Snow fences for Europe

recent post by Karl Smith  got me thinking about sovereign bonds: is it possible to use the disciplining power of the market in a currency union at all? Or in any country for that matter?

One argument against using the market is that you need to be willing to let countries default — with all that entails. According to a report by the German newspaper Süddeutsche Zeitung, Italy and France are now trying to remove private sector involvement (PSI) from the European Stability Mechanism (ESM) that is bound to replace the EFSF in 2013 because the PSI for Greece allegedly has caused contagion (I doubt that, but that is not the point today).

Another related argument against default (or PSI) is that sovereign borrowing works, until it doesn’t. In other words, the market does not discipline the sovereign through interest rates, but once it does, the self-fulfilling nature of the crisis leads to default. This mechanism, as far as I can see, works for countries with a central bank as lender of last resort as well. It will just hit at a later point in terms of debt load.

Karl proposes “administrative discipline”. Well, good luck with that. Not only is the record of European fiscal oversight dismal, it is also potentially a good way to destroy the friendship between countries in Europe, the original purpose of the European project. It might work, and maybe we need this leap of faith in Europe in the current situation, but without substantial treaty changes (with referenda and all that), it is almost impossible.

But I wonder whether there is, at least in theory, another market-oriented way. For instance, we could structure a country’s liabilities as those of banks, as the IMF suggested in 2004. Let me propose a 4-tier structure: equity, cocos, bonds and deposits.

  • “Deposits” would make up the lower, say, 40% of sovereign debt (relative to GDP). They would be senior to all other claims and the risk-free asset of that country.
  • “Bonds” make up the next, say, 20% of sovereign debt. They are slightly riskier than the deposits, but still a safe investment for pension funds and others given that we are just at the Maastricht criterion of 60% of GDP in debt at this point.
  • “Cocos” are contingent convertible bonds for the next 20% of debt, that convert to “equity” once a certain trigger event happens. Barry Eichengreen suggested cocos, but for slightly different reasons.
  • “Equity” is the most junior claim for debt above 80% of GDP. „Equity“ claims are effectively bonds as well. Its coupon payment could be tied to GDP growth of the country to give it a equity-like flavor, but still, there is a principal repayment and other bond-like features.

Regarding the “cocos”, the trigger would be that “equity” needs to take a haircut. Then “cocos” are converted 1:1 into “equity”, after the haircut on the original “equity” is determined. This could be very helpful because it leaves an empty 20% of the seniority structure that can be filled with new coco bonds that arguably will have a lower yield than the marginal equity. Countries in an acute crisis will probably not have a budget surplus and could therefore refinance their deficits through issuing new coco bonds, before having to issue new “equity”.

As far as I can see, there could still be a self-fulfilling “equity” crisis. But it would be limited to the equity part; the more senior claims, when they need to be rolled over, are much less affected and the “deposits” probably not at all (unless markets price in the probability of a Euro exit).

The mental picture I have in my head is that of snow fences against avalanches: yes, there may be an avalanche in one sector of the debt mountain, but it will be blocked by the first array of snow fences, or if it is larger, by the second. You can safely ski under the third.

This setup makes sovereign default a credible threat: it would give regulatory priority to “deposits”, forbids European banks to hold “equity” and thereby isolate the banking sector to a large extent from the sovereign. You also get market signals regarding the sovereign debt, or at least for “equity” and “cocos”.

A few final remarks:

  • Costs: it might not increase the overall costs, as the senior debt would be much cheaper. With the usual debt setup, there is always the danger of dilution such that more debt reduces the value of existing debt. This danger has a strict limit in this model.
  • Incentives: the incentive to borrow short-term is lower, as short-term debt will not be that much cheaper with explicit seniority.
  • Transition: The transition to this new world could be done right away: Spain or Italy would ask the IMF and the Paris Club for help in negotiating the transformation of existing sovereign bonds into these four different categories. Portugal and Greece would do the same. There would be some default on the equity in some countries, but the senior parts are protected, and new cocos could be issued.
    Other countries would make the slow transition, treating all existing bonds as “deposits” and issuing new “bonds”, “cocos” and “equity” over time.
  • Effects: the markets know in this model that some parts of sovereign debt are safe, and others are not. At the moment, the shift from having an ample supply of „safe“ assets to a situation where nothing seems safe, is a threat to the financial system, something that would be avoided with the snow fence setup. The forced transition of countries like Italy and Spain also takes away the self-fulfilling nature of the debt, and reduces it to the “equity” part, and possibly the “cocos”.

Please, do poke holes into this proposal, as I am really interested in whether it could work. Also, please post links to related research or proposals that I might not be aware of.