In the slipstream of the Greek debt exchange

Jeromin Zettelmeyer, Mitu Gulati, 5 March 2012



One of the most interesting questions arising from the ongoing Greek debt restructuring is what it implies about the feasibility – or lack of feasibility – of ‘voluntary’ debt restructurings. This issue is of first-order importance because it has implications for how other countries in the Eurozone (and indeed outside) may want to conduct such restructurings, if it comes to that point.

For many months now, the aim of Eurozone politicians has been to undertake any debt exchange in Europe on a strictly voluntary basis – even the Greek case, which by general consensus (including, since 26 October 2011, Eurozone leaders) required a large ‘haircut’. On the face of it, this makes little sense. To be sure, any creditor not protected by credit default swaps would prefer an orderly haircut to a chaotic default. But most creditors are small enough to free ride on a restructuring agreement supported by the majority. Why would they – and by extension, almost anyone – voluntarily take a debt-exchange offer that promises a large reduction in repayments?

In a recent paper (Gulati and Zettelmeyer 2012), we suggested this is because they might feel safer with the new debt instruments than with the old ones. In an ordinary debt exchange, this consideration is generally irrelevant. But the Greek case is anything but ordinary. First, the existing debt instruments were mostly issued under local law and devoid of niceties such as pari passu or negative pledge clauses. Second, there is the prospect of high continuing sovereign risk after the exchange. To be sure, a successful exchange with a deep haircut would make an involuntary restructuring within a year or two very unlikely – but perhaps not beyond this period, given a high remaining debt burden and large official payments coming due. Hence, we argued that one might plausibly hope to  ‘bribe’ creditors – except for short-term bondholders, holders of credit default swap protection, and foreign-law bondholders – to voluntarily accept a haircut by offering them English-law bonds with full creditor rights.

Now fast forward to last week’s exchange offer. On the surface, this seems to deflate both hopes that the exchange could be conducted voluntarily, and the seniority-based logic underlying it. The main vehicle to engineer high participation in the exchange is a collective-action clause, imposed by parliamentary fiat on existing bond contracts on 23 February, which allow Greece to change the terms of its local-law bonds if two thirds of a quorum of at least 50% of all Greek-law bondholders agree. From the perspective of an individual bondholder resisting such a change, this is the opposite of voluntary. Furthermore, all bondholders, regardless of governing law, have received the same exchange offer. Hence, as far as the terms of the offer are concerned, English-law bondholders do not seem “de facto senior” in any meaningful sense.

Below the surface, however, there is more than meets the eye. We suspect that the enduring lesson of this debt exchange could in fact be the opposite, namely to confirm that differences in governing law can result in a de facto seniority ranking across bonds. And this fact, in turn, could make it easier for other Eurozone countries – if they so chose or were forced to – to undertake genuinely voluntary debt exchanges.

First, consider the lack of voluntariness in the present Greek offer. Upon closer inspection this appears tailored to deal with exactly the loophole left by the purely voluntary approach with respect to the short-term bondholders. As we argued in our paper, there is no way that these bondholders would have come into a purely voluntary exchange, because the option of receiving full repayment in the short term dominates all else. But in the case of Greece, there are so many of these bondholders – holding a total of €34 billion coming due this year, and almost €30 billion next year – that Greece and its official creditors could not afford to repay them in full. Hence the resort to collective-action clauses. Beyond the possible use of such clauses, however, this exchange remains as voluntary as it gets. In particular the exchange offer sends the message, subliminally but clearly, that any holdouts not bound by the invocation of a collective-action clause will in fact be repaid in full.

Second, consider the supposedly equal treatment of Greek and foreign-law bonds. This applies only to the payment terms under the exchange offer. In contrast, the ‘retrofitting’ of collective-action clauses via legislative action only applies to Greece’s Greek-law bonds. And the nature of these clauses makes the Greek-law bonds much easier to restructure. As a consequence, creditors holding the English-law bonds have the ability to demand a better deal than the one that the local-law bonds got. De facto seniority re-emerges through this mechanism.

To see this, it helps to focus on two key differences between the Retrofit collective-action clauses in the Greek local-law bonds and the ordinary clauses in Greek English-law bonds.

First, the vote required to alter the payment obligations under the Retrofit clauses for local-law bonds is 66.67% for all the bonds aggregated. Under Greece’s English-law bonds the vote requirement ranges between 66.67% and 75% for an individual bond. The relevance of the foregoing is that, for the local-law bonds, even if Greece does not receive 66.67% of the votes in any given bond issue, the haircut still applies if 66.67% of the holders, overall, agree to the proposed haircuts. Greece’s English-law bonds, however, have no aggregation provisions (almost no sovereign bonds have them). They have to be restructured bond by bond. In other words, it is a lot easier to buy a blocking position in an individual English-law bond than in the Greek local-law bonds as a whole. Oversimplifying, the cost of purchasing a blocking position in one of the outstanding English-law bond issuances, at today’s prices, would probably be a couple of hundred million euros, at most. By contrast, the cost of buying a blocking position in the mega exchange of the retrofitted local-law bonds would be in the tens of billions of euros. Implication: It is easier to impose a haircut on the local-law bonds.

Second, if the local-law bond exchange fails, the Greek government could pull the plug on the deal and have the legislature retrofit a new collective-action clause that would be even easier to implement. Implication: It is easier to impose a haircut on the local-law bonds.

The conclusion is that holders of English-law bonds face a much better chance to hold out for a better deal. A sufficiently large creditor, or a coalition of creditors, will find it much easier to block the use of a collective-action clause of an English-law bond than a holder or coalition of holders of a Greek-law bond. And even where the bondholders are dispersed and there is no obvious blocking minority, it is much less likely that the ‘exit consent’ mechanism, through which Greece is collecting votes of tendering bondholders to build a supermajority in favour of changing the terms of the bond, will actually work, simply because it is harder to get to that supermajority in the English-law bonds than in the case of the Greek-law bonds. This prospect – and the expectation that unless collective-action clauses are invoked, holdouts will be repaid on schedule – is likely to encourage holdouts. Again, this makes it more likely that English-law bonds will be repaid in full.

There is of course a simple test for the prediction that English-law bondholders are likely to fare better than Greek-law bondholders. It should be reflected in market prices. Controlling for other features, such as remaining maturity, prices of English-law bonds should be significantly higher than those of Greek-law bonds. Figure 1 shows that this is indeed the case. The figure shows all bond prices of Greek government bonds, both foreign-law and domestic-law that were available on Bloomberg on Monday, 27 February 2012. This was the first trading after the terms of the exchange offer, including the way in which collection action clauses would be applied, had been publicly announced.1

Figure 1. 

Source: Bloomberg

In the chart, prices are plotted against ‘remaining duration’, which is a measure of average time to repayment that takes into account not only final maturity but all intervening promised payments, and weights by the size of these payments. Blue points denote prices of Greek-law bonds and red points prices of foreign-law bonds. Logarithmic trend lines are fitted to each of these sets to enhance the visual comparison. It is clear that the prices of foreign-law bonds are both much more dispersed and higher, on average, than the prices of Greek-law bonds, almost all of which traded between 17–25 cents on the euro (there are a few outliers on the upside, perhaps reflecting illiquid issues). This is to be expected. By 27 February it was very likely that all Greek-law bonds would be restructured, while in the case of the foreign-law bonds, the uncertainty in this respect is much higher. Some simple regressions show that the average price difference between the Greek- and foreign-law bond is 15–20 percentage points, depending on how the non-linearity in the duration-dependence of prices is modelled. Hence, on average, foreign-law bonds were trading at almost twice the price of Greek-law bonds.

The de facto seniority enjoyed, in expectation, by Greece’s foreign-law bondholders makes sense for Greece. After the current retrofitting exercise, we suspect that it will be a long time before any foreign investor buys Greek local-law bonds. If Greece wants to issue bonds to foreign investors, it is going to have to do it the old fashioned way, under foreign law, with a full set of creditor protections and rather restrictive collective-action clauses. Given that Greece wants to return to the bond market as soon as possible, it is in its interests to treat the holders of foreign-law bonds with care. This is exactly what it is doing. In effect, it is telling the market that unless it can restructure its foreign-law bonds in line with the original contractual provisions on these bonds – over which it has no control ex post, since they were agreed in a foreign jurisdiction – it will repay these bonds in full.2

So much for Greece. The real lesson here might be for the other Eurozone countries with high debt burdens. According to a 2012 report from Moody’s, roughly between 90% and 100% of the outstanding sovereign debt of these Eurozone countries such as Portugal, Italy, Belgium, Spain and Ireland is governed by local law. Watching the passage of Retrofit collective action–clause legislation in Greece and the level of haircuts being demanded from private creditors may send the message to the holders of local-law bonds of at least the weaker Eurozone nations that they should perhaps exit these instruments. Consistent with that, the Wall Street Journal recently reported that JP Morgan was recommending that its investors replace their Portuguese local-law bonds with Portuguese English-law bonds (Stevis 2012).

In other words, holders of local-law governed bonds in other Eurozone countries that are perceived to be at risk might want to make a trade for English-law governed bonds. Depending on how much these bondholders would be willing to pay to make this trade, it could serve the interest of the country as well to make it. The sovereign in question would reduce its debt load and the likelihood of a future default. The bondholders who accepted the exchange would receive greater contractual protection in the event of a future debt restructuring. In particular, they will get the comfort that if, in the future, the sovereign debtor is tempted to use its own retrofit collective action–clause strategy, they will be immune.

In this way, other high-debt Eurozone countries may be able to capture benefits from the fact that Greece had to do an involuntary debt restructuring where its legislature retroactively modified that contract terms of its local-law bonds. The Greek deal will have increased the attractiveness of holding a foreign-law bond as compared to holding a local-law bond. Effectively, this is a large gift from the Greeks to the parts of the Eurozone that face debt crises. By conducting its debt exchange in the way it did, Greece has in effect resurrected the plausibility of purely voluntary debt-reduction operations in Europe.

There are complications, of course. The foregoing only works if creditors are genuinely fearful that these other countries might need to do an involuntary restructuring in the near future (that is, prior to their bonds maturing). And the same sets of bonds that we mentioned above (bonds held by credit default swap holders, bonds of short maturities and bonds already governed by foreign law) would generally not find such an exchange offer attractive.3 As a result, the reduction in the debt burden that other Eurozone countries might hope to obtain using the voluntary approach would likely be smaller than that which is being sought by Greece. It would constitute a more modest and – from the perspective of creditors –kinder and gentler debt restructuring. But it may still provide critical relief to a country that is struggling with a large – and in the eyes of many creditors, perhaps implausibly large – adjustment burden. It would not be a default, it would reduce its debt load significantly, and it might well allow the country to tap the international debt markets again in the near future.

Followers of the sovereign debt market will remember the back-to-back defaults and restructurings of Argentina and Uruguay roughly a decade ago. Argentina had a disorderly default and has as yet been unable to return to international debt markets. The relief it demanded from its creditors was not far from the one that Greece is demanding, with new bonds offering about 30 cents on the dollar on average. Uruguay did a kinder and gentler orderly exchange, asked for comparatively little relief, and was able to return to the markets within a matter of months. If one is riding in the slipstream of Greece, which outcome would one rather take, that of Argentina or Uruguay?

Authors’ note: The views expressed here are those of the authors and are not necessarily shared by the organisations which they are affiliated with. The authors are grateful to Anna Gelpern, Charles Blitzer, Christian Kopf, Steve Rattner, and Shahin Vallee for conversations about the topic and to Marina Kaloumenou for excellent research assistance.


Gulati, Mitu, and Jeromin Zettelmeyer (2012), “Making a Voluntary Greek Debt Exchange Work”, CEPR Discussion Paper 8754, January (forthcoming in Capital Markets Law Journal).

Stevis, Matina (2012), “Greek Legal Maneuvers Raise Fear of Eurozone Debt Fallout”, Wall Street Journal, 23 February.

Sturzenegger, Federico, and Jeromin Zettelmeyer (2007), Debt Defaults and Lessons from a Decade of Crises. Cambridge, MA: MIT Press.

1 The approximate terms of the offer were published by Greece and the Institute of International Finance on 21 February 2012. A law ‘retrofitting’ collective action clauses on Greek law bonds was passed on 23 February 2012, and the offer was formally announced in the late afternoon of Friday, the of 24 February 2012.

2 This is reminiscent of the Russian defaults and debt exchanges between 1998 and 2000, in which Russia defaulted only of its domestic-law debt, while continuing to service its euro bonds. This allowed it to return to euro bond markets soon thereafter (see Sturzenegger and Zettelmeyer 2007).

3 Some short-term bondholders (except at the very short end) could be persuaded to participate by offering them better exchange terms.

Topics: Europe's nations and regions, International finance
Tags: bonds, EZ crisis, Greece, sovereign debt

Mitu Gulati

Professor, Duke Law School, Duke University

Jeromin Zettelmeyer

Deputy Chief Economist and Director of Research, EBRD