Lee Buchheit and Mitu Gulati have another great paper out on the subject of how on earth a sovereign is meant to restructure its contingent liabilities.

Blogs / US / Felix Salmon

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How do you restructure a contingent liability? Posted: 12 Jul 2013 12:54 PM PDT Lee Buchheit and Mitu Gulati have another great paper out on the subject of how on earth a sovereign is meant to restructure its contingent liabilities. Here’s the problem, in a single chart: What you’re looking at here is the way in which European countries especially have turned to sovereign guarantees as a way of masking the true size of their national debt. Many of these guarantees, once upon a time, would have simply been sovereign loans: the nation would have borrowed the money, and then lent it on, at a modest profit, to the borrower. But European countries want to do everything in their power notto borrow money right now. So instead of lending and borrowing, they simply guarantee a borrower’s debt instead. That brings down the price of debt for the borrower, but it doesn’t show up in any national debt-to-GDP statistics. As you can see from the chart, this technique is increasingly popular — which means, in turn, that it’s going to have to be addressed in future debt restructurings. When sovereign guarantees were de minimis, they could be — and were — ignored. But at this point, they’re too big to be ignored. For one thing, sovereign bondholders won’t allow it. Let’s say Ruritania has $3 billion in bonds and $2 billion in guarantees. The bonds then get restructured, so they’re worth only $1 billion: a 66% haircut. But then, let’s say that half of the borrowers with sovereign guarantees go bust. Will Ruritania really pay out the $1 billion in full, with no haircut at all? It wouldn’t be fair to the original bondholders, that’s for sure. As Buchheit and Gulati explain: The restructurer’s dilemma is that contingent liabilities, if they are of any material size, cannot safely be left out of a sovereign debt restructuring, nor can they easily be included in a sovereign debt restructuring. This problem wasn’t a problem for so long as contingent liabilities represented only a small part of the debt stocks of affected countries. But for many countries, that period ended with the commencement of the financial crisis in 2008. The problem will therefore be unavoidable in at least some of the sovereign debt restructurings yet to come. They do come up with one possible solution. If the guarantees are issued under domestic law, then the problem can be solved with legislation, along these lines: All guarantees issued by the Republic of Ruritania in respect of debt obligations of third parties that are eligible to participate in the [Ruritanian restructuring] shall, if called by the beneficiary at any time after the closing of the [Ruritanian restructuring], be satisfied and discharged in full by delivery to the creditor of consideration equivalent to that offered in the [Ruritanian restructuring]. But the bond markets have seen this one coming. After seeing the awesome power of domestic legislation in the Greek context, look what the market is now demanding in terms of sovereign guarantees: While domestic-law guarantees were commonplace before 2010, that’s changing; at this point, foreign-law guarantees are catching up, and will almost certainly soon become an outright majority of the total. All of which leaves us with the paper’s conclusion — that contingent liabilities are going to have to be addressed somehow, in future restructurings, but no one knows how. If you thought that sovereign debt restructuring has been difficult until now, you ain’t seen nothing yet.

Information wants to be expensive Posted: 12 Jul 2013 09:44 AM PDT What a difference a decade makes. In 2003, when the SEC announced its big settlement on Wall Street research, everybody greeted with joy the way in which it provided more than $400 million to fund independent research over five years. While sell-side research has its place, there are good reasons why investors want research shops to be independent, and the SEC settlement was designed to give such shops something of a running start, with guaranteed income. The logic here is simple: information is good for markets. It improves price discovery, and in doing so helps to optimize capital allocation. But detailed information does not come cheap, and there are lots of reasons why paying for information directly is a much cleaner and much more sensible way of doing things than hiding the payments within the cross-subsidy arrangements of investment banks. As we saw during the Blodget era, investment banks have their own incentives, which aren’t always aligned with those of investors. Sadly, the independent research industry never really took off, the fuel of the SEC settlement notwithstanding — and when the end of the five-year settlement period coincided with the onset of the financial crisis, that was pretty much the end of that. But still, there are independent institutions out there which put substantial resources into sourcing and publishing important information about the various sectors of the economy — information which is invaluable for the market. The more such information we have, the more efficient the market becomes. In a market economy, however, all that research and information has to be paid for somehow. Luckily, there’s a time-tested means of doing so: you charge money for it. Investors value information, especially if (a) it has the potential to move the markets, and (b) they can get a “peek” at the information before it is broadly released to the public. The result is a mini industry of information providers, who put a lot of effort into surveys and analysis and other means of data collection, and who pay for it all by selling that information to investors. Rather than trying to legislate independent research through SEC settlements, this is the much more efficient free-market solution, and it’s one in which everybody wins: the information providers get paid, the investors get access to valuable information, and the market as a whole more efficiently reflects all the new knowledge about the state of the economy. But now that we’ve found a way that independent economic research can actually pay for itself, it turns out we don’t much like it. At the WSJ, Michael Rothfeld and Brody Mullins have been bashing this drum for a while now; on Tuesday they wrote an article explaining, in the words of the headline, that “Peeks Are Still Available for Some Key Economic Data”, and then today they followed that article up with another one, almost identical, under the headline “A Peek at Trucking Data, and Then the Stock Surged”. Breaking: new data can move markets! Here’s my favorite part of the article: The Association of Home Appliance Manufacturers distributes monthly shipment data to nonmembers who pay $600 a year. The data can affect trading in such stocks as General Electric Co., Whirlpool Corp., and AB Electrolux. The group also gives its monthly appliance-shipments report to 20 member companies that participate in the survey a day in advance. Spokeswoman Jill Notini said the association relies on the honor system: “We hope they would use the data appropriately.” I’m not sure what the “honorable” and “appropriate” use of the data is, in this context, but the implication is clear: if you trade on this information in the market, before it is broadly available, then that would be dishonorable and inappropriate. Why would such activity be dishonorable or inappropriate? The WSJ doesn’t say. And why would anybody care about getting such information 24 hours in advance if they couldn’t trade on it? There might be insider-trading reasons why a company can’t trade on non-public information from a survey to which it itself contributed, and in general I’m not sure that corporate treasury departments should be in the stock-market speculation business. But putting that to one side, trading on information is a public good, and it should be encouraged as much as possible. Trading is, after all, the primary mechanism by which market information is reflected in market prices; in many ways, it’s the whole point of having markets in the first place. And in general, no one’s going to trade if they don’t think they have some kind of edge. The perceived problem with “peeks”, as I understand it, is one of fairness and level playing fields: the ordinary individual investor is at a disadvantage, relative to the large institutional investors with advance access to information. But that seems very old-fashioned: the ordinary individual investors is always at an information disadvantage, which is why it’s so silly for ordinary individual investors to trade much, beyond the occasional rebalancing. Even when information is released simultaneously to all market participants at once — through an SEC filing, say, or in a press release — you can be sure that the HFT algobots will have acted on it long before any individual investor has even had time to read the headline. Or to put it another way: back when it was founded, in the 1930s, it made sense for the SEC to try to enforce a “fair” market where all men could trade on a level playing field. But those days are over now, and they’re never coming back. Everybody knows that hedge funds and institutional investors have access to massive amounts of information, on top of high-level access to executives; everybody knows that high-frequency traders can move much more quickly than any individual. If you want to go up against these people in the trading arena, all power to you — but don’t expect the SEC to be able to ensure that it’s a fair fight. Instead, individual investors should play to their strengths, which include the ability to take a long view and not feel any need to mark to market, or to worry about quarterly performance returns. They can make long-term investments without worrying about short-term performance, and — thanks in large part to the rise of high-frequency trading — they can get truly spectacular execution at NBBO at any time they want it. Sometimes, data will cause stocks to move — all individual investors know that, and if they have their priorities straight, they won’t particularly care when that move takes place. But from a public-policy perspective, the market in data is a good thing, which should be encouraged: the more data there is, and the higher the quality of that data, the better that the economy is served by the market. The institutions providing this data are performing an important public service, and being paid for it from private-sector funds. Let’s celebrate that, rather than demonizing them.