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Friday, December 30, 2011

Bond financing versus loan financing

Very little discussion has taken place so far on the difference between bank loans and bonds as instruments for raising public financing. In times of difficulties, it makes a huge difference whether a borrower's debt takes the form of loans or bonds.

Loans 
A loan is a private contract negotiated between lender and borrower. All conditions in the loan agreement can be "tailor-made" to suit the needs of both lender and borrower. Above all, the interest rate can be negotiated freely between borrower and lender (i. e. it is not forced upon them by “market conditions”). The loan agreement stipulates the conditions which must be fulfilled prior to disbursement of the loan as well as the conditions which must be fulfilled during the life of the loan. It also stipulates what happens if those conditions are not fulfilled. There are no "automatic bankruptcies". Before default occurs, both lender and borrower have it under their control to take measures to cure it. Even if default has already occurred, the lender can chose to delay declaring it until the borrower has cured it. If a default cannot be cured but if neither lender nor borrower seek bankruptcy, they will consensually amend the terms of the loan agreement.

Bonds
A bond is a public debt instrument designed to be sold to institutional or private investors and, as a general rule, it can subsequently be traded. Thus, the terms of a bond are dictated by what potential investors require and they can only be minimally "tailor-made" to the needs of the borrower. This applies to documentation and, particularly, to the interest rate. The terms of a bond are worked out between the borrower and the manager of the bond (or a group of managers; typically investment or commercial banks) based on what they deem the "investors' appetite" to be. If their assessment of investors' appetite is correct, the bond will sell well. If they are mistaken, they will sit on the bonds: their role changes from "arrangers of financing" to "investors". 

Once a bond is sold to investors, what began as a relationship between borrower and manager turns into a relationship between borrower and investors (i. e. the bond holders) and it becomes anonymous. Even though the bond managers know who the investors are (because they transfer interest to them), they are not allowed to reveal their names to third parties. The terms of the bond cannot be amended later on because there is no one with whom an amendment could be negotiated.

If all of Greece's debt had been loans...
... then it would have been the most natural thing in the world for Greece to call all her lenders to a bankers' meeting and to present the need for an amendment to loan agreements (i. e. a rescheduling of maturities and a resetting of interest rates to levels affordable by Greece). Most likely, one would not have rescheduled all of Greece's debt but, for instance, only the maturities of the next 3-5 years; possibly by disbursing a new loan to refinance those maturing loans. The lenders would have elected among themselves a Steering Committee with which Greece would have negotiated. If handled well (i. e. keeping up the appearance of voluntariness and consensuality), the banks would not have needed to write-down any of their loans (not to even mention a haircut). 

Who should be the purchasers of bonds? 
Contrary to popular belief, it is NOT one of the principal roles of banks' to finance governments; least of all foreign governments. The principal role of banks' is to finance the real economy. Regrettably, banking regulations (Basel-II) have incentivated bank lending to governments (because they were deemed to be risk-free and required no reserves) over bank lending to the real economy (which is not risk-free and requires reserves).

Sovereign debt tends to take the form of bonds because the idea is not for the managing banks to hold them on their books but, instead, to sell them to investors (and make money through the arranging and selling fees). Banks should be lenders and not investors. Potential investors for bonds are private individuals and those institutions which manage funds for long-term returns (insurance companies, pensions funds, etc.).

Banking regulations (Basel-II) have turned this principle upside down!

Why do governments prefer bonds as debt instruments?
Because bonds are - in good times - an easy way to raise funds in large amounts and with bullet repayments: invite banks to make pitches; award the mandate to one manager or to a group of managers; negotiate more or less standard documentation and pricing with few people; and --- off you go and, before you know it, you have perhaps half a billion Euro in your bank account repayable in one sum at some distant point in the future. No further dealings with your "lenders" until maturity (provided that interest is paid on time). 

One bank alone will hardly make a loan in the large amount of a bond. Thus, a syndicate of banks must be formed which means that documentation and pricing must suit the needs of many lenders. Also, once the syndicated loan is closed, the assets have to stay on the banks' books. Loans are usually structured with instalments (instead of one bullet maturity) which means that there is a more frequent need to refinance maturities. Most importantly, banks who make loans want to "stay in touch" with their borrower during the life of the loan. The borrower is continuously "bothered" by wishes from his lenders "to stay in touch".

What are disadvantages of bonds?
Like with any other public debt instrument which is traded, a bond is a rather standardized "product" which has rather standardized features (tenor, interest) so that it can be traded easily. Consequently, there is virtually no flexibility during the life of the bond: either its conditions are complied with or it goes into automatic default. 

In times of difficulty, a borrower might publicly invite all bondholders to a meeting but the smart ones will stay home because they have nothing to gain from it. The very large bondholders (banks, insurance companies, etc.) can, of course, be "forced" to identify themselves and they may not have a choice but to agree to attend a meeting to renegotiate terms as the case of Greece has shown but no one can be forced to agree to new terms. And a small family office which holds, say, 1 MEUR of Greek bonds will completely ignore any such moves. They will simply hold on to their bonds knowing that with their piece of paper they could trigger default and cross default on the whole sovereign debt of a country if they didn't get paid on maturity.

What are possible conclusions from the above?
While it is the most natural thing in the world for banks to sit down with the borrowers of their loans in times of difficulty to renegotiate the terms of the loans, when they hold bonds they can "hide" behind the structure of that debt instrument. They can argue that, while they would be happy to renegotiate the terms, they legally can't because it would be construed as a default. That threat of uncontrolled default puts banks in a position where they can argue that "someone else" should make sure that the bonds get paid. 

When "danger is at hand" (like in the case of AIG when commitments fell due within days), that "someone else" has virtually no alternative but to succumb to that blackmailing.

With sovereign bonds, there is never "danger at hand" because one knows way beforehand when they mature, and they don't mature as frequently as commitments of players in money markets. Thus, one has plenty of time to exercise pressure. Should "danger at hand" come up (because, for instance, some maturities come up), the "someone else" can decide to cover those maturities, but only those, until an overall solution is found.

The overall solution must be guided by the principal of lending, i. e. "risk takers must remain risk carriers". Large institutions can be held accountable for adhering to that principle. Smaller institutions (like, for instance, the family office of a private investor) may have to be given preferential treatment as the price for keeping the overall problem under control.

What are counter-arguments to the above?
The principal counter-argument is that sovereign bonds have to be risk-free because otherwise the existence of the bond markets might be threatened. Anyone making this argument in Economics 101 will flunk the course!

The only sovereign bonds which are risk free are the bonds of sovereign nations which can print the currency in which their bonds are denominated and where the bonds are subject to their laws (i. e. US Treasuries). Every other sovereign bond has some form of risk (credit risk, currency risk, or otherwise).

When Joseph Ackermann stated in a CNBC-interview that "measures must be taken that sovereign loans are made risk-free again, which is what they should be!", the journalist should not have nodded understandingly but, instead, returned the following question to Mr. Ackermann: "If that is so, Sir, why are sovereign bonds rated differently in the first place?"

This has nothing to do with the Euro-structure, with a central fiscal policy (or not) or whatever. Federal States of the USA do not borrow at the same rates because they represent different risks. When California can't pay her bills any longer, she has to do something about it because she can't print US dollars. Only bonds of the US Federal Government are risk-free because it can print the currency in which they are denominated. There is no Eurozone government which can print Euros!

Things get out of control in capital markets when the reallocators of funds take unwise decisions on a massive scale. The solution to that is not to have those reallocators take even more unwise decisions. Instead, they - and their funders - have to take losses so that they learn from the experience. That is not a "destruction of markets" but, instead, a "readjustment of markets to reality" which assures that, going forward, markets will act more wisely. In the long run, markets cannot ignore reality!

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