Europe's Rigged Sovereign Bond Auctions

Apr 4


Sam Vaknin

Sam Vaknin

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China and Japan are the only two things standing between the currently successful auctions and a global sovereign bonds meltdown.


On January 12 and 13,Europe's Rigged Sovereign Bond Auctions  Articles 2011, Spain, Portugal, and Italy successfully sold 22 billion euros of new debt in the form of sovereign 5-year and 10-year bonds. The European Union (EU) spin-doctored the outcomes of these auctions as a great success. Actually, they came close to the brink of disaster: Spain had to pay an extra percentage point and Italy another half a percentage compared to identical obligations they had sold in November 2010. What a difference three months make! The rising yields demanded by investors indicate a perception of the growing risk of these two not-so-peripheral members of the EU.

All the auctions ended up being mildly oversubscribed (1.4-2 times the supply on offer). But, this is highly misleading: only 40% of the bonds were purchased by commercial investors. The rest were bought by the governments of China and Japan and by the ECB itself! Put bluntly: the auctions were rigged. China extracted an onerous price for its relatively moderate commitment in the form of technology transfer commitments and a further relaxation of EU trade protections.

Alarmed by the results, the beleaguered President of the ECB, Jean-Claude Trichet, lobbied even harder for a sizeable increase in Europe’s rescue (read: bailout) fund and in the European Stabilization Mechanism. He was instantly rebuffed by the Germans, but realities being the way they are, the ECB is likely to prevail and, in the process, become the largest owner of sovereign bonds of illiquid and insolvent member states. This development is the most alarming: in the absence of a liquid, politically-independent and functional central bank, the euro project is all but doomed.

In a little noticed speech, given in January 2003 at an IMF conference in Washington, Glenn Hubbard, then Chairman of President Bush's Council of Economic Advisers, delineated a compromise between the United States and the International Monetary Fund regarding a much mooted proposal to allow countries to go bankrupt.

In a rehash of ideas put forth by John Taylor, then Treasury Undersecretary for International Affairs, Hubbard proposed to modify all sovereign debt contracts pertaining to all forms of debt to allow for majority decision making, the pro-rata sharing of disproportionate payments received by one creditor among all others and structured, compulsory discussions led by creditor committees. The substitution of old debt instruments by new ones, replete with "exit consents"  (the removal of certain non-payment clauses) will render old debt unattractive and thus encourage restructuring.

In a sop to the IMF, he offered to establish a voluntary sovereign debt resolution forum. If it were to fail, the IMF articles can be amended to transform it into a statutory arbiter and enforcer of decisions of creditor committees. Borrowing countries will be given incentives to restructure their obligations rather than resort to an IMF-led bailout.

In conformity with the spirit of proposals put forth by the Bank of England and the Bank of Canada, Hubbard insisted that multilateral financing should be stringently conditioned on improvements in public sector governance and the legal and regulatory frameworks, especially the protection of investor and creditor rights. He rejected, though, suggestions to strictly limit official financing by international financing institutions.

Yet, these regurgitated schemes suffer from serious flaws.

It is not clear why would creditors voluntarily forgo their ability to extort from other lenders and from the debtor an advantageous deal by threatening to withhold their consent to a laboriously negotiated restructuring package. Nor would a contractual solution tackle the thorny issues of encompassing different debt instruments and classes of creditors and of coordinating action across jurisdictions. Taylor's belated proviso that such clauses be a condition for receiving IMF funds would automatically brand as credit risks countries which were to introduce them.

The IMF is, effectively, a lender of last resort. When a country seeks IMF financing, its balance of payments is already ominously stretched, its debt shunned by investors, and its currency under pressure. The IMF's clients are illiquid (though never insolvent in the strict sense of the word).

The IMF's First Deputy Managing Director, Anne Krueger, proposed in November 2001 to allow countries to go bankrupt within a Sovereign Debt Restructuring Mechanism (SDRM). Legal action by creditors will be "stayed" while the country gets its financial affairs in order and obtains supplemental funding. Such an approach makes eminent sense.

Today, sovereign debt defaults lead to years of haggling among bankers and bondholders. It is a costly process, injurious to the distressed country's future ability to borrow. The terms agreed are often onerous and, in many cases, lead to a second event of default. The experiences of Ukraine and Ecuador in the 1990s are instructive. Russia - another serial debt restructurer, lastly in 1998 - was saved from a recurrent default by the fortuitous surge in oil prices. Argentina and its emasculated debtors were not as lucky.

Moreover, as Hubbard observed in his speech, both creditors and debtors have a perverse incentive to aggravate the situation. The more calamitous the outlook, the more likely are governments and international financial institutions to step in with a bailout package, replete with soft loans, debt forgiveness and generous terms of rescheduling. This encourages the much-decried "moral hazard" and results in reckless borrowing and lending.

A carefully thought-out international sovereign bankruptcy procedure is likely to yield at least two important improvements over the current mayhem. Troubles now tackled by a politically-compromised and bloated IMF will be relegated to the marketplace. Bailouts will become rarer and far more justified. Moreover, the "last man syndrome", the ability of a single creditor to blackmail all others - and the debtor - into an awkward deal, will be eliminated.

By streamlining and elucidating the outcomes of financial crises, an international bankruptcy court, or arbitration mechanism, will, probably, enhance the willingness of veteran creditors to lend to developing countries and even help attract new funding. The creditworthiness of lenders increases as procedures related to collateral, default and collection are clarified. It is the murkiness and arm-twisting of the current non-system that deter capital flows to emerging economies.

Still, the analogy is partly misleading. What if a developing country abuses the bankruptcy procedures? As The Economist noted wryly "an international arbiter can hardly threaten to strip a country of its assets, or forcibly change its 'management'".

Yet, this is precisely where market discipline comes in. A rogue debtor can get away with legal shenanigans once - but it is likely to be spurned by lenders henceforth. Good macroeconomic policies are bound to be part and parcel of any package of debt rescheduling and restructuring in the framework of a sovereign bankruptcy process.

Vulture Funds

Vulture funds are financial firms that purchase sovereign debt at a considerable disaggio and then demand full payment from the issuing country. A single transaction with a solitary series of heavily discounted promissory notes can wipe out the entire benefit afforded by much-touted international debt relief schemes and obstruct debt rescheduling efforts.

Nationalizing Risk

During the months of September-October 2008, governments throughout the world took a series of unprecedented steps to buttress tottering banks. In the USA, the Federal Reserve and the Treasury Department have flooded the financial system with liquidity; granted commercial banking licenses to the few investment banks left standing; lent funds against financial instruments turned toxic; and purchased non-voting equity and senior debt in a host of firms and banks. Several European countries have guaranteed all bank deposits and short-term interbank loans.

These steps served to halt the panic at least temporarily and have thus prevented runs on banks and the seizing up of the credit markets. Still, these were mere palliatives. They did not tackle the roots of the crisis, though they averted it.

Instead of eliminating risky, ill-considered investments and bad loans by allowing defaults and bankruptcies, governments have shifted debts and risks from financial institutions to taxpayers and sovereigns. The question was thus no longer: will this or that bank survive, but: will this or that country remain solvent. Iceland, for instance, essentially went belly up. Other countries, including the USA, are liable to pay for this largesse with a bout of pernicious inflation.

And even as the United States begins its long recovery, Europe and Asia are left to bear the brunt of American profligacy, avarice, regulatory dysfunction, and shortsightedness. According to a research note published by Credit Suisse, the Baltics, Bulgaria, Ukraine, Romania and Hungary "face many of the same macro-economic strains as Iceland, with deep balance of payments deficits and a high ratio of private sector credit to GDP". To these one can add South Africa.

Shifting risk from the private sector to the public one and from one locale (the USA) to others (Europe, Asia) are not long-term solutions. They only postpone the inevitable. The imbalances in the international financial system are such that unwinding them requires a prolonged and painful global recession. In economics, there is no free lunch.

Secondary Markets for Distressed Sovereign Obligations   Martin Schubert and his New-York (now Miami) based investment boutique, European Inter-American Finance, in joint venture with Merrill Lynch and Aetna, pioneered the private trading of sovereign obligations of emerging market economies, including those in default. In conjunction with private merchant banks, such as Singer Friedlander in the United Kingdom, he conjured up liquidity where there was none and captured the imagination of businesses on both sides of the Atlantic.

Today, his vision is vindicated by the proliferation of ventures similar to his and by the institutionalization of the emerging economies sovereign debt market. Even obligations of countries such as Serbia and Iraq are traded, though sporadically. Recently, according to Dow Jones, Iraqi debt doubled itself and is now changing hands at about 15 to 20 cents to the dollar.

The demand is so overwhelming that Geneva-based brokerage firm Trigone Capital Finance created a special fund to provide interested investors with exposure to Iraqi paper. Nor is the enthusiasm confined to this former member of the axis of evil. Yugoslav debt is firm at 50 cents, despite recent political upheavals, including the assassination of the reformist and pro-Western prime minister.

Emerging market sovereign debts are irresistible. Some of them now yield 1000 basis points above comparable US Treasuries. The mean spread, according to JP Morgan's Emerging Markets Bond Index Plus is c. 600 points. Corporate securities are even further in the stratosphere.

But with frenzied buying all around, returns have been declining precipitously in the last few weeks. Investors in emerging market bonds saw average profits of 10 percent this year - masking a surge of 30 percent in Brazilian and Ecuadorian paper, for instance. JP Morgan Chase's EMBI Global index is up 19 percent since September 2002.

Nor is this a new trend. The EMBI Global Index has witnessed in each of the last four years an average gain of 14 percent. According to Bloomberg, the assets of emerging market debt funds surged by one tenth since the beginning of the year, or $948 million - compared to $648 received during throughout last year.

The party is on. Emerging market debt is either traded on various exchanges or brokered privately to wealthy or institutional clientele. The obligations fall into categories too numerous to mention: insured and uninsured credits, defaulted or performing, corporate against municipal or sovereign and so on.

A dominant class of obligations is called "Brady bonds" after the former U.S. Treasury Secretary Nicholas Brady. These securities are the outcomes of the rescheduling pf commercial bank loans (sometimes defaulted) to developing nations. The principal of the rescheduled debt - guaranteed by U.S. zero coupon Treasuries deposited by the original issuer in the Federal Reserve or some other credible institution - remains to be fully paid. The interest accrued on the principal until the moment of rescheduling is reduced and the term of payment is prolonged.

Brady countries include Venezuela, Brazil, Argentina, Ecuador and Mexico, to name just a few. The bonds have been trading since 1989. Only one Brady bond has ever defaulted (Ecuador). No interest payment was ever missed or skipped.

As Nazibrola Lordkipanidze and Glenn C. W. Ames observe in their paper, "Hedging Emerging Market Debt", the terms of individual Brady packages vary. Individual countries have issued as few as one, and as many as eight different bonds, each of which can vary with respect to maturity, fixed or floating coupons, amortization schedules, and the degree to which principal and interest payments are collateralized.

The market is besieged by - mostly offshore - mutual funds managed by the likes of Pacific Investment Management Company (PIMCO), AllianceBernstein, Scudder Investments, MFS Investment Management and Mainstay Investment Management.

Emerging market debt attracted entrepreneurial fund managers who set up nimble and agile shop. Ashmore Investment Management was divested to its current owners by Australia & New Zealand Banking Group. Despite the obvious shortcomings of its size - limited access to information and research - it runs a successful Russian fund, among others.

When the United Kingdom based firms, Garban Securities and Intercapital Securities, merged late in 1999, they transferred their illiquid emerging market securities businesses into a common vehicle, Exotix. The new outfit's team was poached from the trading side of emerging markets divisions of various investment banks. Exotix brokers the purchase and sale of fixed income products from risky countries.

Maxcor Financial, a broker-dealer subsidiary of Maxcor Financial Group, is an inter-dealer broker of various securities products, including emerging market debt. It also conducts institutional sales and trading operations in high yield and distressed debt. AIG Trading, of the AIG group, maintains a full-fledged emerging markets team. It boasts of "senior level contacts within many central banks, allowing us to provide rare insight".

Other outfits stay out of the limelight and offer discrete services, custom-tailored to the needs of particular clients. The Weston Group, in operation since 1988, is active in the Mexican market. It does underwriting, private placements and structured finance.

Companies such as Omni Whittington have specialized in "debt recovery" - the placement and conversion of defaulted bank and trade debt from political risk countries. They buy bad debt through a dedicated investment fund, collect on non-performing credits (on a "no cure, no pay" basis) and manage portfolios of loans gone sour, including the negotiation of their rescheduling.

Vulture funds are financial firms that purchase sovereign debt at a considerable disaggio and then demand full payment from the issuing country. A single transaction with a solitary series of heavily discounted promissory notes can wipe out the entire benefit afforded by much-touted international debt relief schemes and obstruct debt rescheduling efforts.

One sure sign of this niche's growing importance is the proliferation of conferences, consultancies, seminars, trade publications and books. Banks and law and accounting firms have set up dedicated departments to tackle the juridical and commercial intricacies of defaulted debt, both corporate and sovereign. International law is adapting itself through a growing body of legislation and precedents. Moody's Investors Service, Standard & Poor's and Fitch regularly rate emerging market issues.

RBC Investment Services (Asia), a business unit of the Royal Bank Financial Group, a Canadian investment bank, advises its clients in their investments in Bradys. Union des Banques Arabes et Francaises, 44 percent owned by Credit Lyonnais and the rest by Arab banks, including the Iraqi Rafidain, is an aggressive buyer of Iraqi and other Middle Eastern debt.

But the market is still immature and inefficient. In an address to the Sovereign Debt Restructuring Mechanism Conference earlier this year, Kenneth Rogoff, Research Director of the International Monetary Fund surveyed the scorched landscape:

"Private debt flows to emerging markets (produce) wild booms, spectacular crashes, over indebtedness, excessive reliance on short-term and foreign-currency denominated debt, and protracted stagnation following a debt crisis. Emerging economies' governments ... sometimes borrow more than is good for their citizens (and are) ... sometimes willing to take on excessive risk to save on interest costs. On the investor side, there is often a reluctance to hold instruments that would provide for more flexibility and risk sharing, such as GDP-indexed bonds, domestic equity, and local currency debt—in part, because of poor policy credibility and weak domestic institutions. The result is an excessive reliance on 'dangerous' forms of debt, such as foreign-currency denominated debt and short-term debt, which aggravate the pain of crises when they occur."

Weak property rights, uncertain debt recovery mechanisms, political risks, excessive borrowing, collective action problems among creditors and moral hazard are often associated with credit-insatiable emerging economies, failed states, erstwhile empires, developing countries and polities in transition.

Signs of trouble abound from Turkey to Bolivia and from Paraguay to Africa. Nigerian President Olusegun Obasanjo said last July that paying civil servants was more important than avoiding default on the country's $30 billion debt. Its Supreme Court ruled in April 2002 that it is unconstitutional to pay down the external debt before all other government expenses. Nor would that be the first time Nigeria reneges. The Paris Club of creditor countries has been rescheduling its debts repeatedly.

This is not to mention Argentina. Its corporate sector missed $4.6 billion in payments in the last six months alone and the country defaulted on a whopping $95 billion in obligations. The conduct of debtors, transparency and accountability are not improving either. Russia all but withheld information regarding a French lawsuit in a  plan to swap $3.1 billion in new Eurobonds for about $6 billion of defaulted Soviet-era debt.

The status of creditors is under further strains by the repeated floating of schemes to put in place some kind of sovereign bankruptcy mechanism. The Bush administration proposed to modify all sovereign debt contracts pertaining to all forms of debt to allow for majority decision making, the pro-rata sharing of disproportionate payments received by one creditor among all others and structured, compulsory discussions led by creditor committees.

The IMF's First Deputy Managing Director, Anne Krueger, countered, in November 2001, with the idea to allow countries to go bankrupt within a Sovereign Debt Restructuring Mechanism (SDRM). Legal action by creditors will be "stayed" while the country gets its financial affairs in order and obtains supplemental funding. Such an approach makes eminent sense.

In opening remarks to the Council of the Americas in November 2001, Martin Schubert offered these observations:

"Talk of adopting bankruptcy procedure protection for governments ... similar to that employed by private companies, could be the match that lights the fire, due to the conflicts such a standstill would create. Moreover, what government debtor would be willing or able to assign assets to a trustee or assignee in bankruptcy, for the benefit of creditors?"

But investors never learn. In a world devoid of attractive investment options, they keep ploughing their money into the high-yield scenes of financial crimes committed against them. This self-defeating tendency is reinforced by the general stampede from equities to bonds and by the slow-motion implosion of the US dollar, partly as a result. Until the next major default, that is.

recession. In economics, there is no free lunch.

Also Read:

IMF: Kill or Cure?

The IMF Deconstructed - A Dialogue

The Washington Consensus - I. The IMF

The Washington Consensus - II. Washington and Sarajevo

Going Bankrupt in the World

Trading in Sovereign Promises