Defaults

Recently we have heard a lot on defaults and I have also written that default is a possible solution to a financial crisis for a country. But as Ryan commented on the previous post my description was quite short. In this post I will expand on the the principles of defaults.

As I described before, defaults can be divided up in two kinds orderly and disorderly: an orderly default is simply the country agreeing with the owners of its bonds not to pay them in full or on time or both. In contrast a disorderly default is a country unilaterally giving the finger to its bondholders and not paying its bonds at all.

Why can a state actually disorderly default? If it does, won't it violate its contracts? The answers to this problem is that if the bonds are hosted under the law from that same state, the state can alter the law so that it won't really violate its contracts. To default disorderly a state just declares the bond contracts void. In the case of an orderly default the country offers bondholders the ability to exchange their old bonds onto new ones(with less principal or more maturity or both) which are treated differently. It will then still declare the old bonds void. There are some entities (appropriately named vultures) which buy up these void bonds and try to get money out from the issuing state, some times that works, some times it doesn't (Cuba is the main case here)

As I described in the previous post, the state is usually more interested in the orderly default since that will still retain some credibility on the financial markets. Since the country is usually in a crisis when defaults occur it could be of a great value to retain the possibility to borrow money (be it against usually extortionate rates). The second reason is that orderly defaults prevent creditors from seizing the assets of the state that are abroad. Finally disorderly default usually create all kinds of chaos that will seriously harm what's left of the economy and society (see Argentina in 2001, another episode from the Dutch show tegenlicht deals with it).

You could wonder why bondholders would agree to an orderly default, after all they have a contract with the state to receive the full amount on the bonds. The reason for this is the possibility of the disorderly default.They agree to be paid less with more certainty, than being paid in full with almost no certainty. The increased certainty can come from another country/entity guaranteeing the payments (as happens in the Greek case, it is not the bond holders but that entity that is demanding the reforms) or by putting the bonds outside of the countries borders. Often countries with less credibility opt to host their binds in New York or London so that the bonds are hosted under the law from the USA/UK.

The situation that then appears is similar to that of the battle of the sexes ( a game similar to the prisoners dilemma). The real question in these games is the preparedness of one player to wreak havoc, the more likely you are to drive of the cliff, the more likely it is that the other party will settle with you on favorable terms. Therefore a state should negotiate with absolute disregard for the economic consequences of disorderly default. I know it sounds strange but that's the world we live in.

Another problematic thing with defaults and negotiations to prevent them is the shear amount of actors involved in them. Here is a list of likely actors involved in any deal: The state, large social actors within that state (unions, employers, state companies etc.), the banks with bonds (most likely also within the country), other bond holders (pension funds, hedge funds etc.), foreign governments whose banks and funds hold bonds, trading partners, maybe courts that are abroad and of course the citizens of the the defaulting state. A Reuters blogger has a nice video on the main actors involved in Greece ( It has also a pirate boat :-)).

Finally, throughout history people and governments have made two big mistakes when it came to defaults. The first was that it doesn't happen to us/ the people we lend money to. And the second one was that a default means the destruction of a country. Both of which are almost always untrue: In the book this time it's different the authors describe how almost all countries (and yes that includes the US in the 1970s by some measures) have defaulted one way or another in the last 200 years. The second thing is that defaults even disorderly ones can be better on the long term than muttering along in a bad situation that is not going to improve with a large debt burden (see also my previous post). It seems that the Europeans have finally understood that with Greece.