Sovereign Debt Restructuring: Risk management and contingent debt

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1 Sovereign Debt Restructuring: Risk management and contingent debt Stavros A. ZENIOS University of Cyprus Norwegian School of Economics Senior Fellow, The Wharton School, USA

2 The devil is in the tails Sovereign contingent debt: a proposal August 2015 January 2016

3 Outline The debate on sovereign debt restucturing Risk management for debt restructuring Sovereign contingent debt Case study of Greece

4 Risk management for sovereign debt restructuring Debt sustainability analysis incorporate risk measures such as VaR Optimal debt reprofiling to restore sustainability with probability 99%

5 Sovereign contingent debt A sovereign debt instrument, with (i) a built-in trigger to allow standstill of payments when an indicator breaches a threshold (ii) invokes a precautionary credit line from the IMF (iii)makes the triggered bond senior to subsequently issued debt.

6 Ongoing debate on sovereign debt restructuring

7 Some facts about sovereign debt IMF 2013 mea culpa on Greece Debt restructurings have often be too little and too late, failing to reestablish debt sustainability and market access in a durable way UN General Assembly 2014 Negotiate legal framework for sovereign debt restructuring (124 in favor, 11 against, 41 abstain) Adopted draft resolution (136 in favor, 6 against and 41 abstained) IMF 2015 declares Greek debt unsustainable

8 Some facts about sovereign debt Data: Bank of Canada 2014.

9 Some facts about sovereign debt: Serial defaults Data: Trebesch 2011.

10 Some facts about sovereign debt: Size of IMF programs Financial Stability Paper No. 27 November 2013, Sovereign default and state-contingent debt Martin Brooke, Rhys Mendes, Alex Pienkowski and Eric Santor, Bank of England and Bank of Canada

11 Observations from the facts Sovereign debt restructuring is pervasive Sovereign debt crises are an equal opportunity malaise Amounts involved are significant Reminders of Hyman Minsky ( ): Debt is fragile

12 The issues in sovereign debt crises To default or not to default? Eaton-Gersovitz (1981), Krugman (1988), Reinhart-Rogoff (2009), Sturzenegger-Zettelmeyer (2006), Benjamin-Wright (2009), De Grauwe (2012) Is to forgive to forget? Bulow-Rogoff (1989), Arsanalp-Blaire (2005) Cruces-Trebesch (2013), B-W (above), Wright (2012) Massive legal problems Krueger (2002), Gianviti et al. (2013), Buchheit et al. (2013), Delays in resolving crisis destroy value

13 Tactical vs Strategic debt sustainability Tactical: Short-term End of an IMF program, under program conditions Given projections (wishes) does debt decline? Strategic: Long-term Past IMF program Under market uncertainties Does debt ratio decline with probability 95%?

14 Given projections (wishes) does debt decline?

15 The issues in sovereign debt crises Risk management has not been part of analysis Operational models are missing Need for development of criteria for optimal debt restructuring process (Wright 2012, Harvard Business Law Review)

16 Risk management for debt restructuring

17 Risk management for debt restructuring Debt dynamics Re-finance debt of different maturities Look at alternative debt stock flows

19 Risk management for debt restructuring Scenario dependent debt dynamics Using Debt-to-GDP ratio

20 Risk management for debt restructuring D is the term structure of debt (multiple issues) r is the term structure of sovereign rates GDP, NB can be state-dependent SF can be state-contingent Scenario tree integrates economic and financial risk factors Objective and risk neutral probabilities (Consiglio, Carollo, Zenios, Quantitative Finance, 16(2): , 2016)

21 The issues in sovereign debt crises Key parameters (Das et al 2012) Face and market value of bonds or loans Interest rate and coupon (fixed, flexible, step-up, linked) Amortization schedule Currency of denomination Enhancements such as embedded options or collateral Legal clauses (CAC, exit consents)

22 Risk management for debt restructuring Conditional Debt-at-Risk (Rockafellar and Uryasev 2000)

23 Risk management for debt restructuring x mj nominal value of debt instrument j issued at node m. Conservation of flow at each node: DeaR: Debt-at-Risk At each terminal node:

25 Case study of Greece

29 Case study of Greece: current debt situation

30 Primary surplus 1.5% and improved country growth assuming fiscal multiplier 0.8

31 Interest rate concessions

32 Sovereign contingent debt: From ex post to ex ante solutions

33 Ex ante treatment of sovereign risk Address creditor moral hazard Deal with neglected risks Contingent contracts

34 Why S-CoCo Contingent contracts (Bazerman and Gillespie, HBR, 1999) Avoid biases Sharing risks Neglected risks (Gennaioli, Schleifer, Vishny, J. Financial Economics, 2012)

35 Why S-CoCo Early proposals Weber, Ulbrich, Wendor, Frankfurt Allgemeine Zeitung, 2011 Barkbu, Eichengreen, Mody, J. of International Economics, 2012 Brooke, Mendes, Pienkowski, Santor, Bank of England, French Aid Agency 2009 Insurance and re-insurance, Michelin, Swiss Re, MBIA Rated firms for capital management, service firms for liability insurance

36 Why S-CoCo Bank contingent capital (Mark Flannery 2002) : $70bn 2014: $208bn, 187 instruments, 68 banks (Avdjeiv et al., BIS, 2015).

37 Sovereign CoCo designs

38 S-CoCo designs: Trigger Accurate Timely Comprehensive in valuation of entity Predictable X Accounting data or institutional triggers

39 S-CoCo designs: Trigger 30-day average CDS spread > 300 to 400bp

40 S-CoCo designs: Trigger Country Trigger Signed Program Early response Greece 24 April Sept months Portugal 16 Nov May months Ireland 1 Oct Dec ,5 months Spain 27 March 2012 Dec months Cyprus 11 July May months

41 S-CoCo designs: Incentives Is there moral hazard? YES Haldane and Scheibe, Bank of England 2004, others NO IMF 2007 Creditor vs Debtor moral hazard Evidence on moral hazard is not definitive, it is likely that the risk of moral hazard increases as the expected size of official sector support packages rise (Brooke et al. Bank of England and Bank of Canada, 2013) Standstill resolves creditor moral hazard

42 S-CoCo designs: Incentives Debtor incentives: - Why sovereigns pay? - Economic incentives: Non-linear discounts on S-CoCo Seniority transfers rates to plain debt - Political incentives: IMF precautionary line Voted out like ousted Bank Board

43 S-CoCo designs: Incentives

44 S-CoCo designs: How long standstill

45 S-CoCo designs: False alarms and missed crises Type I error Type II error

46 S-CoCo designs: Market manipulation and multiple equilibria B-CoCo subject to multiple equilibria Sundaresan and Wang, J. of Finance, 2015 Calomiris and Herring, J. App. Corp. Finance, 2013 McDonald, J. Financial Stability, 2013 Prescott, Economic Quarterly, 2012 Market manipulation

47 S-CoCo designs: Pricing Triggered by CDS spread Mean-reverting diffusion process with jumps and autocorrelation Donoghue et al., Intl. J. of Theoretical and Applied Finance, Regime switching Bai-Perron, Econometrica, 1998 Cross validation K-fold approach for jump parameter (Tibshiriani)

48 S-CoCo designs: Pricing

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53 Risk management for debt restructuring with CoCo

55 Risk management for debt restructuring with CoCo

56 Conclusions Ex post risk management for sovereign debt Ex ante deal with uncertainty

57 Conclusions No matter how misguided the negotiating tactics of the Greek government might have been, debt was unsustainable before they came to power.

58 References Consiglio, A. and Zenios, S.A. Risk management optimization for sovereign debt restructuring Journal of Globalization and Development (J. Stiglitz et al. eds.) Consiglio, A. and Zenios, S.A Contingent convertible bonds for sovereign debt risk management Consiglio, Carollo and Zenios, A parsimonious model for generating arbitrage free scenario trees Quantitative Finance, 16(2): , 2016