Felix Salmon

GM debt has been through a lot of late. In May 2009, car czar Steve Rattner made a bold and unexpected decision to nationalize the company rather than leave it with debt outstanding. That decision was followed by a CDS auction which valued GM’s defaulted debt at just 12.5 cents on the dollar — a valuation unthinkably low just a couple of years earlier. Clearly, when it comes to automaker debt, there’s a lot of uncertainty and volatility — and where there’s debt with uncertainty and volatility, there’s sure to be CDS trading.

The WSJ, however, has decided to take a golly-gee approach to the whole thing, larded with a good sprinkling of demonization. I’m surprised to see veteran bond-market reporter Matt Wirz — a genuine expert when it comes to such things — with a byline on this:

Fresh from Wall Street’s alchemy labs: Credit derivatives tied to General Motors Co. debt. The rub is, no such debt exists…

Investors who bought “naked CDS” to bet on the likelihood of default, rather than to hedge risk from other investments, are credited with worsening the liquidity crisis that gripped financial powerhouses, prompting calls for tighter regulation of the industry.

First of all, there’s no alchemy here. You might not like credit default swaps in general, but they’ve been around a long time, and there’s nothing new or innovative about CDS on GM. Sure, the amount of GM debt outstanding is low, but it’s a bit weird to say that “no such debt exists,” given that there’s still $4.6 billion in bank debt outstanding.

The assertion about the nonexistence of GM debt is backed up with a single extremely vague sentence:

Banks, some of which have made loans to the car maker, have been buying the CDS even though it is unclear whether the contracts would cover their debts, according to people familiar with the matter.

Nowhere is it explained what this is supposed to mean; I’m guessing that there’s a question as to whether a default on GM’s bank loans would trigger the CDS. And then there’s also the question of what would be auctioned and delivered in any CDS auction:

When a company files for bankruptcy or fails to meet its interest payments, the market stages an auction to determine the value of the defaulted debt, and how to compensate the CDS holders.

The value assigned to the CDS relies on investors being able to buy and sell bonds in the open market, so it is problematic for the newly revived GM not to have any bonds outstanding.

This isn’t really true. CDS auction prices are emphatically not a function of the open-market secondary-market price for individual bonds: that’s why there’s an auction in the first place. Would bank loans not be eligible to be tendered as cheapest-to-deliver debt securities? The article doesn’t say. But whenever any company has $4.6 billion in bank loans outstanding, there’s a secondary-market price for those loans, so in principle it should be possible to find them and deliver them. If the number of loans outstanding is small, then that just creates a familiar problem in the CDS market, when the amount of CDS written is larger than the amount of debt outstanding. The CDS market has dealt with that problem many times, and it’s not really an issue any more.

In any event, it has long been common practice for banks to hedge their loan exposure in the CDS market — that’s one of the generally-accepted “legitimate”, or non-naked, forms of CDS trading. There’s a reason why they’re called credit default swaps rather than bond default swaps.

But more to the point, the WSJ seems to be willfully naive about what’s going on here. Why would you sell credit protection on GM debt? Because it currently has very little debt outstanding, because you don’t think it’s going to reach a remotely dangerous level of debt in the next five years, and because you get to cash a steady flow of CDS premiums in the interim. Essentially, exactly the same reasons that you would buy GM bonds, if any existed — only selling protection is much cheaper, so you get a higher internal rate of return.

And why would you buy credit protection on GM debt, if there’s no such debt outstanding? Maybe you intend to buy bonds when GM issues them, and you want to lock in protection now, while it’s cheap. Maybe you are a GM supplier, or you have exposure to one, or in some other way you have GM counterparty risk which is easy and cheap to hedge at the moment. Maybe you’re just taking the opposite side of the GM-Ford relative-value trade featured in the WSJ, betting that over the long term GM is going to continue to struggle in the face of steadily declining US market share. Or maybe you just reckon the price of credit protection on GM debt is going to go up rather than down.

Whatever the dynamics of GM CDS trading, however, this kind of extrapolation is a reach too far:

If the cost of protection on GM continues to trade below Ford, for example, GM should be able to sell bonds at lower yields than Ford.

It’s bizarre to see this at the end of a whole article dedicated to the weirdness of the market in GM CDS, and the fact that the price is largely a function of the fact that GM does not have any bonds outstanding. At some point, GM is going to start issuing new bonds, and at that point various different investment banks will start talking to the carmaker about the level at which they might be priced. I very much doubt that any such bank would tell GM that it could issue through Ford just because of where the two companies’ credit default swaps were trading.

For the time being, GM CDS are trading at a tight level precisely because no one’s expecting a bond issue any time soon. If GM starts making noises about raising money in the bond markets, expect those CDS spreads to widen out significantly. It’s still possible that GM bonds could trade through Ford, of course — after all, Ford would still be much more highly leveraged than GM. But let’s not take today’s CDS market as much of an indication of anything. It might not be financial alchemy. But that still doesn’t make it a particularly useful guide to future bond pricing.

Four years ago, I started pushing back against the idea that whenever the government fails to make good on some obligation or other, that’s exactly the same thing as a bond default. Of course it isn’t: bond payments are a very special form of government obligation, involving specific sums of money to be paid in a specific manner on specific days. If you fail to make such payments, you’re in default. If a government takes money from, say, the military-salaries pot and uses it to make its bond payments, then that’s a drastic way of avoiding default. It’s a broken promise, to the servicemembers in question. But it’s not a default.

No one understands this better than Treasury. Just ask Tim Geithner himself, who was undersecretary for international affairs from 1998 to 2001, during the Asia and Russia crises. When he was dealing with sovereign defaults, there was a clear understanding that what mattered for such purposes was whether or not countries made their principal and coupon payments in full and on time. Domestic obligations, while important, were a separate issue — and in many cases the international community, led by Treasury and the IMF, would encourage countries to radically overhaul those obligations. No one at Treasury back then made the argument that such overhaul might itself be tantamount to default.

How things have changed now that the problem is domestic, rather than foreign. Neal Wolin has penned an astonishing blog entry at Treasury.gov:

Adopting a policy that payments to investors should take precedence over other U.S. legal obligations would merely be default by another name, since the world would recognize it as a failure by the U.S. to stand behind its commitments. It would therefore bring about the same catastrophic economic consequences Secretary Geithner has warned against.

Wolin really seems to be saying here that Illinois has already defaulted, since it’s late on many payments it’s legally obliged to make. And that a late Social Security check is just as bad in terms of America’s creditworthiness as a missed bond payment — even if Treasury is making all of its payments to the Social Security trust fund in a timely manner.

This is a dangerous and ill-advised rhetorical tack to take. For one thing, it’s false: the transfers made from a government to its citizens are qualitatively different from its bond payments to creditors, and if they’re missed the consequences are not nearly as catastrophic. On top of that, Wolin seems to be saying that Treasury has no particular desire to differentiate its bond obligations from any other obligations. Which, at the margin, increases the likelihood of a bond default. If bonds aren’t special — if they’re just one of many US government commitments — then bondholders should rightly worry that spending cuts might hurt them, too.

There may be some political or tactical reasons why it makes sense for Treasury to talk like this. But strategically, I fear, it could turn out to be very a big mistake indeed.

After I blogged Greg Ip’s post on the dangers of a US debt default if the debt ceiling isn’t raised, it became clear that we were very much lacking an expert take on the matter. So I asked James Macdonald, author of my favorite book about sovereign debt, if he might weigh in. Here’s what he replied:

Constitutional issues:

In the event of a refusal by Congress to raise the debt ceiling, would public debts have precedence over other government obligations? Some commentators have referred to the Fourteenth Amendment, passed in the aftermath of the Civil War, which states that “the validity of the public debt… shall not be questioned.” Is the public debt of the United States constitutionally sacrosanct in ways that its other obligations are not?

The Fourteenth Amendment was needed because, as the ex-Confederate states rejoined the Union after the Civil War, they were likely to hold a great deal of power in Congress, just as they had before 1860. In fact southern whites had been over-represented thanks to the extraordinary provision of the original Constitution that States could count 60% of their slave populations towards their seat allocations in Congress even though slaves had no rights. The main purpose of the amendment was to ensure that emancipated slaves could not be deprived of the right to vote, and as an additional weapon the amendment stated that States would only be entitled to seats in Congress in proportion to their voting populations.

The clause on public debt was the amendment’s final provision, and reads:

“The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.”

There are a number of issues raised here. As the southern states regained power in Congress they might have refused to honour war pensions to Union veterans unless an equivalent provision was made for Confederate soldiers. Or they might have demanded equivalent treatment for the war debt of both sides. The amendment put exiting debts, agreed while the Confederate states were not in the Union, out of bounds of discussion. The most striking aspect of the clause may be the second sentence. It rode roughshod over States’ rights by prohibiting them from paying any Confederate war debts, even if they wanted to. It also set aside the protection of property rights enshrined in the Fifth Amendment (“nor shall private property be taken for public use without just compensation”) by making it illegal to compensate slave owners for the loss of their property, even those in States that had not joined the Confederacy. It is perfectly possible that without the Fourteenth Amendment, slave owners could have taken to government to the Supreme Court on the basis of the Fifth Amendment.

What implications are there for the present situation? Prior to the Fourteenth Amendment, the main constitutional protection for public creditors was the Fifth Amendment. It is not clear just how much the Fourteenth Amendment added to that protection in the case of debt securities, which, as a form of property, are protected by the Fifth Amendment anyway. Where the Fourteenth Amendment might have some implications is in the case of state pensions, and by extension Social Security benefits, which could be deemed to be protected in the same way as post-Civil War veterans’ pensions. The Amendment also has a bearing on any attempt by the government to default on some debts while honoring others. (What happens to Chinese holdings of US Treasuries if China invades Taiwan triggering economic war between the two superpowers?)

Neither the Fifth nor the Fourteenth Amendments protected creditors in 1934, when the US declared that, as part of removing gold from circulation, it would no longer honor the “gold clause” that required the government to pay its bonds in gold coin of a fixed standard. The matter went to the Supreme Court, which found for the government on the basis that section 8 of the Constitution allowed Congress to determine what constituted money; so if it wanted to demonetize gold, it could. This, of course, did not mean the the government had not defaulted, merely that the Constitution allowed it to default under certain circumstances.

Since the Constitution gives the government the power to redefine money at will, it could be argued that the government might find a way around the debt ceiling by some monetary sleight of hand. However, the Constitution would not help in this instance, since the power is vested in Congress, not the administration.

Historical precedents:

The power of the debt ceiling can be very effective. The closest historical analogy to the present situation – other than the shutdown of government under Clinton in 1995 – is the run-up to the French Revolution. The French government was running a chronic deficit, although nothing like so large as the present US deficit in relation to GDP. There was no elected assembly in France, but registration of government loans by the Parlement of Paris, an unelected body of lawyers, was required to give them the force of law. In 1788 the Parlement refused to register the loan needed to cover the annual deficit unless the Estates General was reconvened. The government responded by disbanding the Parlement and imprisoning its leaders, but its access to the credit markets was frozen. In the end it was forced to summon the Estates General in 1789, and the rest, as they say, is history.

Thoughts on the present situation:

Clearly the US does not have to default just because the debt ceiling is reached – for the reasons outlined in this blog and elsewhere. It can temporarily cut back, or delay, its expenses. There is very unlikely to be a problem covering interest on this basis, since the interest on the market debt is only running at $16bn per month and only represents 5% of spending.

The problems could occur for other reasons:

- Given a budget deficit of $1,500 billion per year, new debt has to be issued at a average rate of $130 billion per month. The government would therefore have to reduce/delay spending by $145 billion per month to cover interest and avoid increasing its debt. This is a far more serious problem than finding a mere $16 billion per month, and represents 44% of total spending.

- The market could take fright and refuse to refinance existing debt as it matures, leading to default. Since, quite apart from bond maturities, there are around $2 trillion of T-bills outstanding, the government is on a very short leash when it comes to its credit standing. However, I do not take this risk seriously, since the Fed will simply lend the government the money to roll over the debt if the market refuses to do so.

Given that the the prices of government bonds have not collapsed, the market clearly assumes that that Congress will blink first and there will be no crisis. Personally, I am pretty confident that the market is right. However, there is a risk that, precisely because the only thing that the government can do legally to avoid default is to reduce spending, which is what the Republican right wants, there is an incentive for the Republicans to continue with the game of chicken until it is arguably too late.

At that point, even if the government does avoid default, the battle may be such a “damn close run thing” that the markets may decide that American politics is in so parlous a state that the risk premium on government bonds needs to rise sharply.

PS. Diverting the Social Security surplus (as per your blog) is not an option. Because of the recession, the program is currently running at a deficit, although it is supposed to return to surplus as employment increases.

Greg Ip makes a very important point today, which I haven’t seen made anywhere else*: even if the US debt ceiling isn’t lifted, that doesn’t mean the government will default.

In any given month, the government’s income dwarfs its debt-service obligations, which means that the government could simply pay all interest on Treasury bonds out of its cashflow. Greg hasn’t run the numbers on principal maturities, but I’m pretty sure that they too could be covered out of cash receipts—and when that happened, of course, the total debt outstanding would go down, and we wouldn’t be bumping up against the ceiling any more.

The point here is that the government has enormous expenditures every month, and debt service constitutes an important yet small part of them. If the debt ceiling weren’t raised, it stands to reason that just about any other form of government spending would get cut before Tim Geithner dreamed of defaulting on risk-free bonds.

Some of those spending cuts could be implemented almost invisibly. For instance, Social Security runs a surplus for the time being; it invests that money in special non-marketable Treasury securities, which count as Treasury debt. If the Social Security trust fund accepted instead just some kind of promise of a top-up at a later date, that could save billions of dollars right there.

Beyond that, large defense contractors aren’t going to stop working for the government just because they’re late in being paid; neither are doctors, hospitals or most of the rest of the healthcare industry.

But maybe the smartest thing for Geithner to do would simply be to stop paying the salaries of members of Congress and their staffs. It probably wouldn’t take long, in that event, for Congress to vote Obama the debt-ceiling raise he needs.

The bigger picture here is that the US government, like any other company or individual, has enormous freedom when it comes to which creditors it chooses to pay when. Just like GM had every right to privilege some creditors over others, even when those creditors were legally pari passu, the US government can do exactly the same thing. And there’s no way that this administration, or any other that I can think of, would choose to cut debt service given that they have every choice in the matter.

*Update: Which doesn’t mean the point wasn’t made earlier elsewhere, of course. Stan Collender made it in his Roll Call column, which he posted on his blog here. Apologies, Stan, for missing it.

My headline in April 2010, less than eight months ago, said “Ivory Coast’s bond exchange gets it exactly right”. Clearly, I spoke too soon: it seems that they should have simply held off until after the elections.

Ivory Coast’s Eurobonds sank to a record-low 40 cents on the dollar after the world’s biggest cocoa producer missed a $29 million interest payment amid a fight for political control of the West African nation.

Neither of the claimants to the presidency is talking about this issue, although the winner of the election, Alassane Ouattara, says that there isn’t any money left, and his predecessor, Laurent Gbagbo, has been cut off from state accounts.

The chairman of the London Club, Thierry Desjardins, is putting on a brave face, saying that “there is a willingness from the Ivorians to pay” — but it’s unclear who if anybody he’s talking to, or how he can have any good reason to believe that.

If the chaos in Ivory Coast continues past February 1 without the $30 million coupon being paid, the country will have defaulted within a year of restructuring, which would surely be some kind of record. But let’s get real here about this kind of thing:

Ivory Coast’s debt has already been restructured twice because of past defaults, and any repetition would leave it frozen out of international debt markets.

Ivory Coast is already frozen out of international debt markets; there’s no way that it will be able to issue debt in the foreseeable future, whether it makes this particular coupon payment or not. Even if Ouattara takes power and there’s no civil war and the best-case scenario works out, he still won’t be able to issue an international bond for the duration of his term in office. Which, admittedly, hardly gives him an enormous incentive to get that $30 million coupon paid this month.

Back in April, I noted with respect to Greece that “the bear case is terrifying, and the bull case is very hard to articulate”. So it’s extremely useful to have a clearly-articulated paper from the IMF, entitled “Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely”, which puts the bull case much more vividly than I’ve seen it before.

At its heart is this table:

The idea here is that whether or not you default, you’re going to have to embark upon a large fiscal adjustment in order to get back into sustainable territory. And even if you default with a massive 50% haircut, the size of that fiscal adjustment doesn’t change all that much:

The needed adjustment in today’s advanced economies would not be much affected by debt restructuring, even with a sizable haircut. To be concrete, let us consider by how much the primary adjustment needed to stabilize the debt-to-GDP ratio could be reduced by applying a 50 percent haircut—exceptionally large by historical standards. The haircut would make a limited difference for the required primary fiscal balance adjustment: 0.5 percentage point of GDP on average, and 2.7 percentage points for Greece. In percent of the adjustment in the absence of haircut, the reduction in the needed adjustment would be less than one-tenth on average and less than one-fifth in the case of Greece.

That’s the “unnecessary” part of the headline; the “undesirable” is pretty self-explanatory. But as for “unlikely”, I’m not convinced. Here’s the paper:

The essence of our reasoning is that the challenge stems mainly from the advanced economies’ large primary deficits, not from a high average interest rate on debt. Thus, default would not significantly reduce the need for major fiscal adjustment. In contrast, the economies that defaulted in recent decades did so primarily as a result of high debt servicing costs, often in the context of major external shocks. We conclude that default would not be in the interest of the citizens of the countries in question. Fiscal adjustment supported by reforms that enhance economic growth is a more effective response.

Well, yes, we’d all like fiscal adjustment and structural reforms, and probably a pony to boot. But in the case of Greece, and probably other countries too, it ain’t gonna happen. Which is why they’re going to default.

(HT: Alea)

The Daily Beast kicked off this week’s offerings with a slideshow listing “20 Recession-Proof Cities”: the ones with high pay and sustained economic growth. I’m not entirely clear on how to link to any given city on the list, but if you click through you’ll find Harrisburg, Pennsylvania at #7, the very picture of a hale urban center.

Which is now defaulting on its municipal debt. It’s the largest municipal default of the year, after Jefferson County in Alabama, and it surely presages more to come.

It also shows the moral hazard of bond insurance:

A missed payment is “a bad signal,” said Alan Schankel, managing director at Janney Montgomery Scott in Philadelphia, adding that it raises the concern that some distressed issuers may be more likely to skip bond payments guaranteed by insurance companies.

It’s worth noting that Jefferson County, too, had its bonds wrapped by an insurer.

No one explains this better than Warren Buffett, who laid it all out in 2009: the people running municipalities are far more likely to default if they end up harming only insurers than they are to default directly on their bondholders — who are also likely to be their personal friends and colleagues.

Which might partially explain — along with an incinerator fiasco — why Harrisburg, which is doing quite well, economically speaking, has now contrived to default.

David Goldman has reacted with a curious mixture of alarm and reassurance to Dakin Campbell’s story about U.S. bank holdings of municipal debt:

If municipal debt actually defaulted, the capital position of the banking system would be impacted, bank preferred debt might stop paying, and the holders of bank preferred debt–starting with the insurers–would be in serious trouble…

Why buy munis? For all of Warren Buffett’s dire warnings about municipal finances, the fact is that the federal government can’t let major municipal debtors (at the level of states, for example) go under without also bringing down the banking system and everything else.

If it goes, it all will go together. That’s why munis ultimately will be bailed out.

This is altogether far too sanguine. And if you look past the alarmist headline that Bloomberg has put on Campbell’s story, and the out-of-context numbers in his first few paragraphs, he eventually reveals just how much of a non-issue muni debt really is to the banks:

Lenders hold just 8 percent of the $2.8 trillion state and local government debt market, and municipal bonds are only about 2 percent of total bank assets, according to the Fed.

Muni bonds are relatively safe for two reasons. Firstly, they very rarely default; and secondly, when they do default, they generally have very high recovery values.

But let’s get ultra-pessimistic here, and say that 25% of municipal bond issuers will end up defaulting, and that recovery on those bonds will be just 50%. Then banks would have to take a hit of 12.5% on their muni bond holdings, which would correspond to a hit of about 0.25% of their total balance sheets. Needless to say, that’s not the kind of event which would precipitate a default on their preferred debt.

A widespread municipal default would be harmful to the economy more generally. With $2.8 trillion of munis outstanding, a hit of 12.5% would mean $350 billion of losses, spread across individual investors who were looking for safe, tax-free investments, and a lot of monoline insurers. That kind of thing can hurt. But investments in municipal bonds tend not to be leveraged, and for long-only investors, a drop of $350 billion is equivalent to roughly a 2.5% wiggle in the level of the U.S. stock market.

So I don’t think that munis pose a major systemic risk in and of themselves, although a handful of them — California first and foremost — are probably too big and politically important to be allowed to fail. There will certainly be a lot of wailing and gnashing of teeth if munis do start defaulting, since they’ve long been sold as extremely safe investments, and because they’re largely held by individuals rather than institutional investors. But no one’s going to bail them out because they’re worried about the banks.

James Saft today quotes the “six ways to dig oneself out of a debt hole” of Jeffrey Gundlach. Boiled down, they are

1. Growth
2. Lower interest rates
3. A money transfer from an outside benefactor
4. Higher revenues (taxes) and/or lower spending
5. Printing money
6. Default.

He’s too polite to mention the seventh option, which is to lie about how much debt you have and hope the markets don’t notice.

It’s worth bearing this list in mind in light of what David Merkel has to say about sub-sovereign debt:

I have long said that the health of the states is a more valid measure of the health of the nation than looking at national statistics. Why?

• The states can’t print money, or force ask allow the central bank to buy their debt.
• In general, the states must run balanced budgets. (Would that we constrained the Federal government to do the same through amending the Constitution. Somebody bring that up after the crisis is over, please?)
• State statistics are more reliable than Federal statistics, because they serve fewer political goals.

John Dizard seems to be thinking along similar lines, saying that Greece has already started restructuring its debt, on the grounds that the state hospital system is imposing haircuts on its creditors.

It’s only natural to look at sub-national defaults and near-defaults, from entities like Greek hospitals or the state of Illinois, as indicative of a broader fiscal malaise. If nothing else, it’s a sign that the sovereign is either unwilling or unable — or both — to bail out the troubled borrower in question. And as Merkel says, sub-sovereign defaults are “purer” than their sovereign counterparts, since a lot of the tricks available to the sovereign are inaccessible to anybody else.

I don’t think it’s fair to say that problems with Greek hospital debt mean that the sovereign has already defaulted, any more than non-payment from Illinois means that we’re in the middle of a US default. But I do think that default will become more common among sub-sovereign debtors, and as it does so, both creditors and debtors will start considering it seriously among the menu of options available. When nobody’s doing it, default is unthinkable. But once it starts popping up all over the place, it becomes a strategic option. That’s true of homeowners, who are more likely to default when their neighbors are doing it too, and it’s true of sovereigns as well.

Greg Ip reports on how Illinois is going to have to start making unnecessary unemployment payments just because it’s refusing to pay its debts:

Illinois owes Shore Community Services, a non-profit agency in suburban Chicago, some $1.6m for services to the mentally disabled. The agency has had to lay off a dozen staff. Jerry Gulley, the executive director, says his outfit’s line of credit could be exhausted soon. The bank will not accept the state’s IOUs as collateral. “That’s how sad it is,” shrugs Mr Gulley.

Ip explained to me that these aren’t physical IOUs, like California issued, and they’re certainly not bonds — they’re just unpaid receivables. But even so, this is crazy: there’s no way that Illinois should allow the employees of a noble non-profit to be laid off just because it hasn’t got around to paying its bills. It’s the job of the state to encourage employment, not layoffs.

Other banks are reportedly accepting state receivables as collateral, but it seems to me that Illinois would do well to set up a formal system of paper IOUs, which would presumably be much easier to borrow against. More generally, I think that there’s a very good chance we’re going to see quite a lot of state-issued scrip in the years to come, not only from Illinois but also from other states with similar CDS spreads, like Portugal. As Ip notes, these states “do not issue their own currency, so inflating away their debt is not an option”. But issuing scrip is the next best thing.

The problem with states like Illinois, California, and New York is not the willingness of the executive branch to remain current on its debts; rather, it’s the ability of the legislative branch to make the kind of tough fiscal decisions which are politically dangerous. The more dysfunctional the state legislature — and all three of them are pretty gruesome in that regard — the more likely it is that the state treasury will find itself in a position of simply not being able to meet its contractual obligations as they come due.

Outright default on a state’s bonded debt is still unlikely:

The assumption of many investors is that the federal government would never let a state default. It might allow an isolated case, but if a default looked like the start of a wave, the federal government would surely blink—just as Europe did when confronted by Greece.

This is surely right, and I doubt that any state is going to attempt to pay its bond coupons in scrip. Everything else, however, is fair game — including payments for services to the mentally disabled.

NEDAP has an extremely important new report on a particularly evil and sleazy part of the predatory financial universe: debt buyers. These institutions make hundreds of millions of dollars by suing people in low-income neighborhoods, often without properly serving them with notice that they’re being sued. When the alleged debtor doesn’t show up for court, the debt buyers get a default judgment, and start attaching bank accounts and garnishing wages. Often they do this successfully even when the debt is not legitimate.

The debt buyers are massively profitable, despite the fact that they have almost no legal leg to stand on:

When debt buyers purchase debts, they become legal owners of those debts, but obtain very little information about them. Debt buyers usually receive an electronic file that includes only a person’s name and social security number, last known address, the amount allegedly owed, the charge-off date, and the date and amount of the last payment. The portfolio does not include documentation of the debt, such as the governing contracts and account statements. This information is insufficient to ensure that the debt buyers collect the correct amount from the correct person. Debt portfolios are regularly sold on an “as is” basis, without consideration for whether collection of the debts in the portfolio is legal.

Debt buyers’ ability to obtain additional documentation from the original creditor is extremely limited: they may purchase the right to request such documentation in a limited number of cases, or they may not have access to any supporting documentation at all. If the debt is resold to another debt buyer, obtaining such documentation becomes even more difficult, as most second and subsequent sales of debt portfolios do not include any direct access to the additional documentation from the original creditor, which means that those debt buyers almost certainly lack the documentation needed to support lawsuits filed against people whose names appear in their portfolios.

The report makes a number of very sensible recommendations, including a ban on debt buyers filing lawsuits if they don’t have any evidence which proves the debt is owed. More generally, something has to be done to rectify the enormous asymmetry in sophistication and legal ability between the two sides here: as the report says, “many people sued are pressured into unfair and unaffordable settlements that leave them in a worse position than if they had ignored the lawsuits”.

This entire industry couldn’t exist, of course, if it wasn’t for the banks, which tacitly condone this behavior by selling debt buyers utter garbage debt. So while going after the debt buyers themselves is obviously the first order of business, it’s also worth putting pressure on the banks to stop dealing with them. I wonder which bank might like to be first in denouncing these gruesome parasites.

Update: I should add that the report was not just the work of NEDAP: it was co-written with the Urban Justice Center, with help from attorneys at the Legal Aid Society and MYF Legal Services.

Euroweek’s Southpaw column starts off explosively:

A mandate advising Greece on a potential restructuring — understood to have been won by Lazard — is the highest profile piece of business going for bankers working for government clients.

This would seem to imply that Greece has been shopping around this mandate for some time now, and has already settled on Lazard as the bank it’s going to go with. It’s a smart choice: Lazard did a spectacular job recently in both Ecuador and Ivory Coast. But the mere decision to hire advisers sends the message to the market that default is more than just an option. Greece, it seems, is happy to spend serious money on high-priced bankers right now to work out whether and how to do it.

If anybody has the rest of the column — the bit behind the paywall — I’d love to see it. And if anybody sees Lazard’s Michele Lamarche spending a lot of time in Athens, I think we can assume she isn’t on holiday.

If you think that the Dubai situation has pretty much been resolved with that cash infusion from Abu Dhabi, think again. Paul Whitfield and Vipal Monga explain that nothing really has been cleared up at all, and that there are far more — and far bigger — uncertainties surrounding the emirate’s finances than most of us had suspected.

For one thing, Dubai has no real legal structure capable of dealing with a default on this level, which has forced it to hurriedly import a jury-rigged system with UK and Singaporean jurists, based on British and American (not Islamic) legal structures.

But it’s not clear how trustworthy the Dubai’s government — its ruling family — really is, given that they actively encouraged the idea that Dubai World had a sovereign guarantee.

And it’s also far from clear what has happened to the $10 billion received from Abu Dhabi in February, or, for that matter, another $5 billion that was lent to Dubai by two Abu Dhabi banks in November. As for the further $10 billion which arrived in December, we know that $4.1 billion of it was used to repay Dubai World’s sukuk. But the final destination of the remainder of the money is also opaque.

What’s more, no one has much of a handle on the total liabilities involved, either:

Dubai World has officially released a $59.3 billion debt figure as of the end of 2008, but that number isn’t taken at face value by financial experts.

Deutsche Bank AG, for example, says that the figure included more than just financial debt, including equity, and payments due to suppliers. Discounting the nonfinancial debt led the German bank to estimate Dubai World’s financial external debt at $24.27 billion.

Morgan Stanley has its own estimate of the liabilities, taking a disclosed $26.2 billion number from Dubai and then adding another 30% to that to account for a presumed undisclosed amount, putting Dubai World’s debt at a seemingly arbitrary $34.1 billion.

The upshot is that the restructuring is going to be messy and unpredictable: my guess is that it’ll be a highly political process which will drag on for years. As ever, the big winners are certain to be the lawyers.

EMTA, formerly the Emerging Markets Traders Association, had an interesting panel on the Ecuador default today. It was a bit lopsided: no one on the debtor side — and EMTA invited the country’s own representatives, as well as its lawyers and bankers, and even the US Treasury — would agree to attend. As such, it was really a panel of private-sector participants, and felt much like a wake: it was clear that with the success of Ecuador’s exchange offer, the country has won and the private sector has lost.

In the long term, of course, Ecuador might not have benefitted all that much from its antics: Erich Arispe, of Fitch Ratings, pointed out that the country is paying out much more in cash payments for its bonds than it would have had to pay over the next couple of years in coupon payments. On top of that, Ecuador is racking up lots of new debt to multilateral institutions like the Andean Development Fund and the Inter-American Development Bank, so even its fiscal position isn’t really improving.

But in the short term, Ecuador has elegantly managed to buy back a very large chunk of its debt at just 35 cents on the dollar. Old Ecuador hand Hans Humes, of Greylock Capital, summed up how spectacularly successful the Ecuador strategy was, calling it “one of the most elegant restructurings that I’ve seen”.

In hindsight, the deal could hardly have been done any better. First and most important was the matter of timing: as all the panelists agreed, there’s no way that Ecuador could have pulled this stunt in 2006 or even the first half of 2007. But the country was playing the long game: president Rafael Correa was elected president, on a platform which included debt repudiation, in January 2007; Ecuador’s clear intention to default on its debt earned it a pretty much immediate CCC rating from Fitch. Yet the default didn’t happen until December 2008, almost two full years after Correa’s election.

The wait turned out to be the best thing that Ecuador could have done, because in the interim the global debt markets were plunged into turmoil. And Correa didn’t pull the trigger until he could see the whites of his opponents eyes: he announced that he was defaulting on the 2012 global bonds at exactly the time that three huge hedge funds, which held Ecuador’s debt, were being forced by their prime brokers to liquidate their holdings. As a result, the selling pressure on Ecuadorean bonds sent them tumbling from the 70s to the 20s almost overnight.

They would have fallen further, into the waiting arms of a small army of hungry vulture funds eager to get back into the distressed-debt game after many years essentially being priced out of it. But then Ecuador pulled its next smart stunt: it used Banco del Pacifico, a large Ecuadorean bank, to start buying bonds at levels above 20 cents on the dollar. That was just high enough that the vultures didn’t want to amass a large position, and ensured that any future restructuring would face little organized opposition just because Ecuador’s bondholders were so fragmented.

Ecuador’s next clever step was to pay cash for its defaulted bonds, rather than trying to do a bond exchange. That meant that it didn’t need to go through a laborious SEC registration process, during which the legality of the Banco Pacifico stunt would surely have been questioned. And its final clever step was not to put forward a take-it-or-leave-it offer, as Argentina did, which would allow bondholders to agitate for a mass “no” vote. Instead, they just asked bondholders to name their price.

Of course that’s what the bondholders did. None of them wanted to be left as holdouts, given the ease with which Ecuador could change the covenants on the bonds, and also the fact that they hadn’t even managed to accelerate the 2030 global bonds by the time the default happened.

Joe Kogan of Barclays Capital said that bondholders’ inability to accelerate the 30s doesn’t just show a collective action problem. “It demonstrates that people weren’t really willing to hold on to the bonds, and that the original investors who had these bonds were trying to get rid of them,” he said: no one, in the present environment, had any appetite at all for litigation which could drag out for years.

No one expected Ecuador to pull this particular rabbit out of the hat. The country has a reputation for utter incompetence when it comes to fiscal matters, and a few months ago it fired its highly-respected and long-standing legal counsel, Cleary Gottlieb. Somehow, however, this exchange offer was probably the most successful and least fraught debt restructuring in the history of Latin American sovereign defaults.

The multilaterals played their part, by condoning Ecuador’s actions and basically taking its side, despite the fact that the country had no fiscal need to default. And Argentina, weirdly, helped too: holdouts there have got very little to show for their litigation to date, and indeed Argentina was found in contempt of court in New York this week for basically ignoring a judge’s orders to keep certain funds in the US. It was a legal victory for bondholders, but won’t help them get any richer.

And of course it also helped that Ecuador was so small. Even with the bonds at par, they accounted for only about 0.5% of the emerging-market index, which means that at this year’s prices Ecuador constituted about one quarter of one percent of a diversified EM portfolio. You could fight them, but when your portfolio is down 20% for other reasons, what’s the point.

Kogan was sanguine on the question of whether Ecuador’s default would spill over into other emerging-market sovereigns. Most countries with bonds outstanding have some kind of access to the bond market, he pointed out; Ecuador hasn’t been able to issue debt in years, so losing access was no big deal for Ecuador, as it would be for most other countries. Ecuador also isn’t going to suffer as much in terms of economic costs as other countries might — its corporations aren’t going to lose bond-market access either (because they never had access) and it’s not going to suffer a bout of hyperinflation, because it’s dollarized. And although the last Ecuadorean president to default did immediately get kicked out of office, this one was re-elected comfortably, so there aren’t the kind of political costs that you’d expect in other countries. The only real new costs to Ecuador might come in a few years, if holdouts manage to attach Ecuador’s oil exports in one way or another — but given the success of the exchange offer, there probably won’t be any holdouts, or Ecuador could continue to pay them their coupons, just as it’s continuing to pay the coupons on its old Brady bonds which weren’t tendered into the 2000 exchange.

Hans Humes, however, was more worried about Ecuador setting a precedent. “As much as we can say this is an outlier, any country which runs into trouble has a great blueprint now of how to do it,” he said. The last time Ecuador defaulted, it was reasonably constructive, at least in hindsight: it hired Cleary Gottlieb, a big financial-markets law firm, it entered into dialogue with creditors including the Dart family, and it was criticized in some quarters for paying too much to bondholders rather than too little. No one can accuse it of that this time around.

“The world has changed,” said Humes — we’re now living in a world where not only Ecuador can default, but Iceland can default as well. And that’s a world where defaults by small emerging-market countries simply don’t have the systemic consequences that everybody thought they might have. I even heard Humes say something I never thought I’d hear a died-in-the-wool buy-sider like him say: “Maybe,” he said, the solution to “go back to Anne Krueger’s model”

He was referring to SDRM, the attempt by then IMF first deputy managing director Anne Krueger to create a sovereign bankruptcy court. Not a single private-sector player thought this was a good idea, as far as I could tell, and certainly no one on the buy side had any time for the idea. But now, it’s clearly better than nothing — and nothing is what bondholders are ending up with these days. “The official sector’s already beaten us,” said Humes. If you’re going to capitulate to Ecuador, then capitulating to the IMF is easy in comparison.

I’ve lost count of how many times I’ve recommended James Macdonald’s excellent book A Free Nation Deep in Debt: The Financial Roots of Democracy to people interested in the connections between democracy, development, and debt capital markets. So I’m very chuffed that Macdonald has popped up in the comments on this blog to talk about the historical precedents behind Ecuador’s decision to repudiate some of its old debts, while staying current on certain of its newer debts.

His comment is, naturally, worth quoting in full:

One of the interesting features of this default is the revival of the idea of different treatments accorded to different types of debt. There is a long history of such practice. The main purpose has always been to gain the short-term cost benefits of default without incurring the lont-term penalty of reduced access to the credit markets.

In this case, the regime treats its own debts as legitimate while treating those of its predecessors as illegitimate (or at least less legitimate). Eighteenth- century France used a different technique: treating previously defaulted debts as immune to further write-downs, while more recent debts were viewed as fair targets for default because their interest rates were, not surprisingly, considerably higher and could therefore be deemed usurious.

After the Napoleonic War, France finally became a reliable borrower, and one of the main demonstrations of this was honoring the Napoleonic debts in spite of the temptation to repudiate them. It was argued at the time that this was not merely a matter of good faith, but rather an unavoidable price for access to the credit markets on favorable terms as enjoyed by Great Britain.

To my mind, this remains a valid argument. Historically, default almost always had a negative short-term cost – it certainly did so on for France before 1815. The regime always had access to new loans after each bankruptcy; but its access to credit was limited by its previous track record. Attempting to justify its actions by differentiating between types of debt did not fool creditors. They may have continued to lend, but always at rates that factored in the risk of default, and in amounts considerably lower than they were willing to lend to Great Britain.

Just because Ecuador currently experiences a short-term gain will not turn it into a good credit risk. Only paying debts regardless of short-term incentives to default will remove it from the vicious cycle of borrowing and default which has mired Ecuadorean (and Latin American) history since liberation from Spain.

Madonald is right, of course, but it’s also worth noting that “the idea of different treatments accorded to different types of debt” is not something old which is being rediscovered — in many ways it never went away. The international community, including established debtor nations like France and the UK, even enshrined it in the concept of “preferred creditor status” — the idea that the IMF and the World Bank should always be senior to bondholders. And the Brady plan was basically a plan to turn sovereign loans into sovereign bonds on the grounds that while lots of countries had defaulted on their bank loans, none had defaulted on their global bonds, and as a result global bonds were considered safer or more senior than bank loans.

Anna Gelpern has written extensively about this issue: the big difference between sovereigns and corporates is basically that sovereigns are constructively ambiguous about which debts they consider senior to which other debts. “Sovereign immunity,” she writes, “empowers a government to choose the order of repayment among its creditors based on political imperatives, financing needs, reputational concerns or any other considerations”. The answer to this problem is not the idea that all governments should always pay all their debts in full — after all, sovereign credit risk has always existed and will always exist. Instead, a more formal system of transparent and enforceable seniority could make debt markets more efficient and debt restructurings less ugly.

For the time being, however, if and when there’s another wave of sovereign defaults, it’ll be largely up to each individual country which debts they choose to default on. Will it be foreign-currency debts, like Argentina, or domestic-currency debts, like Russia? Will it be bonds, or loans, or both? What will they do with trade finance and other vital short-term credit lines? And where will the multilaterals stand? No one ever knows, until the default actually happens.

Update: Yet more from Macdonald in the comments.