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Wednesday, November 14, 2012

A quick-and-clean solution the the Greek debt

Nowhere in the seemingly innumerable comments on the Greek debt do I see reference to those instruments which I have found to be key instruments in debt restructurings in my banking career:

* variable interest rates
* capitalization of interest
* extension of debt maturities 'way into the future'

First, a comment on what the overriding objective should be. With the present political dissens in the 'paying countries', the overriding objective should be that the politicians of the 'paying countries' can tell their electorates "we have not forgiven Greece one cent of debt and/or interest!" This, of course, while at the same time achieving for Greece the debt relief which the country needs.

Now to the instruments in detail:

A. Variable interest rates
Greece will pay about 12 BEUR in interest in 2012. While that is down from about 15 BEUR in 2011 due to the debt restructuring in early 2012, it is still way too much, given that Greece doesn't even have a primary surplus yet.

Greece's primary expenditures will run close to 100 BEUR in 2012. Thus, 12 BEUR of interest expense represents about 12% of primary expenditures. To make the interest expense tolerable, it should be capped at "6% of primary expenditures". In other words, Greece would commit to always allocate 6% of its primary expenditures to interest, no less but also no more. If public expenditures go down, so does the interest expense (and vice versa). This rule should be valid for 10 years, at which time a renegotiation takes place.

The 6% of government expenditures allocated to interest should easily cover all interest due to private creditors. Thus, there would be no need to renegotiate with these private creditors. All the adjustments would have to come from the official creditors.

B. Capitalization of interest
When capitalizing interest, the interest due is added to principal instead of having to be paid in cash. The debt goes up but the cash debt service goes down. Creditors do not forego any legal claims against Greece.

Once the private creditors are paid interest out of the 6% interest allocation, the remainder of the 6% allocation goes to the offical creditors. Obviously, that will cover only a small portion of the interest due to official creditors. The large portion of interest which is due to official creditors but which cannot be paid out of the 6% interest allocation should be capitalized for 10 years.

C. Extension of debt maturities 'way into the future'
It is futile to attempt a 'complete and final' debt restructuring in the middle of a depression because there is no way of assessing what the debt service capacity of a well-functioning Greek economy would be. By the same token, it is futile to determine a 'debt sustainability' at this time: it may be 120% or 60% or even zero by 2020. It all depends on how the Greek economy develops (and, by the way, how interest rates develop).

A very large part of the official debt must be rescheduled 'way into the future' whereby 30 years would have to be the minimum period. More appropriately, it should be a 99-year bond which I have often recommended. How large should that part be? I would recommend an amount equal to all debt exceeding the Maastricht limit of 60%. Under no circumstances should it be less than 100 BEUR.

The remainder of the official debt (i. e. that portion which is not rescheduled 'way into the future') should be rescheduled to mature in 10 years, the same time when the interest capitalization period ends. Would that require Greece to repay all that debt plus capitalized interest in 10 years from now? No! Instead, the agreement would be: "In 10 years from now we will know if Greece made it, or not. If Greece made it, we will have a clear picture how the total debt maturing then should be structured based on the strength of a well-functioning Greek economy, and we will then structure it accordingly".

And if the Greek economy doesn't make it? Well, no one will be worse off then than he is today!

The importance of leverage
No creditor wants to offer a borrower too generous terms out of fear that they give up leverage on the borrower. Well, if Greece must allocate 6% of primary expenditures to pay interest for the next 10 years, creditors have all the leverage in the world because every time Greece needs to borrow money to pay interest, they can exercise pressure. If that is not sufficient leverage for creditors, they can build into their agreements acceleration clauses which stipulate under which circumstances a renegotiation has to occur before the 10 years end.

And what about the 99-year bond?
None of today's negotiators will live to see the maturity of this bond. Instead, the secondary market value of this bond will depend on the expectation that at least some interest is paid. In 10 years, at the end of the interest capitalization period, a new interest mechanism needs to be structured for this bond. It will have to be structured in such a way that investors can have the hope that at least some interest will be paid.

The 99-year bond will trade near zero during the first 10 years of interest capitalization. Depending on the development of the Greek economy in the next decades and on the new interest mechanism, they might increase in value. Perhaps to 10% of nominal, perhaps to 20%, perhaps even more. Whatever the case, any interest paid on a bond which started with a value of zero represents to investors an infinite return.

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