arthur Richenthal.
In 1975, when New York City was teetering on a Greece-like bankruptcy precipice, the state legislature passed a bill granting the city a moratorium on its bond payments. Mr. Richenthal, a Manhattan lawyer representing a bondholder (tiny Flushing National Bank of Queens), filed a class-action lawsuit to compel the city to pay up anyway. The court agreed, saying the debts were backed by the "full faith and credit" of the city and the state – essentially, that they were unconditionally guaranteed by the state constitution. (The city was forced to scrape together $1-billion to meet its payments.)
Now, the idea that a government could be compelled, by law, to pay its debts is hardly unique to the Big Apple. In the 1990s, U.S. vulture funds successfully either sued or extracted multimillion-dollar settlements out of several Latin American issuers – including Peru, Brazil and Panama – over forced debt restructurings. Argentina continues to be dogged by lawsuits from debt holders who rejected the terms of the country's 2001 default. One Swiss creditor has even tried – several times – to seize artwork, jets and ships to satisfy a court-ordered repayment of delinquent Russian government debt.
These cases take on heightened relevance as Greece prepares to try to change the rules with a stroke of the legislative pen. In an effort to avoid default on a bond issue that comes due March 20, the Greek government is preparing to impose a forced restructuring on all bondholders, using something called a collective action clause (CAC). It plans to retroactively place CACs on its other bond issues, too.
Investor lawsuits in Greece's case, at least on a scale big enough to threaten the restructuring, look unlikely. Most holders of Greek debt are resigned, and in many cases even eager, to see the mess resolved. Some relatively small investors – notably, hedge funds – may want to reject the restructuring terms, but it looks likely that this would allow their credit default swaps (essentially, default insurance) to kick in to cover their losses.
But the point, really, isn't whether we'll see more sovereign-debt lawsuits, but what the past lawsuits represent: The principle that countries aren't supposed to tear up their contractual obligations when it's convenient, that we expect a higher standard. That was what the New York case established.
"This constitutional backing by the full faith and credit of the government is what makes sovereign bonds different from other bonds," Mr. Weinberg wrote. "It is what makes us believe they are safe – or at least safer than other securities."
And it's why we pay more for sovereign bonds – why the interest rate on them is generally lower than other types of bonds. We accept a higher price and a lower return in exchange for lower risk – backed by the force of law, if necessary.
"Sovereign lawsuits … had their defenders," Princeton University law scholar Faisal Ahmed and Harvard University business professors Laura Alfaro and Noel Maurer wrote in a 2010 paper. "In the defenders' view, the threat of litigation made sovereign lending cheaper."
And that's where the threat from a Greek restructuring lies – not in the haircut itself, but in the shift in the ground rules that CACs represent.
"Attempting to fiddle with bondholder protections – whether successful or not – introduces a worm of doubt into the minds of all potential holders of Euroland debt," Mr. Weinberg argued. "If they are willing to try to bend the law for the benefit of the Greeks, why not anyone and everyone else?"
Bottom line? This raises the implied risk profile of the sovereign debt – not just in Greece or other troubled peripheral EU issuers, but potentially across the whole region.
"Yields on Euroland bonds will have to rise universally to reflect the fact that governments can and will change the terms of bond contracts," Mr. Weinberg concluded.
David Parkinson