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When in Default, Do it Right: Ukrainian Competence versus the Insane Clown Posse

Ukraine’s "history with a twist" means a resolution quick off the mark and sharp is the action.

Greece’s "game-theory-you-to-death" opening is at once screamingly funny and somewhat chilling.

Default is a normal, though painful, part of financial life. It starts when a potential debtor meets a creditor. A courtship ensues, often resulting in a debenture of some sort—a committed relationship. Sometimes the relationship is too one-sided: Borrowers often prefer to borrow more than they can afford. Sometimes, creditors get greedy take the borrower’s terms, thinking with something other than their brain. When the borrower’s debts become greater than they are able or willing to pay back, then the commitment is tested. Sometimes the terms are restructured to better reflect the painful realities of the relationship. Sometimes the finality of default and wind-up breaks the relationship.

For countries, the matter is a bit more complicated. The complicating factor is that many countries issue their own currencies and raise much of the finance they need in that currency. And in those cases, default is often disguised through devaluation, allowing the relationship to continue on based on altering appearances. This is actually a new way of doing things.

For most of financial history, countries have borrowed in currencies backed by the promise of redemption in gold or silver (in China it was copper). As long as the promise was kept, a metal-backed currency is not something that a country can create on a whim. If the country owned a big silver or gold mine then they had more latitude, but currency issuance was still fundamentally constrained. Rulers did have the option of debasing their coinage but the action, unlike today, was viewed as an explicit signal to not lend to the sovereign. So what was intended to be a temporary stay of execution really accelerated default because a sovereign could roll their debt at any interest rate.

History seems to be repeating itself in many emerging market countries. There is an increasing move back towards external debt—where countries borrow in currencies they do not print. These USD (and to a much smaller extent EUR, samurai, and Dim Sum) bonds are the rule because a country typically can’t sustain a credible currency without a sufficiently deep domestic capital market to meet their financing needs.

Sovereign debt always depends on both ability and willingness to pay. It also depends on the ability and willingness of creditors to realize losses. Debtors need to show leadership by being honest about their unfaithfulness and compromising in seeking out a sustainable deal for itself. Nothing crazy, nothing flashy, no stunts. Especially no studied airs of game-theoretic pretense—as if that will get you anywhere with a banker holding at your balance sheet. Creditors need to be forgiving and compromising because it took two parties to create a bond baby.

So Ukraine and Greece both have to go the hard way of history. With a twist: modern capital markets allow the ability to hedge credit exposure through synthetic instruments. Ukraine approaches their default indiscretion capably and competently, understanding history with a twist. There is direct simplicity there that expresses the significance of the everyday living reality. Greece has chosen a route of pretending, ineptness, and academically missing the point. There is no place in a debt rework for rockstars, or the academic equivalents of the same. It takes a cool head and steel nerves.

Ukraine’s approach to restructuring feels like how an accountant would do it and has a correspondingly hard edge. Not sure how much of the rework will be in terms of principal reduction, and how much will be in terms of maturity extension, but the combination of the two appears to be the selected tactic. And the settlement will be agreed upon by May 2015 or the haircut will be steep and recovery poor. Oh, yeah… one other item. Ukraine considers the $3 billion owed to Russia essentially a personal, not official loan and thus not subject to IMF conditionality requirements. This is a clear message to Russia: restructure on our terms or we give you nada and call it war reparations.

Meet key player Mr. Michael Hasenstab. He manages the Franklin Templeton Global Income Fund, ticker GIM. This fund reportedly owns about $1 billion in Ukrainian cash bonds at face value. Note two things: 1) this paper was likely bought at a steep discount to face, and 2) this $1 billion notional figure will be restructured down. So it is tough to know the realized loss, but it will be significant. Not so much in terms of total fund AUM, but it terms of loss write-off, it is big. I do not have access to their trading book, so what follows merely speculates on his possible courses of action in the face of default/restructuring.

This tough situation means that bondholders eat losses one way or another and the modern twist creates some market anomalies worth considering. In terms of market action, this week Ukraine 5Y CDS spreads hit 3885 bps—call it 39% premium, roughly. The corresponding 5Y cash bonds trades at 3066 bps—call it 30% yield, roughly. This is a 900 bps basis. This is pure market speculation on recovery prospects. If you sell CDS and collect the premium, you receive the cash bonds under contract, pay notional face, and get recovery value on the bonds. The basis is saying that protection requires 900 bps on top of the arbitrage-implied premium.

So if you had a big position in Ukrainian sovereign bonds and did this twelve months ago, it might have made sense to collect premium on the synthetic and coupon on the cash bond. Depending on the discount off par you received, you might have turned out bruised but not crushed. If you try it now, you are going to lose. Restructuring will be completed by May. At this point, don’t like the terms and you will lose. It’s that hardball.

If you had a big position in Ukrainian sovereign bonds, the other possibility is to hold the cash bonds and buy protection on it at the outset. In this case they received cash bond coupon, paid CDS premium for the protection, and are now just waiting for default to come so they can deliver their defaulted paper into contract and get cash settlement at face value. Most likely you did not buy protection at the first hint of trouble and instead has to pay premium at or in excess of the coupon. Note the 900 bps basis.

There is a rational explanation for that 900 bps basis called the volatility risk premium. This premium is an observed regularity that shows realized (the actual observed) volatility is nearly always less than the option–implied volatility. This is the same thing as saying people can imagine the worst and they are willing to pay extra to prepare for the worst even if it doesn’t come. Here the worst is a restructure offer going bad and losses forced on bondholders that would imply a recovery expectation markedly less than the 40% where cash bonds are pretty much priced.

There are other less influential but still plausible explanations for the basis. The 5Y sovereign CDS could be used as an imperfect proxy hedge for Ukrainian corporate of financial paper. Just because everything is priced for default and there is no other hedge. I would suggest sell, but whatever. The bottom line is that history with a twist means a resolution quick off the mark in sharp lines. This is not a bad thing. It will make creditors more careful and thoughtful in future relationships and making future bond babies. And beware hedging as a substitute for prudence.


Greece joined the same global retreat from sovereign currencies as Ukraine with the launch of the euro in 1999. While this retreat definitely drives imminent Greek default, it is not real culprit in any sense. The blame lies entirely on unsustainable debt taken on by a borrower and reckless creditors.

A Greek default will not be the end of the euro or the EU. The Asian crisis of 1997 shows that a Greek default would create some buying opportunities, but markets would get over it and stronger credit-worthiness would in time succeed in turning the tide. The EU has real assets and earning power. Most of them can pay all their debts. And all of them can pay most of their debts. The EU countries may have big competitiveness and government parasite problems, but they are not a house of cards. A bail-out would make it almost inevitable that weaker credits would continue to borrow more than they can afford—making matters worse for both Greece and other countries in the EU. Ultimately, voters in Germany and other more solvent EU member nations will be unwilling to support unsustainable public spending. Greece has more debt than it can afford and it should get on with restructuring it.

The Greek leadership has damaged their country's restructuring effort because it is taking a bad tack: a game-theoretical one. The main line here is a literature-supported strategy which I refer to as (trying not to laugh here) “commitment to crazy”. The thinking is the more crazy one’s terms are—not just unreasonable, but full-on crazy—at the outset makes the final outcome more favorable to you. It’s like saying to a bank who owns your mortgage: “I have a decent arsenal of weapons at my disposal, including a mini-gun. I want you to write-off my loan.” I’m being egregious only to make the point. But to think that the effect in sovereign debt will amount to any better outcome than in the case of a mortgage is flat-out wrong.

Even when used in the proper context, the overall effect is at once screamingly funny and somewhat chilling, reminiscent of a B movie. At best it makes the negotiation difficult because you look like you don’t know what you want. Most likely you look like a clown that doesn’t know what you are doing. At all. At worst your creditors take it personal and walk out literally wanting to see you bleed out on the floor.

The problem is that game theory is a closed system played in sequential time, or one-, two-, or small finite-periods. There are too many clouding factors to get a clear bead on how someone will react to crazy, especially if they see you as being not honest and direct, but in bad-faith. You see, a creditor, be they sovereign or not, can’t go around looking like a chump. Ever. They will have to kick you to the curb to show others they are not to be trifled with.

Unfortunately, there was no consideration for this reality in the Greek case. They waffled from “we are going to default outright if we don’t get a 50% write off” to “we have a detailed plan we will share to work with our European partners (which they never had)” to “we demand war reparations for WWII damage in addition to what we have already settled on decades ago”. How witheringly stupid they have been.

So Greek has only four possible tools at their disposal now: devalue the currency, cut spending, turn to other governments for a bail-out, and default. The first option is not available. They have made by their approach any bail-outs politically impossible for the bailers. Spending cuts are inevitable of course, but to do the full work would set the country back a couple of decades. Sooner or later, default is inevitable. Bad-faith negotiations just make it uglier.

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