Private participation

So, Greece is the word today.

If I understand the current impasse, much of the trouble is about how to engineer “private participation” in the losses that lenders to Greece and other debtors must eventually bear. The Eurocrats have decided they cannot allow Greece simply to default and impose haircuts on all of its creditors, and they cannot prevent a default by covering Greece’s solvency gap with public sector transfers alone. Despite European leaders’ best efforts to obfuscate and obscure transfers, creditor-state publics know they will be saddled with the lion’s share of these losses. They demand that private sector lenders bear at least a portion of the costs. Yet, there is no way to force a private bondholder to accept anything less than payment in full and on-time without that act constituting a default, thereby triggering the legal controversies and dangerous precedents that the Eurocrats are struggling to avoid.

Suppose the EU were to organize a debt forgiveness fund. This would be a public sector entity whose purpose would be to help Greece and other troubled states retire their unpayable debt. Initially it would be financed by loans from EU member states. With the fund’s help, Greece would make all payments on time and in full. The fund’s contributions would constitute outright transfers. Greece would have eliminated, not postponed its obligations.

However, the fund would repay its loans to member states with income from a dedicated tax. The tax would attach to interest and principal payments on Greek debt, and to capital gains on sales of that debt. This would not constitute a default by Greece and its successors. The troubled sovereigns would make their payments. It would not bind all holders of any class of bond: public-sector and conventionally tax-exempt holders would be unaffected, so it should not constitute a formal credit event (ht @Alea_, @dsquareddigest). For even greater assurance that the EU-wide tax would not constitute a default, it could attach to the debt of all Eurozone states, but at rates computed as a function of various state solvency criteria. Greece, Portugal, and Ireland needn’t be named at all in the law defining the tax, but Greek bondholders might find themselves paying 30% of interest and principal receipts to the, um, “Unity Fund”, while German bondholders pay less than 1%. The rates and total receipts, ultimately the share of the solvency gap that will be borne by the private sector, becomes a political decision within the EU rather than a technical question of smoke and mirrors. Given the discount at which PIIGS debt currently trades, the EU could impose large taxes without further depressing prices, as long as the market is persuaded that the tax scheme eliminates the possibility of default.

To avoid moral hazard, assistance to a particular state could be calibrated to tax receipts from that state’s bonds. (The modest quantity of funds collected from currently solvent states might be held as a form of overcollateralization.) Or there could be some burden-sharing among private bondholders. Again, that’s a political choice.

I don’t necessarily love this plan. But it does seem like it could work, and I haven’t seen the option discussed. So, for your consideration.


Note: An oddity about the Eurocrats apparent determination to impose haircuts without a formal default is that by avoiding a CDS credit event, they impose losses on European bondholders that would otherwise fall to American banks. The scheme above shares that deficiency, but apparently the EU’s leaders prefer paying off American banks to the difficulties that would attend a “hard” default.

 
 

19 Responses to “Private participation”

  1. babar writes:

    sure, they can set something like this up. the bonds would be worth more to holders which don’t pay EU taxes, no?

  2. JKH writes:

    “apparently the EU’s leaders prefer paying off American banks to the difficulties that would attend a “hard” default”

    paying them off, or saving them from having to pay off on CDS?

    a bit of a legal mess when newly taxed European bondholders can’t collect on CDS hedges?

  3. Blankfiend writes:

    Sounds rather ludricruous to me. I would think that the value of the bonds would immediately be discounted by the anticipated tax losses. If you make the tax rate based on “state solvency criteria,” you compound the problem of the tax-induced discount on the bonds already under the most stress.

  4. RSJ writes:

    If banks and pension funds will be immune from the tax, the bonds will be sold to them. The tax isn’t going to raise a lot of money, but it will reduce the market for Greek debt. Most likely, it will force a restructuring sooner rather than later.

  5. Steve Randy Waldman writes:

    babar — Could be. That’d depend on implementation and legal considerations. putting aside all that i don’t know about international tax treaties, the EU could claim the right to tax EU bonds regardless of the nationality of the party holding them. To enforce this, the EU could have sovereigns withhold the tax liability when they pay bondholders, just as businesses withhold employees’ expected tax liability. parties who are exempt could file for a waiver of withholding or for refunds of amounts withheld, but this would be an effective means of enforcing the tax even against foreign holders. I think that, if the EU chose, it could design the tax in a way that would be legitimate under multilateral treaties to impose even on non-nationals. It wouldn’t be called an income tax; it would be called something like a mandatory tax to support a state run, risk-weighted bond insurance pool. When foreign corporations do business in European countries, they have to contribute to unemployment insurance pools just like any other employer. The same principle could apply here. To the degree that public sector and tax-exempt entities are immune, definitions for those categories might have to encompass non-Eurozone government agencies and tax-exempts in a manner that would qualify as nondiscriminatory. All in all, though, I think none of these issues are insuperable. It would be a political choice, whether non-EU holders of the bonds would be taxed.

    The scheme I’ve outlined can be thought about either as a temporary facility designed to impose haircuts on existing bondholders, or as a permanent measure for supplanting market-discrimination among sovereigns with insurance and regulatory discrimination. Since it’s pretty clear that the market failed to imposed discipline, and might well fail to do so again going forward if haircuts to private bondholders are mild, one can make the case that sovereigns should have the equivalent of an FDIC, but an agency that priced insurance in a discriminating way (rather than FDIC’s historical flat rate).

    Anyway, if it’s a temporary facility, it doesn’t matter so much whether non-EU holders are taxed, if (as I think is the case) the vast majority of private holders are Eurozone entities, and capital gains are taxed so they can’t escape current positions. If it’s to be a permanent facility, then it has to be defined to tax all non-EU holders going forward. Otherwise, all new bonds will be sold to entities in the Cayman Islands and everywhere but the EU.

  6. Steve Randy Waldman writes:

    JKH — by “paying off”, I meant letting American banks collect payments without ever having to make good on protection, despite the economic substance of default. And yes, it is astonishing that this seems to be the Eurocrats’ preference, to let European banks pay premia to US entities and endure haircuts (however “voluntarily”) that are not reimbursed. I can only speculate as to why this is. Perhaps banks have shed sufficient PIIGS debt that the CDS are now more speculative than insurance? Perhaps EU banks have been closing those positions, and the BIS data that showed a lot of indirect American exposure is stale? Perhaps the Eurocrats are reflecting the preferences of the banks themselves, and the indirect US exposures are really among related entities for internal or regulatory capital management purposes, so they are mostly indifferent to the cash flows they compel. I just don’t know.

    It seems very strange, if putting basis risk between substantive default and CDS payments would damage European banks, that EU officials are trying so hard to do just that.

  7. Steve Randy Waldman writes:

    Blankfield — I think you are missing something.

    This program would do two things. First, it would guarantee payment of PIIGS debt, which would increase its value from currently very, very depressed levels. Secondly it imposes a tax, which would diminish the value of the debt.

    If the tax is modest, bond prices would certainly rise. The tax would impair the debt less than market expectations of potential default had, plus market participant prefer a certain cost to an uncertain distribution of losses with the same expected cost.

    If the tax is very steep, it could depress the value of debt. But given current market prices of Euro debt, it’d have to be a very steep tax indeed.

    If the tax is calibrated carefully, it could in theory leave prices entirely unaffected. Which I think would be the right target, although it’d be impossible to hit exactly.

  8. Steve Randy Waldman writes:

    RSJ — Many banks in Europe are, I think, taxable entities. I don’t mean to exempt banks entirely, although state banks probably would be exempt. That’s appropriate, since the state will be making up its part of the losses through various transfers, and there’s no need why it should bear a double burden.

    In any case, as I envisioned it, there would be nontaxable entities. But there would be a tax on capital gains, as well as on principal and interest payments. So existing holders of the debt couldn’t evade it by selling it for a gain to nontaxable entities. If a taxable entity tried to do that “arb” with, say, a pension fund or state bank, it would end up paying the tax on its gains anyway. Of course, there would be temptations to corruption: an existing holder of Euro bonds could sell them at near purchase price to a tax-exempt holder, gaining nothing on paper, but arrange for some side-payment from the tax-exempt holder. But this sort of arb exists all the time in a world with tax-exempt parties. We keep the finances of tax-exempt parties under heavy surveillance to avoid this sort of thing.

    (Example: Suppose I hold a bond whose value has appreciated. I can sell it to a charity for my original cost, now below market value. The charity then kicks back to me most of its instantaneous gain in some subtle, unrecorded way. The end result is that the tax I owe goes unpaid, split between me and the nontaxable entity I’ve colluded with. It’s very easy to come up with these schemes, but we seem able to mostly prevent them.)

    By the way, there needn’t, necessarily, be tax-exempt entities at all, if the tax is broadly applied even to bonds of solvent Eurozone countries. Applying a tax to all bondholders might be deemed a general legislative change not a legally imposed default. So, if you really wanted to avoid arbitrage between taxable and tax-exempt holders, you could iminate the category of tax-exempt holders and withhold the tax from all payments.

  9. [...] Yet another non-credit event debt forgiveness plan for [...]

  10. Sid writes:

    Your plan, in a roundabout way, reminds me of the assumption by the US federal government of revolutionary war debt by the states.

    I suppose any feasible plan would, as any solution to this specifically euro-area problem would require a euro-area mandated supranational authority to act as a clearing-house of sorts.

    Therein lies the actual problem.. I don’t see this as an economic or financial problem that requires economic or financial tools to solve. This is about politics. Currently, there is no euro-area mandate, consensus or will that will enable a euro-area solution.

    At some point though necessity will force things through.

  11. Steve,

    The plan’s fine, but no mistake should be made as to who pays the tax. It’s the issuing government. Assuming (only for the sake of argument) that Greece would be able to access markets at 3 percent for ten years plus a 30 percent tax, they would be issuing with a yield of around 4.2 – this without any of the foreseeable complications.

    None of it, though, deals with the underlying problem of vastly differing political cultures and economic policies within the eurozone. Whilst Germany continues to insist that everyone adjust except themselves…

  12. JKH writes:

    “withhold the tax from all payments”

    right; I was going to say that – it should be a clean withholding tax, with its own rules for any potential tax credit/rebate, regardless of prior taxable or non-taxable status

    a withholding tax that defines default in all but name

  13. [...] link: Private participation – [...]

  14. Christine writes:

    Technicality aside, this proposal sounds like they are moving to consolidating country taxes – a move closer to a closer political union (fiscal union). Giving up some control over individual country’s national taxes(revenue) is equivalent of giving up some of its sovereignty. This is a step fwd to form a fiscal union (common treasury) for European union if they can overcome the political difficulties. The next step will be unification of Eurobond after establishing a common treasury. That’s the only long term solution – countries within the eurozone need to form a closer political union.

    Note that US went through a similar process under 1st treasury secretary Alexander Hamilton back in the late 18th after th independence war. Hamilton consolidated states debts into a unified national debt, introduced national taxes, introduced a unified national standing army — all these came together with the unification of national currency….

  15. Indy writes:

    Quick, somebody invent me a new CDS for exactly this kind of scenario! “The Recycling Default” – where we pay you in full but immediately take a hefty chunk back.

    It’s genius in that “legal-loophole technicality” kind of way, but it wont happen, mostly because no one wants to open that can of worms and add an unknowable new level of “political risk” to the premium on sovereigns (and to their market-assessed valuation on the books of the banks required to hold them given the insurance instruments they possess). Since this is largely a “get around the insurance instruments” maneuver, then the markets will wont any longer give the banks full credit for the CDS’s they possess.

    Actually, forget “full credit”, why would I give a bank any credit at all for insurance?

    So, we start in a world where Bank holds a $100 Bond X and CDS-on-X, and the market thinks it’s an asset worth nearly $100 (with some residual systemic risk). Now the European government is trying to neutralize CDS events and recycle-default my bonds. All of my CDS’s for which I paid good money are now worth zero, and all my bonds are worth whatever Europe decides they want to leave me. What’s my bank worth now?

    The only way to keep the banks healthy then would be to do the same recycling-default to the bank’s liabilities as well, which are mostly deposits.

    Wait, if we recycle-default the government’s bonds and also all bank deposits, that’s almost exactly like … a currency devaluation.

    But the recycle-default doesn’t devalue equally, it does so according to the country-specific levels of distress, which is exactly like … not having a currency union in the first place.

    So, why don’t we just call the whole thing off. I miss Drachmas and Punts and Escudos and Pesetas and Lira and Deutschmarks anyway. It looks like a lot of European economies do too.

  16. Doc at the Radar Station writes:

    “I miss Drachmas and Punts and Escudos and Pesetas and Lira and Deutschmarks anyway.”

    Fragmenting currency zones might be helpful in a global depression. I think that in the Great Depression there were a lot of different “city-currencies” that were floated in an attempt to boost local economies. I wonder if the same dynamic could be applied to the U.S. now (as an example). What if all of the differing Fed regions or States (i.e.), issued their own currency? Relatively depressed regions or States would be devalued to the Federal dollar and if their debts (and wages) were automatically re-denominated in the more localized currency, that would help promote recovery.

  17. [...] Understanding Greece’s Plan for Private participation – via Interfluidity-If I understand the current impasse, much of the trouble is about how to engineer “private participation” in the losses that lenders to Greece and other debtors must eventually bear. The Eurocrats have decided they cannot allow Greece simply to default and impose haircuts on all of its creditors, and they cannot prevent a default by covering Greece’s solvency gap with public sector transfers alone. Despite European leaders’ best efforts to obfuscate and obscure transfers, creditor-state publics know they will be saddled with the lion’s share of these losses. They demand that private sector lenders bear at least a portion of the costs. Yet, there is no way to force a private bondholder to accept anything less than payment in full and on-time without that act constituting a default, thereby triggering the legal controversies and dangerous precedents that the Eurocrats are struggling to avoid. [...]

  18. [...] link: Private participation – [...]

  19. Jennifer Taub writes:

    Hi,

    Like you, I think this is a terrible decision. However, I’ve noticed that many (including news sources) miss an important point. The advisory firm, Janus Capital Management and Janus Capital Group were held accountable to the fund shareholders. What the recent SCT decision is about is not the fund shareholders, but, instead the shareholders of Janus Capital Group who attempted to bring a class action.

    I wrote an 8 part series on this on the Race to the Bottom blog. It begins here: http://www.theracetothebottom.org/securities-issues/will-bad-funds-make-good-law-janus-v-first-derivative-trader.html

    And a short piece after the SCT opinion: http://www.theracetothebottom.org/home/facing-the-unintended-consequences-of-janus-v-first-derivati.html