Greece Needs Another Bailout; EU Needs a Bankruptcy Law

"If you borrow one million dollars, the bank owns you. If you borrow one hundred million dollars, you own the bank."

Greece and the Eurozone are squaring off again, in what has to be the most widely predicted, exactly on schedule, third round of a sovereign debt crisis in the history of finance.

Greece's newly elected, ultra-left wing Syriza-led government is gearing up to demand that the austerity measures they "agreed to" - while standing on the business end of the Eurozone plank - be scaled back, and the 2010-2012 bailout packages be "renegotiated." The very real threat is that they will default on their ~300 billion of debt and loans - which are ~80% owned by European official institutions, ergo the Eurozone taxpayers - unless that debt is significantly written down.

Some ECB and European officials, for their part, are threatening to drop Greece from the Eurozone if they default, roll back austerity measures, or continue to lag in implementing the structural reforms and privatization of government assets as agreed to in 2010 and 2012. The cohesion of the European Union and the stability of the euro are again going to be tested in the coming months.

There is a lot of blame to go around here, and it's been covered ad nauseum in the financial press since the crisis originally broke in 2009. There are many excellent sources where you can read about it in as much detail as you can tolerate. I'm not going to rehash it here.

What interests me is that this bailout merry-go-round has reignited fervor - primarily from the IMF and their economic and political agenda sympathizers - for the establishment of a global sovereign bankruptcy regime. I don't think we need (or want) a global bankruptcy authority, but the EU could sure use an EU-wide sovereign bankruptcy law. Despite the fact that the EU could not legislate such a law in the short-term, if the EU agrees with the purpose and goals of bankruptcy, then they could hopefully find their way towards taking a significant haircut on Greece's debt and perhaps help them reformulate some of the austerity measures.

Legal Issues

(1) There is no such thing as a sovereign bankruptcy. That is, currently there is no international law, court or organization that has been granted power and legal standing by the global community to resolve sovereign defaults, or determine and enforce terms of sovereign debt restructurings.

In the US, bankruptcy law is federal law, and individuals, partnerships, corporations and municipalities can file for bankruptcy protection under various chapters of the bankruptcy code.

A fundamental goal of the federal bankruptcy laws enacted by Congress is to give debtors a financial "fresh start" from burdensome debts. The Supreme Court made this point about the purpose of the bankruptcy law in a 1934 decision: "It gives to the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt." 

This goal is accomplished through the bankruptcy discharge, which releases debtors from personal liability from specific debts and prohibits creditors from ever taking any action against the debtor to collect those debts. 

The are very specific rights and protections provided to debtors and to creditors under the US bankruptcy code. Generally speaking, the provisions of the bankruptcy code allow a debtor to renegotiate contracts, refinance or extend the terms of existing debt, reduce principal and interest payments, and be discharged of some debt obligations. Municipalities, in particular, have considerable leeway in bankruptcy to re-write collective bargaining agreements and renegotiate pension liabilities and other benefits packages.

Caveat: There is no chapter that permits a state to declare bankruptcy, primarily due to Constitutional issues of state sovereignty.The EU would no doubt have to navigate a similarly difficult path if it were to contemplate drafting such a law.

(2) Contract law - particularly bond contract law - is the de facto legal resolution mechanism or guide in the event of default, or when debt is restructured to avoid default. 

Since there is no sovereign bankruptcy law or enforceable process, historically sovereign defaults and debt restructurings have been worked out privately and "voluntarily" between debtors and creditors, subject to the provisions and protections spelled out in sovereign bond contracts, bank loan agreements, and terms and requirements embedded in government loans, e.g from the ECB and IMF.

This can increase the complexity and terms of a broad-based debt restructuring, because the contract law that prevails changes materially depending on where the debt originated. For example, in the case of Greece's first bailout, the Greek sovereign bonds issued in US dollars fall under New York bond contract law; those issued in London (and possibly in Europe in euros?) fall under English law; Greek domestic debt is governed under Greek constitutional and contract law.

The Greek restructuring of 2010-2012 was still accomplished, but it required some legal and economic creativity. Excerpts from The Greek Debt Restructuring: An Autopsy, by Zettlemeyer, Trebesch and Gulati (edited for brevity):

The Greek debt restructuring of 2012 stands out in the history of sovereign defaults. It achieved very large debt relief – over 50 per cent of 2012 GDP – with minimal financial disruption, using a combination of new legal techniques, exceptionally large cash incentives, and official sector pressure on key creditors. But it did so at a cost. The timing and design of the restructuring left money on the table from the perspective of Greece, created a large risk for European taxpayers, and set precedents – particularly in its very generous treatment of holdout creditors – that are likely to make future debt restructurings in Europe more difficult.

There are entire areas of bond contract law that seem to have become uniquely relevant to sovereign restructurings and defaults in general, and the Greece bailout in particular. These include collective action clauses (CACs), exit consents, and the rights of holdout creditors. I'm not going to belabor it (for now) but these are among the issues providing great motivation and some traction to the IMF, et al, who would like to usurp the jurisdiction of the New York and EU courts and become the global sovereign bankruptcy resolution authority.

Sovereign debt crises and defaults are commonplace. 

Sovereign debt crises and defaults have occurred with stunning regularity over the centuries, and have increased in frequency in the past 200 years. From Debt Defaults and Lessons from a Decade of Crises, by Sturzenegger and Zettelmeyer (excerpts from chapter 1, edited for brevity):

Debt crises and defaults by sovereigns—city-states, kingdoms, and empires—are as old as sovereign borrowing itself. The first recorded default goes back at least to the fourth century B.C., when ten out of thirteen Greek municipalities in the Attic Maritime Association defaulted on loans from the Delos Temple (Winkler 1933). Most fiscal crises of European antiquity, however, seem to have been resolved through ‘‘currency debasement’’—namely, inflations or devaluations— rather than debt restructurings. 

Editor's note: Historically, many sovereign defaults were also mediated by the creditor country, um, invading that of the debtor. Britain used to be particularly fond of such "resolution mechanisms".

Defaults cum debt restructurings picked up in the modern era, beginning with defaults in France, Spain, and Portugal in the mid-sixteenth centuries.

Only in the nineteenth century, however, did debt crises, defaults, and debt restructurings—defined as changes in the originally envisaged debt service payments, either after a default or under the threat of default—explode in terms of both numbers and geographical incidence.

There have been hundreds of defaults and debt restructurings involving privately held sovereign debt since the early nineteenth century. In some cases, these were a reflection of the tumultuous political history of the period: the by-product of wars, revolutions, or civil conflicts that made debtor governments unwilling or unable to pay. Some countries defaulted after losing wars; others defaulted after enduring major civil wars.

As it turns out, the majority of defaults and debt restructurings involving private debtors that have occurred since the early nineteenth century—including almost all that were experienced since the late 1970s—do not, in fact, belong to this category, but reflect more subtle interactions between domestic economic policies and shocks to the economy, including changes in the external environment and sometimes, though not always, political shocks.

Where does this leave Greece and the euro?

So, sovereign debt crises and defaults are increasingly common. There is a larger base of private investors whose influence can be contentious. Sovereign debt issuance is often in multiple currencies and across financial markets, expanding the legal regimes that need to be crossed. All of which was expertly and perhaps luckily navigated - tadaa! - in the case of Greece's original bailouts.

The Eurozone and the IMF have forced drastic austerity measures on Greece but the ECB did not participate in the haircuts on Greek debt in 2010-2012 along with the private creditors (there were good reasons for it at the time). Greece has plunged into recession, cannot deflate its currency to get out of it, and cannot enact expansionary fiscal policy in the midst of severe austerity. Yes, they ran up an insane amount of debt and they did this to themselves. But you have all come to the same crossroads. It's your money or your union.