A Trichet Plan for the Eurozone

In April 1989, Mexico’s external debt negotiator, Angel Gurria – currently Secretary-General of the OECD – asked his country’s commercial bank creditors for a 55% haircut on their sovereign obligations. This was the opening pitch of the Brady Plan that finally resolved the Latin American debt crisis. The Plan was presented to the Paris Club – the group of government creditors who negotiate restructurings of official bilateral loans. Jean Claude Trichet was the chairman of the Paris Club at that time. Plainly then, Mr. Trichet, now president of the ECB, is familiar with the mechanics of debt restructuring.

At that time, we were part of the debt negotiating team from Bank of America – Mexico’s largest creditor. We also made a presentation of the Brady Plan to the Paris Club.  Mexico’s Brady deal is worth considering in detail, since it shows how sovereign debts can be restructured without damaging the banks.

How the Brady Plan worked
The final package had three options roughly equivalent in market value:

•A 6.25% Par Bond;
•A 35% Discount Bond similar in structure to the one Gurria had proposed; and
•A New Money option in which banks could choose to make new loans equivalent to 25% of exposure.
The banks negotiated the terms of each option to limit the hit to bank capital under the different accounting, tax, and regulatory regimes of banks in different countries.

US banks, for example, used the Financial Accounting Standards Board 15 (FASB 15) accounting rule to avoid a write-down when they swapped their loans for Par Bonds. FASB 15 allowed restructured loans to be booked at original face value if the sum of nominal income and principal payments exceeded the original loan extended.

Conversely, some European regulatory regimes made the Discount Bond relatively more attractive, as policy there was to incentivise banks to reduce their Least Developed Country exposure. The Discount Bond was exchanged at 65% of the original loan amount for a floating rate 30-year bond. The bond had a semi-annual coupon of Libor plus 13/16% and bullet principal payment in December 2019, collateralised in full by US Treasury zero coupon bonds. It also included the same interest collateral as the Par Bond.

Linking payments to economic prospects
Mexico’s Par and Discount bonds also included a value-recovery mechanism, which we helped to design and negotiate, that linked payments to oil receipts. This required Mexico to make up to 300 additional basis points in coupon payments annually if Pemex’s revenues exceeded a certain threshold beginning six years after issuance. The idea was to add value to the replacement bonds by offering the possibility of claw-back portions of the forgiveness granted should the sovereign substantially recover its debt service capacity.

Besides linking Mexico’s obligations to its creditors to its ability to pay, this mechanism motivated the government to retire its Brady Bonds almost 20 years before they matured. If Mexico’s 6.25% Par Brady Bond were still outstanding and trading today, it would be trading close to a price of 150% of face value, providing a 16% plus hypothetical annual return had the bond been purchased at market value at the date of issuance.

While Mr. Gurria insisted that the agreement allow for early retirement, many bankers did not take him seriously. They did not believe that Mexico, so incentivised, would take serious steps to strengthen its fiscal position. They could not imagine that the Mexico’s debt crisis was about to be resolved with the help of a single transaction.

The Trichet Plan
A Trichet Plan for Europe could be implemented in two phases.

The first phase would take the form of an exchange offer negotiated in private between the banks, represented by a Eurozone Bank Committee, and the sovereign debtor. It would address the stock of bonds issued prior to a certain date. These offers, while market transactions involving the principals, would be orchestrated in advance.

The indebted sovereign would offer medium-to-long-term replacement bonds for the existing bonds. Credit enhancements for these instruments could include collateralisation of all or part of principal or interest payments funded or underwritten by the European Financial Stability Facility (EFSF) or the newly created European Stability Mechanism (ESM), which would also provide contingent guarantees, or explicit or implicit seniority.

This treatment could allow EU banks to limit the losses that they must realise, spread them over the life of the new instruments, and bolster their balance sheets with new credits partially guaranteed by the EFSF or ESM.

Special accounting and tax treatment for restructured debt
In addition, the Financial Stability Board, or appropriate authority, may need to write specialised accounting and tax regulations for the Trichet Plan. One possibility is a FASB 15-style conversion of old bonds for new Par Bonds, with losses realised as coupon payments received fall below banks’ funding costs and market rates. Another possibility is enhanced step-up fixed or floating rate Par Bonds or front-loaded interest reduction bonds.

Alternatively, a Phase-In Discount Bond could reduce the face amount of the bonds over time, say by 5%-10% per annum over a seven year period. The discounting of the principal and interest reduction in each year would be linked to the country remaining current in an IMF programme, as in Poland’s Paris Club deal. This would facilitate a reduction of the debt stock while incentivising fiscal and economic discipline.

The second phase of the Plan would then launch an offer with comparable terms to non-bank bond holders and non-EU banks. While this phase could also be negotiated, this may not be necessary if the first phase creates a new benchmark bond with adequate liquidity by virtue of having been chosen by the largest bank creditors.

Case by case
The Brady Plan dealt with each country individually. For example, Brazil said that it had up front access to only $2 billion of collateral. The banks wanted full collateralisation at the close of the deal, but the Brazilians couldn’t afford it (their commercial bank debt was $50 billion at the time). This caused negotiations to stall.

But because Brazil could access more funds from the IMF and World Bank over time with which to purchase collateral, we designed temporary Phase-in Bonds. Although these gave Brazil no debt relief and relatively onerous terms, the government could call and exchange them for Brady Bonds when adequate cash collateral was obtained.

Another example concerned the size of the haircut. Early Brady countries like Mexico, Venezuela, and Uruguay (1991) had smaller debt overhangs and received debt reduction in the neighbourhood of 30-35%. Later Brady countries like Poland, Panama and Peru had bigger overhangs in part because of the need to capitalise larger past-due interest claims. These countries negotiated haircuts in the neighbourhood of 45 to 50%.

Value recovery
Yet another example is Uruguay’s value recovery warrants. In contrast to the oil-linked value recovery mechanisms in Mexico and Venezuela, Uruguay’s value recovery was a modified terms-of–trade index. We included in the numerator the price of the country’s main exports, wool, beef, and rice and, because the country imported oil, the denominator was simply the price of crude petroleum.

The ideal value recovery facility for the European periphery countries would, like Brady-era facilities, vary with the specifics of each case. One alternative is GDP warrants. Others might include an index linked to an international price such as a commodity price or market or industrial index which directly impacts and provides the debtor country with windfall revenues or expenditure reductions.  

Debt-for-education and environment swaps
Menus could also include language allowing for debt-for-equity, debt-for-environment, debt-for-education, or debt-for poverty swaps. The new “Trichet bonds” would be purchased in the secondary market and used as currency in privatisations or to partially pay tuition at local public universities in countries like Portugal where more investment in education is an urgent priority, for example.

Debt could also be extinguished through the purchase of the Trichet Bonds by environmental organisations to finance public sector land at home or even cross-country public land for conservation projects or even used in carbon offset mechanisms. We were involved in debt-for-nature swaps at Bank of America, where the bank donated a certain portion of its Costa Rican loans to finance the purchase of a conservatory in the country’s rain forest.

Conclusion
Our proposal, unlike other European debt proposals, is predicated on the notion that the borrowers and lenders and not outside parties should take the losses, set terms of the restructuring, and design the instruments in a menu of options which best fits their needs. The consenting adults who created Europe’s crisis are the ones who should resolve it – albeit with assistance from EU regulators and officials.

There is much at stake in the Eurozone’s debt crisis, not just for Europe but for the rest of the highly indebted West. Forbearance achieved by piling debt upon debt to deal with what is ultimately an insolvency issue is no longer an option. Policymakers cannot afford to discount the risk that the crisis in the periphery could spread to the core of Europe and even skip across continents and oceans.   

(From Voxeu http://www.voxeu.org/index.php?q=node/6378 [2] )