How a Debt Exchange Could Ease Europe’s Crisis

by Luigi Zingales

Bloomberg
September 8, 2011

The political response to the European crisis so far has been denial and temporary patches. But policy makers are facing more than just a liquidity crunch; they also need to tackle a solvency crisis and possibly a structural one. One of the most pressing issues is addressing the over-leverage of the southern European nations.

Economic theory tells us that in situations of over- leverage there are multiple equilibrium points. If all parties expect a sovereign borrower to be able to pay, the market will refinance that creditor at low rates, ensuring it won’t default. Conversely, if lenders expect a default, it will happen. The enormous volatility we are witnessing is the result of the impossibility of knowing which of these outcomes will prevail.

How can this uncertainty be eliminated?

Corporate finance provides an answer. When companies are over-leveraged, they respond either with a debt-for-equity swap or with a debt exchange offer that reduces the face value of the bonds. While these reorganizations are difficult to negotiate, they have the potential to make both creditors and debtors better off. Even the most conservative estimates put the cost of such financial distress at 15 percent of a company’s value. If we were to apply similar figures to countries, the results would be more than enough to satisfy both bondholders and issuers.

Transforming debt into equity is easier for companies than for countries. While it is possible to convert part of a sovereign debt into claims that would pay creditors according to a country’s gross-domestic-product growth, such arrangements can’t be put in place on a voluntary basis. By contrast, debt- exchange offers can be achieved by mutual consent, if they offer some securities with higher seniority.

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