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Tuesday, July 10, 2012

Why not Evergreen Bonds?

In most of the financial restructurings which I have been involved in, instruments like Evergreen Bonds, interest capitalization, etc. have played meaningful roles. I have written about this before. I am surprised that such instruments, quite common also with sovereign debt restructurings, have not been discussed yet.

Let's assume that everybody would agree that if Greece's sovereign debt were reduced to 60% of GDP (let's say to 120 BEUR), Greece could service that debt (including interest payments) without problems. Put differently, experts would refer to it as being "sustainable".

Following this logic, the remaining debt (I have lost track where that would stand now but let's assume we are talking about another 150 BEUR) would be considered as "unsustainable". Some might immediately suggest that these 150 BEUR should be forgiven.

The better idea would be to issue Evergreen Bonds for 150 BEUR. They could have a tenor of, say, 99 years but they could also have no maturity at all. What is important is that they have regular interest payment dates; ideally every 6 months.

The interest rate would be fixed at a margin over Interbank to be reset every 6 months. For, say, the first 10 years, interest would be capitalized to give Greece a chance to catch breath.

So here you have, at least for the next 10 years, a solution which is economically equivalent to a 150 BEUR haircut (no principal must be paid and no interest expense flows through the budget). However, it is not a haircut because the creditors maintain 100% legal claim. To give that to creditors wouldn't cost Greece anything but it would be of significant value to creditors.

Why would creditors agree to such a scheme? For a very simple reason, namely, because their alternative might be worse; they might have to - again - forgive that amount of debt. If you don't believe me, then ask those creditors who lost money with the recent PSI if they hadn't preferred to receive Evergreen Bonds instead. Even though those bonds wouldn't have had any value for the next 10 years, they would have represented a legal claim.

Now, here is the wonderful thing about Evergreen Bonds. Their value is not driven by the likelihood that they will ever be paid (no one alive will live long enough to see the 99-year maturity...). Their value is driven by the assessment of whether or not the next interest payments can/will be made.

Evergreen Bonds might trade close to zero during the first 10 years of interest capitalization. They might stay close to zero if Greece did not succeed in turning its economy around. BUT: should Greece succeed in turning its economy around, Evergreen Bonds could become a very attractive investment instrument: if they increased in value to, say, only 20% of nominal (from near zero), their holders would still make a killing.

In a way, Evergreen Bonds would be a kind of rating agency where the rating is done by the markets. If Greece is perceived to do well, their prices will rise. If not, they will decline. And this would go on for at least 99 years...


  1. " I am surprised that such instruments, quite common also with sovereign debt restructurings, have not been discussed yet."

    Well, this is something you could ask the german goverment about. I imagine, the reason is the same for which Ireland had to take the burden of the bank recap to its debt, while Spain hadn't (which will now apply to Ireland too and will get her out of the woods).

    Isn't it better to have Greece follow Mr. Schauble's current program, where Greece returns to huge growth rates and primary budget surplus, which all of it goes to servicing the debt ad infinitum? And also those who partecipated in the PSI will get higher interests once greek growth exceeds 3 or 4% (i don't remember the clause)?

    Alas, as in the case of Ireland, the plan may fail at some point, wouldn't it? Yes, i imagine this could be the case. But the proceeding of this crisis has shown, that only then, will the german goverment examine that maybe had maximalistic expectations.

    Mr. Kastner, in a way or ther the other, the german plan on the greek debt will collapse. How badly i don't know, but it will.

    Will it be with Greece collapsing politically and returning to the drachma doing a good old fashioned default?

    Will it be that Germany will change its mind and accept evergreen bonds?

    Will it be that Germany will change its mind and do a new haircut + reschedule the rest of the debt sending it 20-25 years later on?

    I don't know. The fact is, that the way the debt is scheduled now, is unsustainable and politically impossible to follow. If you think that until 2020, Greece will have 5% surplus, but each time something in the budget goes wrong, the goverment will be telling the people "sorry, we have to cut your pensions again, because creditors come first as per Mrs. Merkel's plan", you won't only see Mr. Tsipras as PM, but also Mrs Papariga of the KKE.

    The sooner the debt's figures become realistic, the more the chances that the population will show more tolerance and investors come to Greece and as such, Greece remains in the euro.

    It will happen one way or the other, Mr. Schauble may as well make peace with it in his mind and be for once realistic, before he too, suffers more damage. Making "wonderful" PSIs, that solve nothing, only make the anti-memorandum population stronger when they say that Greece is like a cat trying to catch its tail.

    Greece won't return to growth easily without foreign investors. Foreign investors exist (even Greek expats, who live in Europe or USA), but before they put their money they need to know: "Am i investing in a EZ country or in a non EZ country?".


  2. I took the liberty of adjusting the classic greek text to the modern situation (maybe it would help Mr. Schauble have a more clear vision):

    Schauble: Abominable fellow, pay up the debt.
    Greece: Go ahead and shout, Schauble, if this gives you some pleasure.
    Schauble: Pay up, I say, for having you given so much money.
    Greece: You can't get it from one who doesn't have it.
    Schauble: Is there anyone who doesn't have a primary debt surprus to pay his debts?!
    Greece: I don't know whether anyone else has or not, but I don't.
    Schauble: By the Nibelungen, you rogue, I'll oust you out of my euro if you don't pay.
    Greece: And I'll bust your banks with my debt.
    Schauble: Then you will have made this crossing to Brussels to no avail.
    Greece: Let Schroeder pay you for me, since he handed me over to you.
    Schroeder: By Odin, I'll be damned if I am going to pay for the cheaters, too.
    Schauble: I won't give in to you.
    Greece: Then let me default and get over with it; how can you take what I don't have?
    Schauble: Didn't you know that you had to pay for it?
    Greece: I knew but I spent it all. What was I to do? Should I have not enjoyed life because of it?
    Schauble: So you will be the only one to boast that you were lent money for free?
    Greece: Not free, my fine fellow. I consumed your products and helped grow your firms and I was the only one to buy so many useless weapons of your industry.
    Schauble: These things have nothing to do with it. You must pay the debt; no exceptions allowed.
    Greece: Then take me back to conditions that i am able to pay.
    Schauble: A fine remark, so that I may get a beating from Merkel if I do.
    Greece: Then don't be so upset.
    Schauble: Show me what you have in your coffers.
    Greece: A eurocent, if you want, and one batch of our old drachmas. I can make new ones too if you like.
    Schauble: From where did you bring this dog to us? He kept babbling like this during the Eurogroup, laughing and jeering at the other debtors; she alone was singing while the Irish and Portuguese were moaning.
    Obama: Schauble, don't you know what country you have taken in the euro? Corrupt and overspending, she doesn't care about anyone or anything. This is Greece.
    Schauble: Indeed if I ever get hold of you i will make you sign a new memorandum which you will be repaying till your great grandchildren!
    Greece: If you do, my fine fellow. You won't get another chance.

    Curious, there was no "god of economy" in ancient Greece...

    Without a change in political situation, 2 are the likeliest scenarios: a) a sudden default even caused by accident, b) referendum, in order to make transition with more social cohesion.


  3. In February the German Council of Economic Advisors published the following ==>> The European Redemption Pact

    To me it sounds similar to Evergreen Bonds. But perhaps it is something totally and entirely different cloaked in similar language.

    According to AEP in the Telegraph Chancellor Merkel is not entirely opposed to the idea.

    I have a dim recollection that back in February Schauble was reported as something like - "Redemption Bonds would be more acceptable than Eurobonds".

    I leave it to Klaus to be the judge of whether a Redemption Fund and Evergreen Bonds have anything in common.


    1. 1 of 2
      There is one HUGE difference between the European Redemption Fund (ERF) and my proposal of Evergreen Bonds (EB): the ERF transfers all sovereign risks (above the 60%) into the pockets of European tax payers (at least tax payers of those countries which guarantee it) whereas EB would leave the risk with the original risk takers.

      European tax payers stand behind Troika-financing and ECB-financing. Thus, European tax payers have so far bailed-out financial institutions and their shareholders in Europe and even world-wide. That, to me, is a totally unacceptable premise!

      Take the following example: my understanding is that the principal owners of the Greek Eurobank are a Greek oligarch family. Without the support of European tax payers, Eurobank would have ceased to exist a long time ago and its owners would have lost their entire investment. Now it will be re-capitalized with monies of European tax payers. If all goes well, the bank’s owners would make a killing (something worthless would become valuable again, perhaps even very valuable). I agree that the tax payers would get interest on their monies but, please, an interest rate is absolutely no adequate return for the risk taken. For sure, they should get at least 90% ownership of the bank. In the capitalist system, it is the equity investors who carry the greatest risk and not the tax payers!

      I also question the premise which is behind the ERF. It starts from the premise that all sovereign debt will eventually be repaid 100%; if not by the borrowers themselves, then by the guarantors (tax payers).

      I think this is the wrong premise! Hardly any sovereign debt has ever been 100% repaid. Instead, it gets refinanced. The more the ability to refinance is called into question, the lower the debt will trade. At some point, it will trade low enough so that investors are prepared to buy it again.

      I do not rule out that the entire sovereign debt of some countries may indeed at some point in the very distant future become 100% manageable again. For Greece, that can be ruled out because 100 BEUR of their sovereign debt has already been forgiven.

      If behind the ERF you would put the holders of the debt which is supposed to be transferred into it (instead of the countries), then you would have something conceptually similar to what I mean by EB. Except, that debt would then be in the fund and sit there. An EB can be traded and that, at least to me, is a very key feature. I remember how 20-30 years ago, some Latin American debt was classified as “distressed assets” (but it was not forgiven). At first, no one thought that there would ever be any interest on anybody’s part to buy distressed assets. Wrong! A huge market developed and some players made enormous profits. Where did those profits come from? Very simple: some investors did not believe in the long-term future of country X while others did. The profits came from those who didn’t. Some countries turned around completely and bonds would return to 100% (i. e. Argentina, until it collapsed again in 2000/01).

      Mexico, not too long ago, emitted 99-year bonds. No one who invested in those bonds will be alive when those bonds mature. They don’t invest in repayment. Instead, they invest in secondary market values relative to the interest rate.

    2. 2 of 2
      Another wrong premise, in my mind, is the insistence that more or less market interest rates have to be paid. Since interest paid goes through the budget, it eats up any primary surplus which there may be (more often it increases the primary deficit!). And since market rates would be far too high today, they are searching for all sorts of vehicles how those market rates could become lower by adding guarantors to the risk.

      One cannot draw water from a dried-out well! One first has to repair the well and hope that there will be enough water afterwards to not only cover ongoing demand but to also return water to those who have lent it in the meantime.

      In the case of Greece, one has agreed to a haircut in order to achieve a lowering of the cash interest burden on the budget. All I can say to that is --- STUPID! The same effect would have been achieved if one had capitalized interest on that debt for 10-20 years (and converted the capital into EB). Some would say “that’s the same difference”. Well, it is not. In this scenario, creditors would have held on to their legal claim. Is that worth anything? Probably not now, but who knows in 20 or 30 years’ time? (see Latin America above).

      On a bank’s balance sheet, the equity is normally shown at the bottom of the liability side. Just turn the liability side around and then go from top down. Then you have the list of those who ought to contribute to the problem solving by taking losses. At the top would be equity holders. Then would come secured creditors. Then would come normal capital markets creditors (mind you, so far I am talking about those who can be considered as “professional market participants” who understand what risk is). Those who are not “professional market participants” (like savers) are way down the line and they should not be forced to take losses.

      My first career was with the then Continental Bank of Chicago, the 6th largest US bank at the time. Within 3 months of 1982, that bank went from triple-A to near-insolvent. The bank was later split into a good and bad bank. Existing shareholders remained owners of the bad bank (and a few points of the good bank as an incentive to go along). The good bank was recapitalized by the government. Obviously, the good bank was very profitable instantly. Now, the government could have said to the good bank “we will hold on to you for decades until you have made enough money to pay off all losses in the bad bank”. Wisely, they decided that it would not be good to have a bank nationalized for that long. So after a few years they made a trade-off: the accumulated profits of the good bank and its sales price to Bank of America were good enough to recoup its capital investment and bring down the losses on the bad bank to a level which could be justified to tax payers. Obviously, the old shareholders (of which I was one) walked away free and clear of the money invested…).

      There is a difference between doing a bail-out via funding or via new preferred equity!!! If it works, the funders get an interest rate and the preferred equity investors (tax payers) get the equity return. When the US government bailed-out AIG (via preferred stock), it looked like that money would be gone forever. Today, I understand, the US government will make a profit on all the monies which they invested into AIG, Citigroup, etc. at the time. In the case of AIG, I believe old shareholders lost pretty much everything. In the case of the others (like Citigroup), shareholders had their stake diluted.

      That is what I call a successful bail-out. There are situations, even in a market-based economy, where tax payers have to jump in for the common good. But they should never jump in as creditors but, instead, as equity holders. That is in and by itself no guarantee that they will get their money back (AIG could have failed, after all) but they at least get some value and future potential in return for the risk they are assuming.

    3. Addendum to the above

      First, in the top-down list on the liability side, unsecured capital markets creditors come, of course, before secured ones (if there are any to begin with).

      I thought I should emphasize that we are talking about "European tax payers" (and not only German ones). Everyone seems to be zeroing in on Germany and the German tax payers whereas, in actual fact, the Greek tax payers are similarly on the hook. I can't say offhand whether a recipient country like Greece is also on the giving side of Troika-loans. Probably not. But it is certain that Greece stands behind the ECB with its percentage just like every other country. Should the Eurozone go to pieces and the ECB ends up with a huge bag of losses, these losses would be distributed to the countries standing behind the ECB in their respective percentage. In the final analysis that's the tax payers, again.

      Another comment about the ESM. Here it is different, if I recall correctly. A country is either on the giving side or on the taking side, but not on both. For example, Italy is presently on the giving side of the ESM. Should Italy apply for access to ESM funds, it would leave the giving side and become a taker. What's the relevance of this?

      Well, the Eurozone has 17 countries. At the latest when 16 of them are on the taking side, Germany will ALONE be liable for ALL THE OTHERS (and for itself, too...).