Illiquency 2010, Sovereign Edition: A Lawyer’s Cut

Just as struggles over the true meaning of “liquidity support” for financial conglomerates recede to crisis post-mortems, the Greek rescue package has pushed the illiquidity-insolvency conundrum back to the center of the policy debate.

If Greece is illiquid, it only needs a bit of EU/IMF emergency cash to tide it over until investors regain confidence in its policy path.  If Greece has no hope of durable recovery under current economic and political assumptions, it is insolvent and should seek debt reduction.  The conundrum has a simple answer:  there is no way of knowing for sure, and even if there were, there is no way of talking about it in polite company until it is too late.  In other words, Greece has entered the twilight zone of Illiquency.

For most policymakers and observers, the onset of Illiquency brings an uptick in the perennial illiquidity-insolvency argument.  For lawyers, it marks the time to bring out the debt contracts and precedent books. And, as my friends Lee Buchheit and Mitu Gulati have just confirmed, the Greek lot promise the most interesting reading in decades.

First and most important, word is that the bulk of Greek debt is governed by Greek law.  In theory, this could make up for at least some of the flexibility Greece lost on ceding monetary sovereignty to the EU.  Like Russia and Argentina before it, Greece could restructure domestic-law debt by fiat—rewrite its contracts by law or decree.  Apart from the reputational damage of such a move for Greece and other sovereigns, the EU law overlay could make it risky from the enforcement perspective—a constraint that neither Russia nor Argentina had to reckon with.

Second, some of the contracts that are not governed by Greek law may tie contractual protections to the currency of debt denomination.  Such contracts define “domestic” debt as Euro-denominated debt—perhaps a product of the time-worn “find ‘Drachma,’ replace with ‘Euro’” drafting technique?—and give it much less contractual armor, such as cross-default terms, than its “external” (e.g., U.S. dollar) counterpart.  It follows that—again, in theory—Greece could play hardball with its creditors even if it decided against restructuring by fiat.  At the extreme, this resembles Russia’s London Club restructuring in 2000, where the formal obligor was not the government itself, but the old Soviet foreign trade bank, which was an insolvent shell at restructuring time.  The creditors had no one to sue.  Russia used the leverage to cut its debt by half.

On the other hand, Buchheit and Gulati report that the same quirky dichotomy between domestic and external debt in Greek contracts would give Greece more leeway to pledge collateral to secure any new bonds it might issue in a debt exchange.  All in all, more stick-and-carrot potential than your average sovereign debt contract.

Third, no matter what Greece’s debt contracts might say, the identity of its creditors could make all the difference.  If most of the debt is with European banks fresh out of their own Illiquency zone, and backed by those same European governments that just put up €80 billion in Greek liquidity support, Greece’s political leverage to restructure may be limited, even if its legal leverage is considerable.  (That is, of course, if it wants to stay in or near the EU.)  This situation resembles the early days of the 1980s debt crisis, which dragged on under the pretense of illiquidity in part because the creditor banks had no capital to absorb losses from sovereign default.  Worse yet, the presence of Greek pension funds among the creditors raises domestic political barriers to restructuring.

Finally, no matter what the identity of Greece’s creditors might be, the identity of such creditors’ derivatives counterparties could turn out to be more important.  If the French and German banks bought protection from, say, Greek banks, any sovereign debt haircut would fall on the latter. This would achieve no relief for Greece, just a bit of fiscal accounting—which recent revelations suggest is nothing to sneeze at, but probably not a path to solvency.  Greece could respond by blocking its banks from performing on the contracts (as Russia did in 1998), but the legal and political cost of such capital controls within the EU may be prohibitive.

But of course, Greece’s creditors could have bought protection in far-away places outside the EU.  Which reminds me—was AIG illiquid or insolvent in September 2008?

Anna Gelpern is a law professor at the American University Washington College of Law, and a visiting fellow at the Peterson Institute for International Economics.  Her writing on sovereign debt and financial crises may be found here.

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