debt restructuring and sovereign contingent debt

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Risk Profiles for Sovereign Debt Restructuring

Sovereign Debt Restructuring: Risk management and contingent debtStavros A. ZENIOSUniversity of CyprusNorwegian School of EconomicsSenior Fellow, The Wharton Financial Institutions Center

Joint work with Andrea ConsiglioUniversity of Palermo

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The devil is in the tailswww.voxeu.org, Aug. 2015

Sovereign contingent debt www.voxeu.org , Jan. 2016

OutlineThe debate on sovereign debt restructuring

Risk management for debt restructuringSovereign contingent debtPricing sovereign contingent debt

Case study of Greece

Ex post: Risk management for debt restructuring Incorporate risk measures in debt sustainability analysis

Optimal debt reprofiling to restore sustainability with high probability

Ex ante: Sovereign contingent debt A sovereign debt instrument, with a built-in trigger to allow standstill of payments when a crisis indicator breaches a thresholdinvokes a precautionary credit line from the IMFmakes the triggered bond senior to subsequently issued debt.

Ex ante: Sovereign contingent debt

Ongoing debate on sovereign debt restructuring

Some facts about sovereign debtIMF 2013 mea culpa on GreeceDebt restructurings have often be too little and too late, failing to re-establish debt sustainability and market access in a durable way UN General Assembly 2014Negotiate 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

Some facts about sovereign debt

Data: Bank of Canada 2014.

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

Some facts about sovereign debt: Serial defaultsData: Trebesch 2011.

Observations from the facts Sovereign debt restructuring is pervasiveSovereign debt crises are an equal opportunity malaiseAmounts involved are significantReminders of Hyman Minsky (19191996):

Debt is fragile

The issues in sovereign debt crisesTo default or not to default?Eaton-Gersovitz (1981), Krugman (1988), Reinhart-Rogoff (2009), Sturzenegger-Zettelmeyer (2006),Benjamin-Wright (2009), Brunnermeier et al. (2011), 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

Tactical vs Strategic debt sustainabilityTactical: 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%?Consiglio and Zenios, Greek debt sustainability: The Devil is in the tails, Vox.eu, Aug. 2015.

Projections or wishes?

The issues in sovereign debt crisesRisk management has not been part of analysisOperational models are missing

Need for development of criteria for optimal debt restructuring process (Wright 2012, Harvard Business Law Review)

Risk management for debt restructuring

Debt dynamicsRe-finance debt of different maturitiesLook at alternative debt stock flows

Risk management for debt restructuring

Risk management for debt restructuring

Scenario dependent debt dynamics

Using Debt-to-GDP ratio

Risk management for debt restructuring

D is the term structure of debt (multiple issues)r is the term structure of sovereign ratesGDP, NB can be state-dependentSF can be state-contingentScenario tree integrates economic and financial risk factorsObjective and risk neutral probabilities(Consiglio, Carollo, Zenios, Quantitative Finance, 16:201-212, 2016)

Risk management for debt restructuring

Risk management for debt restructuring

DeaR: Debt-at-RiskAt each terminal node:Conservation of flow at each node:xmj nominal value of debt instrument j issued at node m.

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

Risk management for debt restructuring

Risk management for debt restructuring:Flow constraints

Risk management for debt restructuring:Ednogeneity

The issues in sovereign debt crisesKey parameters (Das et al., IMF 2012)

Face and market value of bonds or loansInterest rate and coupon (fixed, flexible, step-up, linked)Amortization scheduleCurrency of denominationEnhancements such as embedded options or collateralLegal clauses (CAC, exit consents)

What does risk optimization give us?

Case study of Greece

Case study of Greece

Case study of Greece

Case study of Greece

Case study of Greece: current debt situation

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

Interest rate concessions

Case study of Greece: IMF projections

Sovereign contingent debt:From ex post to ex ante solutions

Sovereign contingent debt A sovereign debt instrument, with a built-in trigger to allow standstill of payments when an indicator breaches a thresholdinvokes a precautionary credit line from the IMFmakes the triggered bond senior to subsequently issued debt.

Ex ante treatment of sovereign risk

Address creditor moral hazard

Deal with neglected risks

Contingent contracts

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

Why S-CoCo Early proposalsWeber, Ulbrich, Wendor, Frankfurt Allgemeine Zeitung, 2011Barkbu, Eichengreen, Mody, J. of International Economics, 2012Brooke, Mendes, Pienkowski, Santor, Bank of England, 2013.French Aid Agency 2009Insurance and re-insurance, Michelin, Swiss Re, MBIARated firms for capital management, service firms for liability insurance

Why S-CoCoBank contingent capital(Mark Flannery 2002)2009-2013: $70bn 2014: $208bn, 187 instruments, 68 banks (Avdjeiv et al., BIS, 2015).

S-CoCo designs: Trigger AccurateTimelyComprehensive in valuation of entityPredictableX Accounting data or institutional triggers

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

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S-CoCo designs: Trigger CountryTriggerSigned

Program Early responseGreece24 April 20105 Sept. 20104 monthsPortugal16 Nov. 201020 May 20116 monthsIreland1 Oct. 201016 Dec. 20102,5 monthsSpain27 March 2012Dec. 20129 monthsCyprus11 July 201115 May 201321 months

S-CoCo designs: IncentivesIs there moral hazard?YES Haldane and Scheibe, Bank of England 2004, othersNO IMF 2007

Creditor vs Debtor moral hazardEvidence 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

S-CoCo designs: IncentivesDebtor incentives:

- Why sovereigns pay?- Economic incentives: Non-linear discounts on S-CoCoSeniority transfers rates to plain debt- Political incentives:IMF precautionary lineVoted out like ousted Bank Board

S-CoCo designs: Incentives

S-CoCo designs: Market manipulation and multiple equilibriaFalse alarms and missed crises? Type I and II errors B-CoCo subject to multiple equilibria? Sundaresan and Wang, J. of Finance, 2015Calomiris and Herring, J. App. Corp. Fin., 2013McDonald, J. Financial Stability, 2013 Prescott, Economic Quarterly, 2012Market manipulation?

S-CoCo Pricing

CDS spreadMean-reverting diffusion process with jumps and autocorrelationDonoghue et al., Intl. J. of Theoretical and Applied Finance, 2014.Regime switching Bai-Perron, Econometrica, 1998Model using hidden Markov process

S-CoCo Pricing

CDS spreadMean-reverting diffusion process with jumps and autocorrelation(Donoghue et al., Intl. J. of Theoretical and Applied Finance, 2014.)

Regime switching (Bai-Perron, Econometrica, 1998.)

Model using hidden Markov process

S-CoCo Pricing

Greek data START 2007 and END 201252

S-CoCo Pricing

S-CoCo state-contingent pricing

F.A. Longstaff and E.S. Schwartz. Valuing american options by simulation: A simple least-squares approach. Review of Financial Studies, 14(1):113147, 2001.

Case study of Greece

Risk management for debt restructuring with CoCo

Risk management for debt restructuring with CoCo

Conclusions and challenges

Conclusions on S-CoCo

Reduce probability of defaultMarket discipline debtorsSolve creditor moral hazardAutomatic stabilizers, countercyclical fiscalSpeedy crisis response

ChallengesSafe asset for Banks CDS adjust to the issue of S-CoCoIMF/ESM involvement Develop solid investor base

ConclusionsEx post risk management for sovereign debt

Ex ante deal with uncertainty

ReferencesConsiglio, A. and Zenios, S.A.Risk management optimization for sovereign debt restructuringJournal of Globalization and Development (J. Stiglitz et al. eds.)

Consiglio, A. and Zenios, S.A. 2016Contingent convertible bonds for sovereign debt risk management http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2694973

Consiglio, Carollo and Zenios,A parsimonious model for generating arbitrage free scenario trees Quantitative Finance, 16(2):201