The European view on insolvency

The new proposed European Stability Mechanism looks like it will come into force via a change to The Lisbon Treaty, and will avoid facing public vote by referendum. It provides a process for sharing losses with sovereign creditors in the case of national insolvency. (More details on that below).

In yesterday’s FT, Lorenzo Bini Smaghi, an executive at the ECB, made the case against sovereign debt restructuring in the Eurozone. He argues that government debt is a central plank of the European banking system, imposing haircuts on the holders of sovereign debt may have a knock-on effect. This would make additional bank recapitalisations necessary. Even the threat of debt restructuring alone may destablise Western developed nations’ banking systems. Other commentators have argued that comparisons with defaults in emerging economies such as Russia and Argentina are less valid for Western Europe, as those countries were able to access foreign cash via booming commodities exports in the aftermath of their 1998 and 2003 restructurings. Lorenzo Bini Smaghi’s analyses adds the sophistication of developed nations financial systems as a further compounding variable.

The upshot of all this is that he argues that debt restructuring may actually increase the real debt burden, and the impact of a rising real debt burden may be most keenly felt by the most vulnerable in society. You can read his article here.

That analysis helps explain why the method for creditor burden sharing contained within European Stability Mechanism (the new permanent replacement for the EFSF post-2013) only applies to new bonds issued after 2013. See European Stability Mechanism (ESM) – Q&A

What happens in the extreme and unlikely case of insolvency?

Collective Action Clauses (CACs) will be included in the terms and conditions of all new euro area sovereign bonds starting in June 2013. These clauses will be standardized and identical for all countries and will provide the legal basis for the negotiation process with creditors.

CACs will enable the creditors to pass by qualified majority a decision agreeing a legally binding change to the terms of payment. This could take the form of a standstill, extension of maturity, interest-rate cut and/or haircut, depending on the specific case.

CACs will be consistent with those common under UK and US law after the G10 report on CACs. They will include aggregation clauses allowing all new debt securities issued by a Member State after 2013 to be considered together in negotiations.

Loans under the ESM will enjoy preferred creditor status, junior only to IMF loans.

None of which helps European countries which may already be facing structural problems today that make insolvency tomorrow inevitable (such as loading up massive private bank debts onto the sovereign account). And if unilateral default is not an option, either because of the structure of our economies or because certain organisations may retaliate, then that means that countries facing an insolvency crisis need proper support from their European partners. A crisis of too much debt can not be solved by more debt at higher interest. Some form of debt relief (debt forgiveness, debt sharing /e-bonds) is required.