Sovereign Debt Restructuring: instruments and risk management models

Stavros A. ZENIOS

University of Cyprus

Senior Fellow, The Wharton School, USA

(Joint work with Andrea Consiglio and Ashoka Mody)

Outline

Some facts about sovereign debt

The issues in sovereign debt crises

Risk management for debt restructuring

Instrument innovations

Case study of Greece

Some facts about sovereign debt

Some facts about sovereign debt

IMF 2013 mea culpa on Greece:

“Debt restructurings have often be too little and too late, thus failing to re-establish debt sustainability and market access in a durable way”

IMF Board 2013

Discuss legal and policy framework for sovereign debt restructuring

UN General Assembly 2014

Negotiate legal framework for sovereign debt restructuring(124 in favor, 11 against, 41 abstain)

Some facts about sovereign debt

Some facts about sovereign debt

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

Observations from the facts

Sovereign debt restructuring is pervasive

Sovereign debt crises are an equal opportunity malaise

Significant amounts involved

Reminders of Hyman Minsky (1919—1996):

Debt is fragile

The issues in sovereign debt crises

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),

The issues in sovereign debt crises

Operational models are missing

Risk management has not been part of analysis

“Need for development of criteria for “optimal” debt restructuring process”

(Wright 2012, Harvard Business Law Review)

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)

Risk management for debt restructuring

Debt dynamics

Re-finance debt of different maturities

Look at alternative debt stock flows

Risk management for debt restructuring

Risk management for debt restructuring

Scenario dependent debt dynamics

Formulate 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 rates (or spreads)

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, forthcoming)

Risk management for debt restructuring

Risk management for debt restructuring

DEaR: Debt-at-Risk

At each terminal node

Conservation of flow at each node

Risk management for debt restructuring

(Rockafellar and Uryasev 2000)

Conditional Debt-at-Risk

Risk management for debt restructuring

Instrument innovations

Instrument innovations

“Financial optimization makes a good manager better,

and a bad one worse.”

Zenios, S.A., Financial Optimization, Cambridge University press, 1993.

Instrument innovations

QUESTION 1. 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)

Instrument innovations

QUESTION 2. Are there neglected risks? Are we optimizing under uncertainty or risk?

Gennaioli, Shleifer and Vishny, J. of Financial Economics, 2013

Bermudes and Pardo, Notre Dame J. of Law, Ethics and Public Policy, 2015

Frank H. Knight, Risk, Uncertainty and Profit, 1921.

Sovereign default treated ex poste

Instrument innovations

Ex ante treatment of sovereign risk

CAC – Collective Action Clauses International Capital Markets Association, 2014.

GDP-linked bonds

Kamstra and Shiller, Cowles Foundation, 2009.Borensztein and Paolo Mauro, Economic Policy, 2004.

Sovereign COCOs – Convertible contingent debt

Instrument innovations

Sovereign COCOs – convertible contingent debt

Calomiris and Herring, Journal of Applied Corporate Finance, 2013.Barkbu, Eichengreen, Mody, Journal of International Economics, 2012.

Mody, Oxford Review of Economic Policy, 2013.Brooke et al., Bank of England and Bank of Canada, 2013.

Too big to fail

Too important to fail

Instrument innovations

Features of sovereign COCOs Convert to equity (GDP-linked bond) Delay principal payment Suitable trigger Conversion price

Pricing Triggered by CDS spread Mean-reverting diffusion process with jumps and

autocorrelationsDonoghue et al., International J. of Theoretical and Applied Finance,

2014.

?

Instrument innovations

Case study of Greece

Case study of Greece

Case study of Greece

Case study of Greece: current debt situation

Case study of Greece: IMF projections

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

Interest rate concessions

Interest rate concessions:extreme frontiers

Debt extension

Risk management for debt restructuring with COCOs

Swap plain vanilla debt instruments by COCOs

Conversion at nominal value

Triggered by CDS spread

Payments delayed by three years

1 2 3 4 5 6 7 8 9 10 11 12 130

20

40

60

80

100

120

1 2 3 4 5 6 7 8 9 10 11 12 130

20

40

60

80

100

120

Triggering the COCO conversion

Difference of trigger variable from threshold

Risk management for debt restructuring with COCOs

Risk management for debt restructuring with COCOs

10 11 12 13 14 15 16 17 18 19245

250

255

260

265

270

275

280

285

No Cocos Cocos 1.2 Cocos 1.4

Conditional Debt at Risk (CDeaR)

Expecte

d c

ost

of

debt

financin

g

Conclusions

Ex post risk management for sovereign debt

Ex ante deal with uncertainty

Interesting conclusions about Greek debt

References

Consiglio, A. and Zenios, S.A.Risk management optimization for sovereign debt restructuringhttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=2478380

Consiglio, A. and Mody, A. and Zenios, S.A. (in preparation)Contingent debt for sovereign debt risk management

Consiglio, Carollo and Zenios,A parsimonious model for generating arbitrage free scenario trees http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2362014