Choice-of-Law Clauses in European Sovereign Debt
All is proceeding as my colleague Anna Gelpern has foreseen. Indeed. Years ago, she mentioned to me in passing that the markets seemed remarkably unaware, or anyway remarkably sanguine, about the question of whether local law (e.g., Greek law) or foreign law (e.g., English law) governed as the choice-of-law clause for the vast tonnage of European sovereign debt. Today, we find the Greek government passing retroactive laws imposing collective action clauses and aggregation mechanisms on the very large proportion of its sovereign debt governed by Greek law.
Was this possibility priced into the bonds? Or correctly priced-in? I myself find it hard to believe that it was, though without any evidence to speak of. But there are two excellent papers on these topics by Stephen Choi, Mitu Gulati, and Eric Posner that bear reading. The first, last updated in March 2011, is “Pricing Terms in Sovereign Debt Contracts: A Greek Case Study with Implications for the European Crisis Resolution Mechanism”; the second, posted November 2011, is“Political Risk and Sovereign Debt Contracts.” (Thanks to commenter from my last sovereign debt post for reminding me of these.)
But one of the reasons for my (unsupported) intuition about pricing choice-of-law terms in European sovereign debt is simply my perception that the market (up until the sovereign debt crisis hit the newspapers) consisted of people for whom the issue was fundamentally interest rate risk, not credit risk. So I was interested to see this post today at Zerohedge, attributed to Hypo Capital Management. Ordinarily, I find Zerohedge a bit too edgy and conspiracy-theory oriented for my taste, but if the folks in this guest post have done the work they report here, I think it is quite interesting and important.
HCM say they have managed to walk through a sample of individual sovereign debt issuances, looking at debt covenants and choice-of-law clauses particularly, comparing local law and foreign law issuances. They then plot these as yield-to-maturity against maturity, separating the local and foreign law-governed bonds to see whether there is a separation, for Greece, Italy, and several others. Thus:
We did the unthinkable, read the unreadable and made it back alive to tell the tale: we ploughed through all of the individual bond prospectuses of our favorite list of countries in peril and actually found a lot of useful information for the investor. Given that the sovereign bonds of the Eurozone used to be looked at as riskless assets, it is safe to assume that the exercise hasn’t been done by a lot of investors on a regular basis. Judging by the difficulty to even obtain the information, both the interest of investors to obtain it and that of issuers and underwriters to provide it has been and remains extremely limited. [Emphasis added]
Well, good for them. (I’ve since spoken with some market friends who tell me that others are busily doing the same exercise, but I don’t know what conclusions others have reached and haven’t had time to look.) The countries they looked at were Greece, Portugal, Italy, Austria, Hungary, and Spain. And their conclusion is, excepting Greece, there remains a potentially significant mis-pricing of sovereign debt, because prices continue to reflect the assumption that there is no important divergence created by choice-of-law clauses in the debt. Which is to say, no political-legal risk in the countries listed above, apart from Greece, running to debt governed by local law rather than foreign law. Which is also to say, the assumption of the markets continues to be that (excepting Greece) pari passu means pari passu:
In our view, the state of the crisis warrants a broad-based significant markup for investor-friendly prospectus language and we see trading opportunities in most of the countries we analyzed …. Establish selective long/short pair trades in maturity-matched foreign/local bonds, or go long foreign law bonds and hedge via CDS.
I have not tried to reproduce their graphs here; you can see them at Zerohedge. Their broader comment is worth reproducing, however (emphasis added):
Relative illiquidity and low issuance sizes distort yields and spreads. Investors traditionally shunned foreign law bonds and piled into local law issues. This may seem puzzling at first glance, given the duration and severity of the crisis. We attribute this to the investor base: their thinking remains entrenched in traditional categories, namely interest rate risk as opposed to credit risk. Only when the threshold is clearly crossed -as in the case of Greece- does duration-based pricing make way for default-based pricing and a different investor base takes over. When Greece lost its last IG rating, it disappeared from the universe of EZ government bond managers and entered the realm of HY bond investors. Thus credit criteria began to matter and were being priced in. In our view, the state of the crisis warrants a broad-based significant markup for investor-friendly prospectus language and we see trading opportunities in most of the countries we analysed.
I am not sure I understand – or agree – with all their thinking here, however. They say that investors shunned foreign law bonds and instead bought local law bonds. Is that what the evidence (see their charts at ZH) or their deductive argument suggests? It seems to me they argue that investors had reason to be, and in fact were, indifferent as between legal regimes governing the bonds. That does not alter the conclusion that there might well be a mis-pricing opportunity as between foreign and local law bonds, but I don’t see that it arises strictly from a preference for one over the other, rather than indifference.