Greek Sovereign Debt. Why some Greek bonds might be worth more than others

Jun 10th 2011, 15:17 by A.M | LONDON 

IT TOOK some time, but Germany finally seems to be addressing how, rather than if, a Greek restructuring will occur. Finance Minister Wolfgang Schäuble has written to the ECB demanding a lengthening of bond maturities as a condition of further German lending to Greece. As our leader this week argues, this will not be enough to restore Greece to solvency. If it wasn't for ECB opposition, Germany might be willing to go much further. Last year Angel Merkel called for irresponsible investors to be punished for mispricing sovereign default risk. She is not averse to imposing haircuts on bondholders. Bailing them out, after all, creates moral hazard.

If a restructuring is to take place, how could it be best designed to incentivise bondholders to monitor default risk in the future? Conventionally all bonds are treated identically in a restructuring. But what if all bonds aren’t the same? If some bonds offer stronger creditor protection against default, should they receive more lenient treatment? That is the argument made by a group of American lawyers, including Mitu Gulati, in a recent paper.*

Followers of the Greek crisis may recall that Professor Gulati was the first to find that most of the debt Greece has issued since it joined the euro zone is governed by Greek law, and could therefore be restructured by legislation in the Greek parliament. This time Professor Gulati is interested in the few bond contracts that are governed by English law.

He has found that since 2009 investors have been willing to pay a premium to hold those English-law governed bonds. The right to sue in an English court offers investors a greater chance of holding out against a restructuring. Some are willing to pay for that chance. Professor Gulati and his colleagues argue that this is a rare example of investors seeking to price default risk. If Europe’s leaders want to incentivise risk monitoring, those investors should be rewarded for their cautiousness. The haircut on English-law governed bonds should be smaller.

There are at least two potential problems with the professors’ proposal. First of all what type of investors would pay extra for the right to hold out against a Greek debt restructuring in an English court? They would have to be sophisticated investors with cash to spend on legal fees. The likeliest candidates are so called “vulture funds”, who buy up the debt of defaulting sovereigns at a fraction of face value and then sue the governments, often of poverty-stricken African states, to recover the full amount. When Mrs Merkel calls for responsible sovereign lending, that’s probably not what she has in mind.

Second, the premium paid to hold the English-law governed bonds is quite small, except when default fears spike. When Greek default fears peaked in April 2010, the yield on English-law governed bonds was 7% lower than the yield on Greek-law equivalents. But within days of the EU-IMF bail-out announcement the yield spread had all but disappeared. What the law professors have uncovered is not investors buying and holding English-law governed bonds, but investors piling into the safer asset class when a default appears imminent. European leaders might not want to reward such opportunistic purchases.

Nevertheless, Professor Gulati has been a regular visitor to Frankfurt this year, advising on potential restructuring mechanisms. Greek bondholders might be wise to check which type of contract they hold.

The Economist