Academic journal article Contemporary Economic Policy

Leveraged Buybacks of Sovereign Debt: A Model and an Application to Greece

Academic journal article Contemporary Economic Policy

Leveraged Buybacks of Sovereign Debt: A Model and an Application to Greece

Article excerpt

I. INTRODUCTION

When the outstanding debt of a sovereign borrower quotes significantly below its face value, the government of that country may try to improve the financial position of the public sector by purchasing some of its own debt through a buyback transaction. The interest for this kind of deal was originated in the 1980s by the debt overhang problem affecting several developing countries. (1) The current crisis of sovereign debt, hitting particularly some countries in the euro area, has revived the interest in this matter at the policy leve1. (2) A buyback operation was actually one of the tools employed in 2012 to try to fix the Greek issue.

This article provides a simple model, analyzing the effects of a leveraged buyback": this is the label I use to identify the case where a government borrows the money, needed to purchase some of its own debt, from an international organization (named "Fund"). I will show that the priority structure, defining the rights of the lenders in the default state, is crucial to determine which party benefits from the deal: either the borrowing country or the bondholders. If the Fund is senior, the deal benefits the country at the expense of bondholders: on one hand, the overall amount of government debt is reduced, implying a lower probability of default; on the other hand, the deal makes the price of outstanding bonds go down, since their recovery rate in the default state declines. The opposite happens if the Fund is junior. If the Fund and the private lenders have the same creditor status, the deal has no impact on payoffs and on the bond price.

Those results are derived under the assumption that the loan made by the Fund is fairly priced, so it fully incorporates the credit risk incurred by the Fund. The model is then extended to analyze the case where the loan is underpriced, for some political reasons. This underpricing is equivalent to a subsidy, which benefits not only the borrowing country but also its private lenders. The buyback has a positive impact on the price of outstanding bonds, even if the Fund retains the same creditor status as private lenders.

The buyback transaction made by the Greek government in December 2012 allows me to complement the model with a case study. The deal was funded by the European Financial Stability Facility (EFSF), so it was a leveraged buyback. Moreover, the loan made by the EFSF to the Greek government was significantly underpriced. The EFSF retains officially the same creditor status as private lenders, although it can be expected to be actually junior. The model prediction, that this kind of transaction should have a positive impact on the price of outstanding bonds, is confirmed by the econometric analysis.

The traditional literature, initiated by the seminal contributions of Krugman (1988a) and Bulow and Rogoff (1988), has considered the case where a country employs its own resources to fund a buyback: I label this deal as "unlevered buyback." In this literature, the crucial parameter, determining the payoffs of the parties involved in the deal, is the share of country's endowment available for debt repayment: if the bondholders (as a group) can seize only a tiny share of the country's endowment in the default state, the buyback turns out to be a good deal for them and a bad one for the government. While this result is true for an unlevered buyback, it does not hold anymore for a leverage transaction: in the latter case, I will show that the share of country's endowment that creditors can seize in the default state is totally irrelevant.

Following Krugman and Bulow-Rogoff, other models of sovereign buybacks have been proposed, showing that debt repurchases can have some positive effects, overlooked by those initial contributions. In particular, Rotemberg (1991) shows that debt repurchases by highly indebted sovereign nations are advantageous for all the parties concerned. The reason is that when sovereign debts are large, bargaining costs between the government and its creditors (e. …

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