Sovereign Debt Restructuring: Risk management and contingent debt
Stavros A. ZENIOS
University of Cyprus
Norwegian School of Economics
Senior Fellow, The Wharton Financial Institutions Center
Joint work with Andrea Consiglio
University of Palermo
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 (i) a built-in trigger to allow standstill of
payments when a crisis indicator breaches a threshold
(ii) invokes a precautionary credit line from the IMF
(iii)makes the triggered bond senior to subsequently issued debt.
1 2 3 4 5 6 7 8 9 10 11 12 130
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1 2 3 4 5 6 7 8 9 10 11 12 130
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120
Ex ante: Sovereign contingent debt
Ongoing debate on sovereign debt restructuring
Some facts about sovereign debt
IMF 2013 mea culpa on Greece“Debt 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 programs
Financial 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 defaults
Data: Trebesch 2011.
Observations from the facts
Sovereign debt restructuring is pervasiveSovereign debt crises are an equal opportunity malaiseAmounts involved are significantReminders of Hyman Minsky (1919—1996):
Debt is fragile
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), 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 crises
Risk 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-contingent
Scenario tree integrates economic and financial risk factors
Objective 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-Risk
At 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 crises
Key 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
Sovereign contingent debt:From ex post to ex ante solutions
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.
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 proposals
Weber, Ulbrich, Wendor, Frankfurt Allgemeine Zeitung, 2011Barkbu, Eichengreen, Mody, J. of International Economics, 2012Brooke, Mendes, Pienkowski, Santor, Bank of England, 2013.
French Aid Agency 2009 Insurance and re-insurance, Michelin,
Swiss Re, MBIA Rated firms for capital management,
service firms for liability insurance
Why S-CoCo Bank contingent capital
(Mark Flannery 2002) 2009-2013: $70bn 2014: $208bn, 187 instruments, 68
banks (Avdjeiv et al., BIS, 2015).
S-CoCo designs: Trigger Accurate Timely Comprehensive in valuation of entity PredictableX Accounting data or institutional triggers
S-CoCo designs: Trigger 30-day average CDS spread > 300 to
400bp
S-CoCo designs: Trigger
Country TriggerSigned
Program Early
response
Greece 24 April 2010 5 Sept. 2010 4 months
Portugal 16 Nov. 2010 20 May 2011 6 months
Ireland 1 Oct. 2010 16 Dec. 2010 2,5 months
Spain 27 March 2012 Dec. 2012 9 months
Cyprus 11 July 2011 15 May 2013 21 months
S-CoCo designs: Incentives
Is there moral hazard?YES –Haldane and Scheibe, Bank of England 2004, othersNO –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
S-CoCo designs: Incentives
Debtor 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 equilibria
False alarms and missed crises? Type I and II errors
B-CoCo subject to multiple equilibria? Sundaresan and Wang, J. of Finance, 2015
Calomiris and Herring, J. App. Corp. Fin., 2013
McDonald, J. Financial Stability, 2013 Prescott, Economic Quarterly, 2012
Market 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, 1998
Model 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
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):113–147, 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 default Market discipline debtors Solve creditor moral hazard Automatic stabilizers, countercyclical
fiscal Speedy crisis response
Challenges
Safe asset for Banks CDS adjust to the issue of S-CoCo IMF/ESM involvement Develop solid investor base
Conclusions
Ex post risk management for sovereign debt
Ex ante deal with uncertainty
References
Consiglio, 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):201-212, 2016
