Will bondholders be asked to share pain?
When President Obama’s deficit-reduction commission this week unveiled its proposals to bring the government’s mushrooming debt under control, it cited the necessity of “shared sacrifice.” In other words, pain all around.
One group, however, wasn’t asked to sacrifice anything: the people and institutions to whom the debt is owed.
The idea that America will pay its creditors 100% of what they were promised is a bulwark of the global financial system, of course. Nobody would seriously expect the deficit commission to suggest that Washington should consider an alternative approach.
Yet as countries and their states and municipalities worldwide face up to the bitter reality of deleveraging — working down the mountain of debt and pledged entitlements built up over the last 30 years — bondholders increasingly may find themselves with targets on their backs.
That could be unnerving for the many Americans who have shifted much of their savings to bonds over the last two years, trying to earn decent interest income while seeking a relative haven from the vagaries of the stock market.
Public anger already has boiled over in Greece and Ireland, both of which face economic austerity as the price of European Union bailouts that are intended to keep interest and principal payments flowing to bondholders.
Significantly, those bondholders include European banks that could have their net worth obliterated if they were forced to suffer massive write-downs of the sovereign debt they own.
“So the message to the people is, ‘You have to have a miserable life for 20 years to pay back our banks,’” said John Taylor, head of FX Concepts in New York, the world’s biggest currency hedge fund.
Since 2008, American taxpayers have become all too familiar with the strategy of using public funds to prop up banks. That’s what the TARP bailout was about. It’s also what the Federal Reserve’s 2-year-old policy of zero short-term interest rates is about: Many banks take consumers’ deposits, pay virtually nothing on them, then simply invest that cash in Treasury bonds at higher yields.
And why not? It’s still unthinkable that the U.S., though the world’s biggest borrower, would actually default on its $13.8 trillion in outstanding bonds. Nor is there a reason to do so as long as the government can print more money to meet its debt obligations.
But in Europe, the unthinkable has become thinkable. Pushed by Germany and France, which fear they’ll bear the brunt of the costs if more euro-zone governments need bailouts, European finance ministers this week agreed to a plan under which private bondholders could be forced to share the pain of any restructurings of sovereign debt issued after July 2013.
In effect, the plan puts investors on notice that they can’t count on perpetual help from the rest of Europe if struggling countries’ debt woes persist. Bondholders might have to agree to a moratorium on debt payments or face permanent cuts in interest or principal payments.
But by lending Ireland and Greece more money now, the rest of Europe is digging deeper holes for them, perhaps all but assuring that bond buyers after July 2013 would face the prospect of losses.
That line-in-the-sand approach “obviously doesn’t make any sense,” said Simon Johnson, an MIT finance professor and former chief economist of the International Monetary Fund.
“If in 2013 they’ll have too much debt, then they have too much now,” he said, given that the austerity programs forced on any bailout recipient are likely to make it extremely difficult for its economy to grow significantly if at all.
At bond fund titan Pimco in Newport Beach, Chief Executive Mohamed El-Erian said his firm isn’t tempted to buy Irish or Greek bonds despite their depressed prices and high interest yields.
He thinks it’s time for European leaders to admit that the Continent’s weakest states face “not a liquidity issue but a solvency issue.” And the permanent solution for a solvency issue is to reduce the debt that’s at risk — as General Motors bondholders found out the hard way if they failed to anticipate the company’s 2009 bankruptcy.
Within Europe, “in a wider policy debate, debt restructuring would be considered as a possible preemptive option rather than a disorderly inevitability,” El-Erian said.
It isn’t as if the world hasn’t seen this before, and survived it. In fact, as Carmen Reinhart and Kenneth Rogoff showed in their 2009 book “This Time Is Different,” sovereign defaults have happened with relative frequency over the last eight centuries.
Argentina is the most infamous of recent cases, defaulting on $83 billion in bonds in 2001. That followed Russia’s default in 1998. In 1982 Mexico defaulted, ushering in the “lost decade” for much of then-debt-burdened Latin America.
When Reinhart and Rogoff looked back further, they found that Spain defaulted seven times in the 19th century alone.
Although forcing bond investors to absorb some of the cost of saving a country from financial ruin has understandable populist appeal — “shared sacrifice” — it also can worsen the country’s economy if much of the debt is held by its own people, banks and pension funds. Their interest and principal losses would mean there is that much less to spend or invest.
That would apply particularly to municipal bonds and their investors. If a rash of California municipalities were unable or unwilling to pay their bondholders, the effect would be to drain spending power from thousands of Californians who own those securities.
That is a key risk of any widespread debt write-down in the fragile U.S. economy: It could help fuel a deflationary spiral as investor losses further depress spending and tax revenue, in turn making it harder for more municipalities and companies to service their debts. Not to mention what it would do to investors’ and creditors’ willingness to lend money.
Could we get to that point? Realistically, it would take another devastating plunge in the economy. And even then, the Fed and the Treasury could do what they’ve done for the last two years: just keep papering over debt problems by printing more money.
Indeed, many investors who are nervous about bonds are focused not on the potential for actual defaults but for de facto default: Historically, the easy way for governments to cure a debt problem has been to stoke inflation, which is good for debtors — and ruinous for creditors, because they’re paid back in devalued dollars.
And if market interest rates rise with inflation, owners of older debt face the double whammy of declining prices for their bonds.
The message in Europe’s latest debt crisis and in the U.S. deficit commission’s report is that the need to deleverage is taking on a new urgency.
Creditors are always supposed to be vigilant about the debtors they’ve financed. Newbie bond investors need to remember that they are creditors.
