DEBT
RESTRUCTURING:
GAPS IN LEGAL AND
INSTITUTIONAL
STRUCTURES
Joseph E.
Stiglitz
November 17,
2014
OUTLINE
I. The Current situation
II. Objectives of restructurings
III. Designing a good bankruptcy system
IV. Implications: When will restructuring
help?
V. Reflections on the basic theory—why it
can’t be left to markets
VI. The need for a FSDR
THE IMPETUS FOR A FSDR
 Background: Judge Griesa’s ruling and UN resolution
 Following earlier calls for SDRM by IMF, UN Commission
 Earlier efforts blocked by US
 Some concerns that current efforts will be similarly stymied
 Questions about “underlying political economy”
 Borrowing countries reluctant to show enthusiasm for reform, lest it
provide unfavorable signal
KEY QUESTIONS
Policy questions
 Are there quick fixes posed by these developments? Are the
problems really systemic, needing a systemic solution?
 Could private contractual approaches provide an adequate and
easy solution? What improvements in the standard contracts are
desirable?
 What can/should be done about large body of existing contracts written
under old language?
 Could old bondholders be encouraged/forced to exchange bonds with
new language?
 To what extent can principles that are reflected in good bankruptcy laws
be incorporated into contracts?
 What reforms in domestic law in issuing countries would be
desirable?
 What might a FSDR look like?
ECONOMICS UNDERLYING THE LAW
Answers to these questions need to be informed by analytics
 What are the underlying economics of debt restructurings
 Equity and efficiency considerations
 Why are debt restructurings desirable?
 What are the underlying market failures? Why are market solutions
unlikely to be efficient and fair?
 In what ways are sovereign debt restructurings dif ferent from
private debt restructurings
ARGUMENTS AGAINST NEED FOR FSDR
 There are quick fixes
 Just extend sovereign immunity
 But will they really work?
 Do they address underlying problems?
 Private contractual framework as an alternative
 Just change language of contracts, clarifying pari passu, and using collective
action clauses
 But what about existing debt?
 And will these approaches really suffice?
 If they could, why does every country have a bankruptcy law for private debts
 Sovereign debt restructuring are more complex than private debt restructuring
 It is impossible to achieve a FSDR
 We actually have some incomplete frameworks
 These need to be extended
 There are significant costs to not doing so
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Inefficiencies and inequities
Flow of funds
Timing of restructurings
Cost of restructurings
II. OBJECTIVES OF RESTRUCTURINGS
 Bankruptcy has a central role in modern capitalist economies.
 One cannot imagine a modern economy without limited liability and
the possibility of debt restructuring
 Both ef ficiency and equity dictate providing a fresh start
 As a result of excess indebtedness (as in Europe), there is a massive
waste of resources
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Resources before the crisis are the same as after
Debt is just an obligation
The problem is that there are “excess claims”
In the fight over whose claims will be satisfied resources are destroyed
 This is a distributive battle
 Private outcome may be (is likely to be) Pareto In ferior
 Market equilibrium (flow of funds before crisis; restructuring after crisis)
characterized by market failures
 Coordination failures, bargaining failures, signaling failures
 Even more so in presence of macro-economic externalities—essentially always
present with sovereign debt restructuring
 Part of the explanation for why every government has a private debt
restructuring mechanism (bankruptcy law)
III. DESIGNING A GOOD BANKRUPTCY
SYSTEM
 A system of orderly discharge would more likely lead to more
ef ficient use of resources today
 But if no one repaid debts, debt market would dry up
 Bankruptcy regime attempts to balance
 Ex post efficiency
 Ex ante efficiency (credit assessment, excessive risk taking)
 Efficiency in the restructuring process
 Excessive penalties in restructuring can induce costly delay
CREDITORS ARE TO BLAME
 Creditors are to blame as much as debtors —loans are voluntary
agreements
 Creditors are typically more financially sophisticated —should know how
to assess risk
 Creditors often engage in predatory lending
 In case of lending to sovereigns, problems are even worse
 Often make loans, knowing that there will be IMF bail -out
 Even worse, often make loans to private borrowers, knowing (or at least
hoping) that the private debts will be socialized, and then there will be IMF
bail-out
 In case of loans to poor countries, high interest loans may even displace
concessionary loans
 If projects were good, FDI should be used—lender at risk
 Problem evident in Africa today
 Take advantage of political economy problems
 Those benefiting from loans are different from those bearing cost of repayment
 “Audits” to see what really happened
 Many of debts are “otiose debts”
 But fairness is also important, especially in a world with
predatory lenders
 Who take advantage of those who are financially less sophisticated
 Fraud laws may not suffice
 Creditor equity issue: creditors have (at least partially) been
compensated for risk in form of higher interest payments
 There is not a single bankruptcy code to be packaged and sold
around the world.
 Large differences across countries
 Large debates within countries
 America’s bankruptcy reform was a step in wrong direction, creating
partially indentured servitude, and contributing to financial crisis
OBJECTIVES OF FSDR
 A framework that facilitates the flow of capital in ways which:
 Maximize sustainable growth
 Minimize hardship following crisis
 Include concerns of all, including those within the developing country,
formal domestic creditors, and foreign creditors
 A quicker more certain resolution would
 Reduce risk premia
 Reduce costly delay (problems of asset stripping, deterioration of
value in limbo state)
 Reduce magnitude of macroeconomic disturbances
 Exchange rate stabilization
Objective is NOT to maximize the flow of
capital
 Or even to minimize short-term interest rates – when costs of
borrowing have to be borne by others
 Excess capital flows have contributed to crisis, with high costs
Objective is NOT to maximize income of
intermediaries
SPECIAL PROBLEMS OF SOVEREIGN DEBT
RESTRUCTURINGS
 Legal framework —dif ficult to enforce
 And even more so in an era of privatization
 Judge Griesa’s ruling putting burden of enforcement on financial system imposes
burden which will provide adverse to role of US financial system
 Contempt rulings raise further questions about sovereign immunity
 Fundamental rewritings of understandings of international law
 Not clear who full list of claimants should be
 Implicit versus formal claimants (pensioners)
 Chapter 9 of US bankruptcy code gives weight to these other claimants
 Political economy/agency problems
 Costs of painful restructuring borne by different political actors than those who
create problem (Greece)
 Citizens are made to bear costs of others’ mistakes
 Ireland—bankers and political leaders made mistakes
 Raises issues both of effectiveness of incentives and of fairness
 Issues of debtor moral hazard may not be so important
 Issues of creditor incentives may be more important
 Most importantly, we must distinguish between
systemic/sovereign bankruptcy and “isolated” firm
bankruptcy.
 A default by a single firm does not have macro -economic
consequences
 A default by large number of firms and a sovereign restructuring
typically have significant macro-consequences, especially when
accompanied by exchange rate changes
 In the case of systemic private sector bankruptcies sorting out the
consequences may be difficult
 Which is why there needs to be a special Super Chapter 11, or other broad procedures to deal
with these circumstances
 Debt contracts may have to be rewritten
III. IMPLICATIONS: WHEN WILL
RESTRUCTURING HELP?
 If a country has a primary surplus, it can be potentially better off
if it has a deep restructuring of debt, even if there is a
suspension of credit flows
 Especially if there is Keynesian unemployment
 Money that went to foreign creditors can now be used to stimulate demand
 Especially if the government had borrowed excessively from abroad
 “Optimal” investment going forward may call for no borrowing, and especially
no borrowing from abroad
 Which can impose a high price through multiple channels
 Recent research has shown that there is typically excessive borrowing, and especially in foreign
denominated currencies
 Governments with primary deficits and current account deficits, who lose
access to finance, have to contract quickly (or risk inflationary printing of
money)
 Bargaining power obviously differs in two different situations
 Outcomes in private bargaining more dictated by bargaining power than either
efficiency or equity
EXCESSIVE FEAR OF LACK OF ACCESS TO
MARKETS
 But if the country wished to return to markets, it normally
can
 Markets are forward-looking
 In competitive markets, there is no way they can collectively impose
punishment
 IMF sometimes viewed as “creditor cartel”
 Tried to impose punishment (“Can’t accept yes as an answer”)
 Once debts have been restructured and country grows, it can gain
access more easily
 Prior to restructuring, the flow of money is out of the country, not in
DEBT RESTRUCTURING WITH EXCHANGE
RATE ADJUSTMENTS
 Exchange rate adjustments mark many crises
 There are significant short run costs
 Contracts have to be rewritten
 Distributive conflicts can be magnified
 Bankruptcies can become widespread
SIGNIFICANT BENEFITS FROM DEBT
RESTRUCTURING
 But there can be long -run gains
 Both from the debt restructuring and the realignment of exchange
rates
 “Internal devaluations” are slow and costly; issues of bankruptcy still
significant
 Delay is very costly
 Even creditors can lose from delay
 But private bargaining games often characterized by excessive delay
 Benefits at micro and macro level
 Before restructuring, growth slow, unemployment high, large waste of resources
 Imperative that Central Bank, government maintain flow of credit
 Can be done
IN ABSENCE OF A FSDR THERE IS A
TENDENCY FOR EXCESSIVE DELAY
 Given likelihood of high SR costs (which may cost them their
job), understandable that political leaders try to postpone day
of reckoning: incentives for excess delay
 Which is why an FSDR should not impose excessive penalties on
restructuring—the market is likely to do it on its own—but rather to
provide temporary assistance
 Problems are made worse by investment treaties —lesson of
Argentina is that countries should be wary about signing them
 Little evidence of benefit, strong evidence of high costs
 Recent “trade” agreements trying to extend investment agreements
V. REFLECTIONS ON THE BASIC THEORY
 Economic theory focuses on “equilibrium,” has much less to say
about adjustments, out of equilibrium behavior.
 Bankruptcy largely about “incomplete contracts”
 Risk sharing (equity) contracts would (in absence of information
asymmetries and contracting costs) be better; would avoid bankruptcy
 Government necessarily “completes” contracts—specifies what happens
when creditor can’t pay what is owed; prioritizes different claims
 That makes bankruptcy law political—different laws have different equity
and efficiency consequences
 Some are more pro-creditor, some are more pro-lender
 Pro-creditor laws attenuate incentives for due diligence
 Some put partial blame for America’s mortgage crisis on Bankruptcy Reform Act
 Excessive risk taking encouraged by law giving derivatives priority in bankruptcy
MARKET SOLUTIONS BY THEMSELVES
WON’T WORK (BE EFFICIENT)
 Bankruptcy af fects not only lenders, but also other "stakeholders (large
externalities)
 Signaling problems
Ex ante, contract provisions are used to signal
Again, signaling equilibrium is typically inefficient
With incentive to offer excessively stringent contract provisions
Bargaining models with imperfect information often engenders delay as a costly
signal
 When there are macro-economic disturbances, there are externalities associated
with delay which parties will not take into account
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 Problems exacerbated in political context (sovereign lending), where
government making commitment does not bear costs
 Asymmetric information also leads to contract rigidities —dif ficulty in
moving out of inef ficient equilibria
MARKET SOLUTIONS BY THEMSELVES
WON’T WORK (BE EFFICIENT)
 There are large conflicts of interest among dif ferent claimants
 There are often large disputes about valuations (both of
claims and proposed settlements) and priorities
 Such disputes are a manifestation of imperfect
markets/imperfect information (whole issue of
“liquidity/solvency” reflects dif ferences in beliefs)
 In such situation, there is no presumption that market
solutions will be ef ficient (let alone fair)
MARKET SOLUTIONS BY THEMSELVES
WON’T WORK (BE EFFICIENT)
 There are also important coordination problems across
contracts
 Exacerbated when different debt contracts are written under the laws
of different jurisdictions
 And public good problems—
 Each claimant wants to enjoy benefit of country’s ability to repay
from debt reduction
 But each wants to be repaid in full
COLLECTIVE ACTION CLAUSES DON’T
SUFFICE
 I f t h e y d i d , w i t h i n c o u n t r i e s f o r “ s i m p l e r ” o r d i n a r y b a n k r u p t c y, t h e y w o u l d h a v e s u f f i c e d
 No country relies upon them
Complicated issues of dealing with multiple classes of claimants
 Dangers of majority voting within a class
 If every classes agreement is required, easy for “vulture” to block agreement if there are many
classes
 Majority may have ability and incentive to deprive minority of legitimate claims even with pari
passu clause because of their ownership position on other claims (including CDS’s)
 Problem is exacerbated because of “endogeneity” of voting (ownership shares )
 Even/especially with rational expectations (of a bad outcome )
 Dangers of majority voting across classes
 Risks exacerbated because of likely dif ferences in interests
 Again, majority may have ability and incentive to deprive minority of legitimate claims even with
pari passu clause because of their ownership position on other claims (including CDS’s)
 Separation of ownership and economic interests because of CDS’s has made issues even more
problematic
 And how does one treat “implicit” creditors (social contract) —de facto, under collective action
clause, they would have no voting rights?
 Would provide incentive for governments to give full creditor rights to social security claimants
 But make government agencies fiduciary for those claimants
 But then these might “drown out” traditional creditors
“COMPLETING THE MARKET”
 CDS’s are “advertised” as helping complete the market —but
have failed—but have made matters worse
 “Triggering” event interpreted by secret committee of ISDA that has
representatives of banks that have self-interest in outcomes
 Lack of transparency of contracts have increased financial fragility
and impeded restructuring
 ECB’s insistence that the Greek restructuring be voluntary —paying more
attention to interests of banks than of countries, CDS’s were supposed to
reduce risk, thereby making restructuring easier; have had exactly the
opposite effect
 Over-the-counter CDS’s undermined decentralization of the market
economy and effectiveness of capital market discipline
 Most importantly, have resulted in those having a seat at the table in
debt negotiations having no interest in good resolution —may even
have an interest in “bad” outcomes
 Recent US court decisions have made matters worse
 Interpretations of “pari passu” clause makes debt restructurings
essentially impossible
 Have introduced new level of uncertainty into sovereign lending
 Attempt to use of bilateral investment agreements to enforce
claims may also make matters worse
THE SPECIAL PROBLEM OF VULTURES
 Not really in business in providing credit to countries
 Really engaged in “legal arbitrage”
 Buying bonds in default (or about to go into default) at deep
premium
 Demanding payment in full
 Even though high interest rate reflected risk of not being paid
 Using bargaining power to extract rents —economic extortion,
especially for countries needing to reenter capital markets
 Because of CDS’s, real economic interests in settlement not
clear
 Questioning “good faith bargaining”
 Viability enhanced by successful campaign to eliminate
Champerty defense
 Change in property rights advantaging vultures
 Further “unjust enrichment” through litigation changing meaning
of pari passu clause
IMPROVING UPON THE MARKET
 Trying to do better job at risk -sharing than the market—
through GDP bonds
 For sovereigns, akin to a debt-equity restructuring (chapter 11)
 Align incentives—creditor now has an interest in borrower doing well
 But markets have resisted
WHY COURTS ARE NEEDED
 Necessity of courts to ensure no inef ficient delay
 Necessity of courts to ensure fair asset preservation
 Necessity of courts to coordinate across classes, jurisdictions
 Necessity of courts to ensure reasonably fair treatment of all
parties
 Even when restructuring does not go through courts,
bankruptcy law af fects the outcome of the bargaining
process, which is typically designed to avoid the uncertainty &
delay of relying on courts
REFORMS ARE NEEDED IN NATIONAL
LAWS
 Reinstating some variant of champer ty defense
 Reinforcing long established principle of “unjust enrichment” resulting
from changes in legal framework
 Clarifying pari passu on existing contracts
 Clarifying that creditors have been compensated for risk through
interest rates above T -bill rate
 Demanding transparency on CDS’s holdings of those at the bargaining
table (and their af filiates)
 Extending provisions of Chapter 9 to sovereign debt restructurings
 Encouraging use of GDP -linked bonds as par t of restructuring (similar
to debt-equity conversions under chapter 11)
These reforms could be made even without a FSDR
Coordination among issuing countries would be desirable
Could competition among issuing countries suf fice to bring about these
changes?
 Should countries (like China) aspiring to become global financial
centers be encouraged to adopt these legal frameworks?
CHANGING PERCEPTION ON DEBT
(LEVEL AND FORM)
 Bankers encouraged countries to take on more debt
 Irony is that money is flowing wrong way—from poor countries to rich
 Risk has also been flowing wrong way—poor countries are asked to
bear burden of risk
 Evidence that international capital markets do not work in the way
they should
 Not really improving efficiency of capital allocation
 Financial markets take advantage of lack of sophistication of borrowers,
political economy problems
 And even work to undermine transparency
IMPLICATION
 Countries should be wary about excessive foreign
indebtedness, other than for investment projects
 Especially in foreign denomination
 Less “real” risk in domestic debt, can reflect changes in domestic
circumstances (Korinek)
 Large growth in domestic borrowing
V. THE NEED FOR A FSDR
 There is no orderly process for restructuring sovereign debt
 In Argentina crisis, recognition of need
 But US vetoed discussion
 As a new wave of restructurings appears in offing and in light of
recent US court decision, discussion needs to be reopened
MUST BEGIN WITH RECOGNIZING
LIMITATIONS OF MARKETS
 Design of contracts
 Decision to default
 Outcome of bargaining
 Capital flows (quantities and allocations)
 Resolution of problems which follow from default
Recognizing conflicts of interests, perceptions
 What kind of system might we try to work
towards?
A WORLD BANKRUPTCY ORGANIZATION
 Arguments for an international legal framework even more
compelling than need for Court framework for bankruptcy
domestically
 Potential conflicts over contracts written under dif ferent
jurisdictions need to be addressed
 Existing institutional arrangements inadequate
 IMF too linked to creditors
 Informal arrangements slow and not up to task
 UN Commission called for a World Bankruptcy Organization
A POSSIBLE FRAMEWORK
 Sovereign initiates resolution
 Stay in litigation; provision for lending into arrears
 Temporary exchange controls
 Sovereign proposes a restructuring
A POSSIBLE FRAMEWORK (CONT.)
 Those who believe that proposed restructuring treats them
“unfairly” may submit counterproposals. Such objections and
counterproposals should provide a methodology for assessing
the magnitude of the ef fective debt write -down and an
evaluation of the seniority of dif ferent creditor claims. All
those af fected by proposed settlement would have standing .
 The bankruptcy court (arbitration panel) would rule on the
alternative resolution proposals, giving deference to the
proposal of the sovereign and its legitimate concerns to
maintain the economic strength of the economy in the short
run and the long, and recognizing the claims not only of
foreign and domestic bondholders but also claimants,
including pensioners and workers
AN INTERMEDIATE SOLUTION
But is there something the could work shor t of a WBO ? If we can’t get
the international consensus on a binding legal and institutional
framework?
 Recognition of the impor tance of the imposition of capital controls/exit
taxes in the event of crises that are likely to lead to sovereign
bankruptcy; and provisions for lending into arrears .
 An agreement on “mutual recognition” of the bankruptcy laws of each
other and procedures to resolve jurisdictional conflicts.
 Sovereign would propose a resolution/alternative resolutions.
 An international bankruptcy evaluation/mediation ser vice, which would
help evaluate the consequences of dif ferent proposed resolutions on
dif ferent par ties, on dif ferent categories of creditor s, the government
and the economy, working with sovereign (and creditors) to arrive at
one which is viewed to be “reasonably fair”.
LIFE AFTER DEBT
 Restructuring is costly
 But not restructuring may be even more costly
 Economic theory and experience has shown the advantages of
a timely restructuring and that delay can be costly
 How the restructuring is done has implications for ef ficiency
and equity
 Remember: the financial markets have a vested interest, and their
perspectives have to be treated with caution
CONCLUDING COMMENTS
 There is ample room for improving private contracts
 But the private contract approach will not suf fice
 There is a need to reform of the legal framework within
issuing countries
 Restoring some variant of the Champerty defense
 But neither of these reforms go far enough
 It would be desirable to have a more ef ficient restructuring
framework, a FSDR
 Or, going further, a World Bankruptcy Organization