Roubini on Eurozone sovereign debt restructuring mechanisms

First, consider that any holder of CDS protection would not be a creditor of a distressed sovereign unless he/she has an actual long position in the underlying bonds; holders of CDS protection don‘t vote in a debt restructuring process (i.e., an exchange offer) if their CDS protection is naked without any underlying actual exposure to the bond........

Since most likely an exchange offer under threat of default is considered—as it is by rating agencies that considered them as coercive thus triggering a selective default rating–as a credit event that triggers the CDS an holder of CDS protection would be paid regardless of whether he/she has underlying exposure to the bonds and regardless of whether he/she tries to sabotage the debt restructuring. In effect, the holder of CDS protection has no incentive to sabotage a restructuring because such a restructuring is by itself a credit event that triggers the CDS regardless of whether the restructuring is successful or not.........

In summary, a European SDRM is not necessary to achieve an orderly restructuring of public debts of eurozone members. Such restructuring can be achieved in an orderly manner any time via the traditional tool of exchange offers that have been successfully been used for emerging market sovereigns in distress. Thus, the current debate on a European SDRM is a total red herring: The reason why the EU has so far decided to provide financing to member states in distress is not the lack of a legal mechanism for an orderly restructuring; rather, it reflects concern about systemic contagion. But an orderly restructuring via exchange offers can significantly reduce such a risk while providing significant debt servicing relief to sovereign that are financially distressed via an orderly—if coercive—debt restructuring.

The current tragedy is that the European debate on a crisis resolution mechanism or SDRM has had perverse effects: .... the talk about a European SDRM has been the trigger of the recent blow-out of Irish spreads and created greater turmoil than order. Additionally, the confusing and contradictory remarks of EU officials and national leaders on when the restructuring mechanism will take effect and to which debts it will apply (new or old ones) has created greater uncertainty among investors. The reality is that, regardless of what the EU says or doesn‘t say, the probability of a coercive restructuring of the Greek or Irish debt is totally independent of whether a European SDRM will be created in 2013 or later and whether its terms would apply to new or old debt. The EU has zero effective power in deciding—via a new legal mechanism—whether Greece or any other EZ sovereign will restructure its debt and when.

Indeed, if Greece does not regain market access it will be forced to restructure its debts when the IMF/EU bailout program expires even if, as possible, the IMF or the EU were to decide to maintain its exposure to Greece upon expiration of that official support. In effect, if Greece doesn‘t regain its market access, its need to finance its new yearly deficits and to rollover private claims coming to maturity will force a debt restructuring. To prevent this, IMF/EU would have to not only extend their existing program but, on top of that, significantly increase its lending/financial commitments beyond the current €110 billion lending envelope since Greece will have large financing needs beyond 2012 given its ongoing fiscal deficit and need to rollover private claims coming to maturity.

This is why the recent statement by some European finance ministers asserting that the proposed debt restructuring mechanism will apply only to debts issued only after 2013—a statement which backpedaled away from previous pronouncements in order to calm spooked bond markets—is totally meaningless.....Moreover, the recent statement of a sub-set of EU finance ministers that haircuts will be imposed on new debts issued after 2013 not the old one is actually counter-productive and ensures that PIIGS in distress will lose market access rather than regain it over time: Why would any private creditor of a PIIGS want to purchase the newly issued debt of such a sovereign when such debt—rather than the old one—would be restructured? The whole logic of DIP financing is that new debts get seniority relative to old debts—that are already locked in—to ensure that new financing arrives to a sovereign under distress. The weird EU view that new debts—rather than old ones—would be subject to debt restructuring turns the basic principle of DIP financing on its head and ensures that market access will be lost even to distressed sovereigns that still have such access.

The constraints for an orderly debt restructurings are not legal–the lack of a formal crisis resolution mechanism; they are rather political: i.e., when will the EU agree that some of its member states are not just illiquid but near insolvent and thus in need of an orderly market based restructuring of their public debts that would provide debt relief while limiting the risk of a systemic contagion to the rest of the eurozone.