The Council of the EU agreed on 21 July 2011 to a second bailout for Greece (Council 2011). This deal is predicated on “private-sector involvement”. The Council seems to have implicitly endorsed a form of private-sector involvement made by a private institution – the Institute of International Finance.
The proposal consists in a voluntary debt restructuring with a bond-exchange menu with four options (IIF 2011). The Institute indicated the exchange will result in a 21% “haircut” or reduction in the net present value of an estimated €135 billion of Greece’s sovereign debt that matures between 2011 and 2020. Two recent press columns, Nascimento-Rodrigues (2011) and Dixon (2011), argue that this will likely result in an increase – not a reduction – in Greece’s indebtedness.
This column uses one of the exchange options to replicate and explain the issues with the Institute of International Finance haircut estimate. It argues that a much lower post-exchange discount rate should be used and that in such a case the net present value of Greece’s debt subject to the exchange offer would actually increase.
How does the Institute of International Finance arrive at an estimate of a 21% “haircut”?
The most critical variable in performing a discount or “haircut” calculations is the choice of the pre- and post-exchange discount rates.
- Most authors use the same discount rate to compare cash flows before and after the debt restructuring.
Sturzenegger and Zettelmeyer (2008), for example, argue that the haircut should be calculated as the difference between the pre- and post- present values. The discount rate to use is the yield of the new debt instrument once it start trading. Adjustments should be made to reflect any change in maturity. In Greece’s case the new instruments are not yet available, so the yield is unknown. The Institute thus faced a challenge in choosing the discount rate.
The 5-page document issued by the Institute is scarce on methodological details (IIF 2011). Indeed, it is possible that the details of the offer may still be the subject of ongoing negotiations with policymakers. The Institute of International Finance (IIF 2011) states that the exchange offer, though fully voluntary, is expected to result in the tendering of 90% of about €150 billion of Greece’s bonds subject to the exchange offer, which mature between 2011 and 2020. This would result in the tendering of Greek sovereign debt amounting to €135 billion.
As mentioned, the proposal foresees four exchange options and the Institute assumes they will be chosen in equal proportions. The IIF estimates – using a 9% discount rate that each of the options would result in a 21% haircut.
Replicating the 21% haircut calculation
In replicating the Institute’s calculations, this column, for simplification and illustration, assumes that all investors would choose the first exchange option only.
The first menu option consists in an on-par exchange of maturing debt by a new instrument enhanced with a AAA-rated 30-year zero coupon bond collateral, and a coupon growing from 4% to 5% of face value paid by the Greek state. The AAA 30-year zero coupon bond would be purchased by the European Financial Stability Facility on behalf of Greece (IIF 2011; Allen and Evans 2011; Baglioni et al. 2011). Greece would support the financing costs on that EFSF purchase.
To replicate the Institute of International Finance’s 21% haircut estimate, the net present value of the cash flows associated with the current Greek sovereign debt maturing between 2011 and 2020 is compared to the net present value of the cash flows associated with the new instrument that would mature in 30 years time (2041) and a coupon rising from 4% to 5% (see Table 1). The Institute makes no mention of an adjustment for maturity (Sturzenegger and Zettelmeyer 2008). Assuming the 9% discount rate indicated by the IIF (2011), the pre-exchange net present value of the €135 billion the estimates will be tendered is approximately €127 billion.
Table 1. Pre-exchange cash-flows and net present values (estimates)*
The calculation of the net present value of the new post-exchange instrument poses a problem because the IIF states that the “principal is repaid to the investor using the proceeds of the maturity of the zero-coupon bonds” (IIF 2011 p3). If so, then a constant 9% rate cannot be used to discount all cash flow payments after the exchange, since the principal, which represents a significant portion (about 48%) of the net present value of the new instrument (Hau 2011) is really an AAA-rated zero coupon bond, whose discount rate should be around 3.5%.1 With that in mind, I calculated the post-exchange net present value by discounting the interest payments with a 9% discount rate, and the principal payment, in 2041, with a 3.5% discount rate.2 I arrive at an estimate of the net present value, post-exchange, at €118 billion. Thus, the estimated haircut would be approximately 7% and not the 21% presented by the IIF.
Thus, the IIF Financing Offer (2011) likely means that post-exchange cash flows are discounted with an average discount rate of 9%. If we assume that the principal is discounted at 3.5% then the interest payments were likely discounted at approximately 12.9% to achieve the IIF’s 21% haircut estimate (see Table 2 below). This seems quite a high discount rate for the post-exchange cash flows, and quite a large difference for Greece’s pre- and post-exchange cash flows for reasons that shall be discussed below.
Table 2. Post-exchange cash-flows and net present values (estimates)
Issues with the Institute of International Finance, with the exchange proposal, and with the 21% haircut estimate
There are several issues with the IIF’s debt restructuring proposal:
- Greece’s interest payments on the €135 billion of debt subject to the exchange offer would not fall as suggested by the IIF (2011) but actually rise slightly to between around 5.4% and 6.4%. This occurs because Greece has to finance the purchase of the AAA-rated zero coupon bond collateral with a loan from the EFSF.3
- With an exchange to the first menu option only, approximately 35.5% of Greece’s pre-exchange default risk on the €135 billion of sovereign debt would be immediately transferred from private sector holders of Greece’s sovereign debt to the EFSF (Hau 2011).4
- As pointed out by Dixon (2011) Greece’s gross debt would likely increase in the short-term, not fall.
- The 9% discount rate assumed on the pre-exchange debt cash flows seems too low. I estimate that the market discount rate (yield) for the €135 billion of debt subject to the offer prior to the announcement was approximately 24%. The net present value of the debt was at the time about €84 billion. With a 9% discount rate, the IIF assumes that the pre-exchange debt was worth €127 billion. This seems quite a generous valuation of pre-exchange debt that has close to default rating by Moody’s.
- The EU and the IMF have committed nearly €310 billion to aid Greece (Alcidi et al. 2011). The Council (2011) has committed to undertaking measures to promote economic growth. These funds will be used, to a significant extent, to fund post-exchange interest payments. So, a 12.9% discount rate for interest payments that are to some extent implicitly backed by the EU, IMF, and the European Central Bank (ECB) seems excessive.
- The EFSF loan interest rate reduction to 3.5% could alternatively be interpreted as a “sweetener” to induce Greece to accept the debt restructuring proposal, a sweetener that is actually backed by EU’s creditor nations’ taxpayers. In addition, the reduction in EFSF loan rate to about 3.5% ensures that more of Greece’s resources are available to pay interest on the new post-exchange instruments held by private sector investors.
- Finally, if we assume a post-exchange average discount rate of, for example, 4.2% to account for the implicit EU and ECB backing of Greece, then the exchange would likely result in an about 86% increase in the net present value of debt to €157 billion from the about €84 billion that the debt was worth in the weeks prior to the Council agreement. The post-exchange net present value of the debt would be about 16% higher than the face value of the pre-exchange debt instruments. This would mean that the exchange would result in no debt haircut at all, but instead in an increase in net present value of the debt.
- Moreover, if it were possible for EU policymakers to design a debt restructuring exchange so as to engineer a post-exchange average discount rate of 4.2%, then it would be possible, with the same 21% haircut as envisioned by the IIF, to reduce interest payments on the new debt instruments by €3.4 billion per year, or by about 1.5% of Greece’s 2010 GDP. Since it is the EU that is, to a large extent, supplying the funds to allow Greece to make those interest payments, it seems illogical to support higher financing costs by allowing EU policy ambiguity towards Greece to result in higher post-exchange discount rates.
Further evaluation of the discount rates used in the Institute of International Finance’s proposal is probably warranted. The pre-exchange discount rate seems too low, the post-exchange discount rate too high. This results in an IIF haircut estimate that may be over optimistic.
Moreover, the uncertainty regarding EU policy towards Greece likely results in higher bailout costs through higher post-exchange discount rates. It seems preferable either not to back a debt restructuring at all, resulting in a probable default by Greece, or alternatively, to explicitly back a more credible debt restructuring proposal, which would lead to much lower post-exchange discount rates, and thus to much lower bailout costs.
Alcidi, Cinzia, Alessandro Giovannini, and Daniel Gros (2011), “History repeating itself: From the Argentine default to the Greek tragedy?”, CEPS Commentary, 1 July.
Allen, Peter and Gary Evans (2011), “A Trichet Plan for the Eurozone”, VoxEU.org, 14 April.
Baglioni, Angelo, Richard Baldwin, Samuel Bentolila, Tito Boeri, Paul De Grauwe, Juan Dolado, Luis Garicano, Francesco Giavazzi, Daniel Gros, Jean Pisani-Ferry, Richard Portes, Guido Tabellini, and Beatrice Weder di Mauro (2011), “A call to action: EU leaders must act to save the euro and avoid a recession”, VoxEu.org, 20 July.
Council of the European Union (2011), Statement by the Heads of State or Government of the Euro Area and EU Institutions, 23 July.
Dixon, Hugo (2011) “Greek rescue bizarrely increases its debts”, Reuters Breaking Views, 25 July.
Hau, Harald (2011), “Europe's €200 billion reverse wealth tax explained”, VoxEu.org, 27 July.
IIF (2011), IIF Financing Offer, The Institute of International Finance, available from <http://www.iif.com/press/press+198.php>.
Nascimento-Rodrigues, Jorge (2011), “Cimeira europeia: Grécia saiu prejudicada”, Expresso Online, July 25th (citing my own estimates of the IIF debt restructuring proposal haircut).
Sturzenegger, Federico and Jeromin Zettelmeyer (2008), “Haircuts: Estimating investor losses in sovereign debt restructurings, 1998-2005”, Journal of International Money and Finance, 27:780-805.
* The author is grateful to Tobias Blattner for comments that resulted in a correction to Table 1.
1 For example, similar to that of German 30 year sovereign debt, which has a AAA rating.
2 Depending on the actual wording of the exchange offer, the discount rate for the principal payment could actually be lower than that of German sovereign debt (3.5%). This would occur if the exchange offer required the EFSF or the vehicle created to that effect to maintain AAA collateral throughout the 30-year term of the instrument. Germany’s sovereign debt could suffer a rating downgrade during this period, whereas the EFSF would have to replace any downgraded collateral with new AAA collateral.
3 This is calculated by adding to the 4%-5% interest rate mentioned in the IIF prospectus, the interest paid on the EFSF loan to purchase the AAA zero coupon bond with an estimated present value of €48bn. This is equal to 3.5% plus a spread of 0.4% to cover EFSF costs times €48bn over €135bn of the pre-exchange sovereign debt subject to the offer.
4 This is only approximately correct, since there is also a default risk associated to the AAA zero-coupon bond.