Whose hair gets cut in a sovereign default?
On 4 June 2019, almost unnoticed by the wider investment audience, Venezuela defaulted on a $750m gold swap with Deutsche Bank. After missed interest payments, Deutsche Bank accelerated the swap, which was supposed to run until 2021 and, after Venezuela did not pay its dues to close the swap, took possession of 20 tons of gold that the country had posted as collateral.
Then, last week, Argentina announced it would postpone the repayment of $7bn in short-term debt by six months and try to convince investors in $50bn of long-term debt to agree to a “voluntary reprofiling”. Furthermore, the $44bn loan from the IMF the country got earlier this year will likely not be repaid in time. Putting aside the creative new term “voluntary reprofiling” of debt, this is the ninth time since its independence in 1810 that Argentina will default on its debt. It was not so long ago that investors were rushing to buy bonds from Argentina with a maturity of 100 years. I wonder how these investors feel today?
Now, the question in the case of Argentina is not if lenders will lose money, but who will lose how much? To answer this question, it is worthwhile to read a recent paper by Matthias Schlegl and his colleagues. In this paper, the researchers analysed data on external debt (i.e. debt denominated in hard currencies like the US Dollar) from 127 countries. They distinguished between six different creditors:
Bilateral creditors. These are international institutions that make loans on behalf of one government to another.
Multilateral creditors. These are loans made by international institutions on behalf of a group of governments. This group includes international developments banks and the World Bank but not the IMF.
Bonds. These are the sovereign bonds issued by the government to private and public investors.
Bank loans. These are loans made by international banks to a government like the Deutsche Bank loan mentioned above.
Trade loans. These are loans to facilitate international trade and are typically made by manufactures and exporters in the private sector.
The IMF.
While the contractual agreements for each loan typically stipulate a certain level of seniority, a sovereign default often leads to a protracted negotiation process during which the different creditors will have to negotiate with each other and the country in default about who gets paid what and when. This allows to measure the size of the loss on existing debt suffered by each of the six creditors listed above. In short, one can measure who gets a haircut and how short the hair will be after everything is said and done. As Matthias Schlegl and his colleagues show in their paper, the IMF and multilateral creditors are most senior in this process and typically suffer the smallest haircuts, while bank loans and trade loans are junior and suffer higher losses. This is not too surprising since the IMF and the World Bank typically lead the negotiations with defaulted sovereigns and thus have plenty of opportunity to look after their own interests.
But there is good news for bond investors. It turns out that bonds have higher seniority than bank loans and trade loans. In fact, the losses incurred of bond holders are typically junior only to the IMF and the multilateral creditors like the World Bank.
But the chart below, taken from their paper also shows some bad news for investors. It shows the calculated haircuts suffered by private creditors (i.e. bondholders and bank loans) after a debt restructuring. One has to take these haircuts with a grain of salt, because they had to be estimated based on Paris Club data that is not always transparent and available – especially in the 1980s and before.
But no matter these constraints, there is a clear trend towards higher haircuts in debt restructuring since the 1990s. In other words, defaults have become rarer over the last two decades but when they occur, investors suffer more and face losses in excess of 50% of their invested capital. During the Latin American defaults in the early 1990s after the Tequila Crisis, the haircut suffered by private investors on Mexican, Argentinian and Brazilian bonds and loans was in the range of 40% to 45% of debt value. After Russia defaulted in 1998, the haircut rose to an estimated 62% and with the Argentinian default in 2001 the haircut for private investors surpassed 75%. The largest private default in the history – Greece’s default in 2013 also led to haircuts in excess of 75% of the existing debt.
During the Eurozone debt crisis, many market pundits argued that one should let Italy and other southern European countries default in order not to create a moral hazard where bond investors always expect to be bailed out by the IMF and other international agencies. As the example of Greece shows, the losses occurred by private investors in Greek debt were so big that there is no risk of moral hazard there. And the case of Greece should be a lesson for bond vigilantes who argue in favour of an orderly default of sovereign debt instead of a coordinated bailout: given the enormous leverage of sovereign borrowers these days (think Italy or Japan), a default would likely lead to haircuts that are much larger than historic averages. In such an environment, it would not surprise me if bond markets underestimate the potential losses of a default until it is too late – at which point the remaining creditors will likely be stuck with largely worthless paper. In other words, the haircut private investors may get in the future, may accidentally cut off their ears.
Haircuts for private investors of historical defaults
Source: Schlegl et al. (2019). Size of circle indicates amount of debt in default (in 2015 US Dollars).