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Delusional lawyering won’t save European bonds

Mocking the delusions of US populism has been easy work for journalists. Now it is time to do the same for European elite opinion. Lately, I have been coping with the sheer tonnage of bank and law firm research on redenomination risk.

This refers to how European sovereign bond investors should prepare for the risk of one or more eurozone countries readopting national currencies. Would another paragraph of lawyering do the trick?

To me, this seems like preparing for a giant meteor strike by packing another pair of socks. Yet we are seeing just that sort of thinking in the market’s pricing of European bonds.

The magic lawyering in European sovereign bonds is supposedly provided by the Model CAC, for Collective Action Clause, that has been incorporated in all eurozone sovereign bonds since January 2013.

The Model CAC was a post-Greek crisis bit of language that says any hypothetical restructuring of bond payments can be agreed by a supermajority of 75 per cent of bondholders.

At the time, this was considered a way to avoid allowing a few evil New York hedge funds to profit by refusing to take a haircut like nice regulated Europeans wanted. Not that any other European countries would ever “do a Greece”.

Except that now leading national candidates in France and Italy are openly proposing a return to the franc and the lira, at least for paying foreigners and distant institutions. Nothing would happen to voters’ savings, those candidates tell us, just as their counterparts in Argentina told that country’s voters over the years.

Some of the bond market’s lawyers believe that if such a candidate is elected in either France or Italy, they will not be able to pay the national debt in depreciated francs or lire, at least for those bonds that incorporate Model CAC’s.

The assumption is that more than three-quarters of bondholders would vote against confiscation and the new populist government would have no choice but to pay in full in euros.

The problem with this logic is that most of the older French and Italian bonds were issued without CACs, and the post-2013 bond issues that include these clauses are all governed by national law.

Any French or Italian government that chose to switch the national currency could also just retroactively change the bond issues to either remove the Model CAC language or otherwise render it ineffective.

Despite offering only evanescent protection from a populist redenomination, French and Italian bonds incorporating Model CACs have been outperforming comparable older bonds, at least for shorter maturities.

According to the economics group at ABN Amro, the Dutch lender: “The outperformance of [French] Model CAC bonds started in the autumn of last year, in which the French elections moved more to the headlines and radar of investors.”

Similarly, in Italy, the ABN Amro researchers added: “The outperformance of Model CAC bonds is also found in Italian sovereign bonds . . . as also here the Eurosceptic party MS5 has signalled [it will] possibly convert the euro into a new currency.”

There is no such relative outperformance of German, Belgian or Spanish bonds that have the Model CACs, since the market’s pricing is apparently driven by algorithms that count headlines about currency redenomination.

But this is delusional. All of Europe would be a mess.

Lee Buchheit, the eminent sovereign debt lawyer, says that with or without these clauses, “an abrupt redenomination would risk chaos”. Look at Argentina in 2002.

“Were a large eurozone country to redenominate unilaterally, it would shake the foundations of the monetary union,” he says.

The key legal point is not which clauses are in the euro sovereign bonds, but whether the bonds are governed by “local law”.

In the case of an Italian exit from the euro, Mr Buchheit says the collateral value of bonds governed by Italian law would collapse. This would prompt the European Central Bank to tell the banks to top up their collateral, but they would not be able to.

Mr Buchheit says: “The Italian legislature may have the power to redenominate the currency of bonds governed by Italian law. But exercising that power abruptly would have many unintended consequences. For example, the value of Italian government bonds pledged as collateral could collapse, resulting in margin calls that Italian banks would struggle to meet.

“To do this in an orderly way would probably require the imposition of capital controls. If even a rumour of a coming redenomination were to leak — and how could it not leak — euros would begin flooding out of the country.

“The only solution I can see would involve a reprofiling of Italian government debt, extending all maturities by, say, five years with a coupon adjustment. That would have to be accompanied by a fiscal adjustment program. The theory is that the government could use the resources saved during a five-year debt service holiday to restart growth. A simple reprofiling, with no haircut to the principal of the debt, might give the banking system a fighting chance of survival.”

Even if Italy’s unsustainable debt burden is magicked away for a few years, the country still has a competitiveness and growth problem. Any “reform” programme requires a rapidly ageing population to remake itself like the characters in a vitamin-supplement advert.

Or Italy could devalue its way into competitiveness and full employment. Would France follow? I do not know, but I do know that the market’s fixation on fine points of bond language is pointless.