Tuesday, August 14, 2012

Seeing the erred ways of my thinking... (8)

With so many financial experts involved in the Greek debt problem I would have expected a bit more "financial restructuring creativity". My mistake was that I expected this.

Let me just mention three of the most common instruments used by "financial engineers" when structuring an amount of debt which seems to exceed the borrower's ability to service: (a) move maturities way out into the future; in most cases bullet maturities; (b) work out an interest payment schedule which makes sure that the borrower does not collapse under it but which also makes sure that a reasonable pressure to pay interest is kept in place; structure much of the interest on a variable basis so that the actual interest expense is tied to the available cash; capitalize all the remaining interest for which there is not sufficent cash now; and, finally, (c) take the company private so that no public debt instruments trade on any markets and so that no happenings in the secondary markets can cause problems.

Take a large private equity transaction. At the end of the day, the acquired company (= take-over target) is settled with an amount of debt which has no chance of being serviced/paid in any foreseeable future. The largest item on the company's asset side is typically "goodwill". That represents mostly the price paid for the company above the company's book value. You can consider it as the "market value" of the company; you could also consider it as "hot air". Take that goodwill out of the company's net worth and the company will show an enormously negative net worth.

Suppose the total debt were 100 MEUR. How could that be structured if it is far more than the company can sustain? Below is a structure which, in the go-go times of the 2000s, would have been considered as a conservative structure:

Step 1: make 40 MEUR due in 15 years (bullet repayment) and capitalize the interest during the first 10 years (i. e. no cash flow required for debt service for at least 10 years).
Step 2: make another 30 MEUR due in 10 years with debt instalments beginning after 5 years. Capitalize interest during the first 5 years.
Step 3: call the remaining 30 MEUR a "revolving commitment" valid for 7 years with interest payable quarterly.
Final step: structure the interest rates and maturities in such a way that that the bulk of available cash goes to the lenders.

If you look through that structure, you will note that the company pays back zero principal during the first 5 years. After those 5 years, it will beginn to amortize the loan under Step 2. Since the revolving commitment can be expected to be rolled-over after 7 years, the company really won't have to do any serious repaying of debt until the first 10 years are up.

The private equity investor doesn't worry about what will happen in 10-15 years from now because he expects to sell the company again after 5 years. And then the next private equity firm will take its chance to do the same trick all over again. In most cases, the system only works if, at the end of the day, a useful idiot comes along who buys the company for strategic reasons and pays an enormous price for it because of that. Call it a Ponzi-scheme with some chance for a benevolent ending.

Greece is not a borrower which can be sold. Thus, one has to be a bit more creative when it comes to sovereign debt. However, from a creditor's standpoint, a sovereign country has one huge benefit over a private corporation: the sovereign country can never cease to exist.

How could one have applied some of the above logic to Greece?

First, and most importantly: the burden of interest on the budget could have been contained within reasonable/tolerable limits. One would have worked out a variable interest rate structure to assure that enough "budgetary discipline" remains in place but to avoid that the budget is strangled. Typically, one would have structured the amount of interest payable in cash as a percentage of government expenditures, say 5% of government expenditures (if "wise men" were to conclude that this would be an appropriate percentage). All interest which creditors insist on getting but which cannot be covered within that 5% range would have had to be capitalized (at least for 5 years initially).

Secondly, one would have had to structure a maturity schedule which assures that a long period or "breathing space" is made available to the country to fix its problems. Actually, this was partially accomplished with the February restructuring.

Thirdly, one would have had to take a large portion of the debt and structure it as an Evergreen Bond or a 99-year bond. Thus, those creditors wouldn't see repayment during their lifetimes but they would have the opportunity to unload their risk in the secondary market once some stability returns to secondary markets. Nothing which creditors would applaud but certainly better than any haircut.

Finally, and this should ideally have been the first step: every effort would have had to be made to convert all public debt (except for the Evergreen Bond) into private debt; i. e. repay all public bonds with one or more new syndicated loans in equal amounts from the same creditors which hold the bonds (i. e. not risk change for existing creditors). The small private creditors would likely have had to be paid out in the process. Once the debt is private, there are no longer rating agencies to cause trouble. There are no longer secondary market activities which turn the tables through their speculations. There would no longer be the risk of an uncontrolled default. And --- one would no longer deal with anonymous capital markets but, instead, with institutional investors where the counterparts are people with first and last names with whom one can negotiate.

Moral of the story
If EU-elites had bothered to seek advice from countries in Latin America or Asia which have gone through such processes, they might have done something like the above. But to seek advice is only for those who are not sure that they know everything better in the first place.

The final question
Does anyone still believe that EU-elites will eventually come around to work out "comprehenive debt solutions" or will they continue with the kind of comprehensive solutions which they have applied for over 2 years now? Will they ever understand that there is only one way to deal with sovereign debt: reschedule, reschedule and reschedule again?

PS: previous posts in this series: P1, P2, P3, P4, P5, P6, P7.

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