Hoover Institution
February 23, 2015
Germany and Greece have both wisely blinked on how best to renegotiate Greece’s outsized debt to its reluctant playmates inside the European currency union. The present fix will last for only four months, which means that the unresolved issues will surge to the fore yet again if some long-term solution is not crafted in the interim. In dealing with bailouts of this sort, financial gurus unduly rely on macroeconomic principles. In my view, that approach overlooks the gritty transactional challenges that routinely arise when parties attempt to work out delinquent loans in the shadow of bankruptcy. The picture is not pretty.
To see how the process unfolds, start with a simple situation where a lender advances $1 million to a debtor who at the appointed hour is unable to repay the loan in accordance with its terms. At this point, the lender first looks to foreclose on any specific collateral that the borrower has given to secure the loan. But specific assets do not secure many loans, like those made to Greece.
In dealing with these unsecured debts, one option open to the lender is to insist that all the money be repaid, come hell or high water. But if the current funds are not available, these futile and aggressive demands could easily disrupt the debtor’s productive capacity, so that the lender will cut off its nose to spite its face. Backing off on these onerous collection demands, by taking some reduction to the principal or interest, or both. Typically, these revised deals also require delay in repayment, but that haircut, as it is usually called, ultimately works to the lender’s benefit. To see why, do the math: backing down results in a higher probability of collecting a smaller amount. Its present value is often worth more than some lower probability of collecting the original debt with interest in full.
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