Lounge readers have no doubt followed the Eurozone's recent travails with interest. Below is a guest post from Mitu Gulati on one of the recent fix-it proposals: Collective Action Clauses. At the height of the Greek crisis, we featured many posts from both Lounge regulars and guests on the European financial crisis, which are collected here:
Numerous press reports tell us that the French and Germans have arrived at a solution for the Eurozone’s woes. Bonds issued by Eurozone nations, in the future, will contain “Collective Action Clauses” or CACs. Essentially, these are clauses that help coordinate bondholders; that is, solve collective action problems. In effect then, we are being told that the sovereign debt problems in the Eurozone were, at least in large part, caused by a failure to coordinate bondholders.
So, what do the typical CACs do to solve the coordination problem? In their most basic form, they set up a mechanism by which the debtor can ask its bondholders for a modification of the debtor’s obligations. Typically, either in a meeting or via a written solicitation of votes, the debtor can obtain relief if it can persuade a supermajority of bondholders (typically 75%) to agree to restructuring. Individual bondholders cannot block the deal; in effect, a supermajority of creditors can force a deal on the others. The supposed magic here is that if the private creditors themselves give the debtor financial relief – and this is the big payoff that the politicians in Germany and France are trying to sell their voters – there will be no need for the type of bailouts that we have seen for Greece and Ireland (and maybe now Portugal and Spain).
There are two surreal things about the foregoing. First, it is not at all clear that there has been the slightest bit of evidence that there was a coordination problem among the holders of the Eurozone debt in the first place. Indeed, if press reports are correct that most of the debt in question is held by Eurozone banks, then coordination should not be that difficult. Plus, we know that the ECB, via its big purchases of Eurozone sovereign debt in recent months is likely one of the biggest holder of this paper. If anything, as compared to many prior sovereign debt restructurings, it should be relatively easy to coordinate the restructuring of a Eurozone sovereign such as Greece or Ireland. The second bizarre aspect of this is that no one seems to be bothering to ask whether the contracts for Greece and Ireland (and, in the future, for Portugal and Spain) already contain these magical Collective Action Clauses. If they did – and we are fairly certain that their external debt instruments did – then the question is why they were not used. After all, presumably the reason we (and the German and French taxpayers) are being told that CACs are needed is that the old versions were tested out and turned out not to work. Plus, when these new clauses were put in place in 2003-2004, for both sovereign issuers in the U.S. and Europe, they supposedly were the solution to precisely the type of problems that we are facing now. And Belize does appear to have used these CACs successfully in its restructuring in 2007.
Perhaps policymakers will come up with some story for why the existing clauses were flawed. But the fact that they didn’t even try them out makes that story more than a trifle implausible.
-- Mitu Gulati