DRAFT FOR STAFF USE ONLY LDC BORROWING: THE OPTION To REPUDIATE AND DEBT RESCHEDULINGS Sayeed Sadeq (Consul tant) CPD Discussion Paper No. 1984-28 April 1984 CPD Discussion Papers report on work in progress and are circulated for Bank staff use to stimulate discussion and comment. The views and interpretations are those of the authors. Abstract LDC BORROWING THE OPTION TO REPUDIATE AND DEBT RESCHEDULINGS This paper extends the analysis of CPD Discussion Paper No. to a study of possible repudiation of the external debt of countries and the impact on the "value" of debt when reschedulings can occur. It uses options valuation methods to define the claims held by various lenders on the earnings of LDCs. The primary purpose of the paper is to develop a systematic structure, using modern finance theory, with which to analyze sovereign borrowing. The critical role played byoptions (or contingent claims) embedded in country debt is clarified and then used to study the incentives and expected behavior of lenders and borrowers under various circumstances. Factors which determine option values are then shown to determine also the value of the debt to each party. The paper also demonstrates that since lenders and borrowers have the ability to influence these factors, predictable conflicts and concordance can-occur among them under well defined circumstances. Reschedulings are given an options trading interpretation and a clearer understanding is thus provided for what actually occurs when LDC debt is restructured. The knowledge that reschedulings can occur in the future is shown to allow lenders and borrowers to take actions which increases the value of loans to both parties. INTRODUCTION Games played by equity holders and the creditors of a country were analyzed in CPD Discussion Paper , within the context of discount bonds. At maturity date, the debt was fully paid off, if all was well, or if risky, partly paid or not at all. The three-period framework was only relevant in the sense that states of nature revealed themselves, and options to invest in growth opportunities either were exercised or allowed to expire worthless. In this paper, the analysis is further expanded to include periodic debt payments (of interest and/or principal) in addition to discount bonds. Although the main focus here will be on the repudiation option, the problem needs to be set up first with a discussion of how debtor-creditor game playing is restricted. This will help to isolate the repudiation option as, to put it awkwardly, a super threat, the exercise of which damages asset values both for the country and its creditors. The purpose of this paper, therefore, is first to resolve some issues which split the asset value in a way such that one's loss is the other's gain; and then to go on to consider repudiation and reschedulings as joint losses and gains albeit with differential impacts. That a country owns real assets and a portfolio of options is once again assumed. But now the valuation of the various claims on the country's assets depends more on the seniority structure of the claims, rather than largely on the exercise of options. This means that there exists a mutually agreed upon (or understood) order, according to which claimants will be paid off when and if necessary. Behind this seniority structure, however, is A set -2- of restrictive conditions which .the governments of countries are expected to follow with respect to their investment and consumption policies. Now, if government debt were sold on public markets, rather than being largely privately placed, the demands placed by investors on the issuer's available set of policy options would be considerably more restrictive. This analogy with corporate placements of public versus private debt is made because it explains to an extent why most country borrowing has been in the form of commercial bank loans rather than public bond issues. In the corporate world, public offerings of debt securities are commonplace though the largest borrowings are made through private placements. The latter fulfill special purpose borrowing requirements and satisfy a clientele which requires that their instruments be free of the various provisions that accompany public offerings. Of needs, a publicly offered issue must be embedded within a contract which frees the purchaser of the debt from incurring costs of monitoring the issuing corporation to ensure that it does not play some of the games described above and below, which would increase equity value at the expense of debt. Free rider and public good proble..- are obvious in a public bond issue which can have hundreds, if not thousands, of subscribers: no individual owner of the bonds has the incentive to incur the entire cost of moiltoring, for the benefits redound to the rest of the bondholders as well. In the case of a country, syndicated loans, for example, suffer from similar problems. Privately placed issues, however, internalize this problem, for now the monitoring costs and benefits accrue to the same party. Furthermore, debt contracts can be more "personalized" -- that is, the payment structure and terms can be geared to the needs of both the borrower and lender. Freed from -3- the restrictive covenants of public debt, corporations, nevertheless, refrain from policies which hurt bondholders for now the incentives to monitor their actions are not distorted. Therefore, debt can be issued at rates more closely linked to the exogenous risk faced by the corporation and remain free of the endogenous "behavioral" risk induced by public issue. Much of this discussion is directly applicable to the case of country borrowing. It is clearly enormously difficult to place credible restrictive covenants around debt"issued by countries. Not only are the monitoring costs high, the nature of public policy is such that only imperfect signals c&A be gathered as to what the actions (adverse or otherwise) taken by governments really w :e. This information signalling problem adds to the public goods problem mentioned above and the result is that debt cannot be publicly issued, at virtually any price. By no means is this to suggest that credit markets are inefficient; rather, it suggests that market uncertainty can manifest itself in a way that causes the market itself to disappear, or at least to ration out a certain class of customer. Any suggestions that country debt be sold to public holders, thus, is not really reasonable. For were it the best way to do things, it would have been done when a degree of optimism surrounded the entire issue; when things are as adverse as they now seem to be, it is unimaginable that the debt could be sold at any price, much different from zero. The Claim Structure of a Country's Debt: Having put into place some ideas on the nature of the problems associated with what determines the yield (and thereby the value and riskiness -4- of debt), the problem of the various claims on a country's assets is now structured in the fashion of modern corporate finance. Here, the contingent claims analysis suggested previously plays a critical role in defining how the value of the commercial bank debt claim on a country's assets may be determined. In later sections, the analysis will further be extended to link up these valuations with cash flows rather than with asset value. This will allow a more realistic way of thinking about what factors determine the riskiness of debt, but it brings with it a fair amount of complication which arises from defining how these cash flows are correlated over time. In the simplest case, when a corporation defaults on its debt, contractual provisions upheld by national law ensure that its assets are transferred over to bondholders, among whom are senior and junior (and perhaps several more) classes of creditors. These are strict rules that then allow bondholders to recover what they can from sale or use of these assets. Implicitly, ownership of the corporation passes on to the creditors. In the case of a country, this is clearly difficult to envision (except perhaps in a colonial world, or with the existence of gunboat diplomacy), especially when a country can chose to repudiate the debt holder's (commercial bank's) claim. This suggests that upon default or repudiation, commercial banks are left with little - they may seize airplanes, country assets placed aboad, etc, but the value of these is likely to be small. The real factor which keeps countries from defaulting on or repudiating their debt is the expected loss of trade credits, and loss of future access to external borrowing. While stockholders of a corporation are protected by limited liability, the country's residents are protected only to the extent that sovereignty ensures that repudiation is a possibility, which -5- also can be construed as limited external liability. Stockholders, or the equity claimants of a corporation, though, do not face the additional co8t of lack of access in the future to capital markets - a country does. While a corporation disappears after filing under Chapter 11, a country does not. Thus, the important question is -- What is the value of a country's assets if it defaults or repudiates, given these costs of doing so? Once the question is phrased in this way, the structure of contingent claims analysis is again relevant. Consider Figure 1. So long as the country's assets, in present value terms as always, are worth more'than Vf, the debt is risk-free and is worth D as given by the vertical axis. If asset value lies between Vd and Vf, the entire asset value passes to the creditors. At Vd and to its left, even they get nothing. This payoff diagram is relevant only at the maturity of the debt, which is necessarily the starting point for any contingent claims analysis. Clearly, if the value of the assets is greater than Vf the residents of the country obtain the residual, after paying off their creditors. Their payoff diagram then is as given in Figure 4. Terminal payoffs of this kind are only valid under enforceable contracts which determine, ex ante, the values of Vf and Vd. Within the framework of this analysis, however, such contracts do not exist; rather, there exist contracts between debtor countries and their creditors, but certain terms are clearly not enforceable. Repudiation is a possibility. What, then, is the payoff diagram under repudiation? In this case, the entire value of the assets does not pass over to the creditors. In fact, they get nothing. The countty is left with the residual. Therefore, Figure 2 is tranformed into Figure 3 while Figure 1 must be given a new interpretation. -6- Think of the value of the assets of a country as net of the present value of the costs of repudiation. (These costs are stochastic and will later be formulated as such; for the present, however, think of them as known). The diagram does not change, but Vd and Vf are now net asset values. Payoffs which accrue to the creditors are given by the vertical axis. But it is still not so simple: sinde the 450 line between Vd and Vf in Figure 4 defines the value of creditor payoffs when debt is "risky", it depends on discretionary repudiation by the country. In other words, the country sets a threshold proportion ( r ) of asset values which are to be transferred to creditors in certain adverse states of the world. With the assumption that the proportion does not change with asset value, this line is no longer a 45* line, but of slope less than unity. Figure 2, therefore, is changed to Figure 4. This leads to Figure 3 which is now easy to interpret. The sloping line between Vd and Vf is of slope (1 - r ), while beyond Vf, the line slopes up to 45* Again, the vertical axis defines payoffs, this time to the country's residents. Recall, again, that these are terminal payoffs - i.e. valid only at maturity of the debt. Nevertheless, this claim structure of a country's assets defines exactly not only the terminal payoffs, but under some very unrestrictive assumptions the valuation of each claim at any point in time before maturity, in terms of the country's asset value. The theory of options pricing, or in mre general terms, contingent claim pricing, which has received considerable attention in the current corporate finance literature, allows these valuations to be carried out without recourse to any assumptions about the attitudes of the various claimholders towards risk. A following paper, using cash-flows rather than asset values, demonstrates the mathe- matical validity of carrying out such valuations. -7- Finally, consider the claim of the other external claimants on a country's assets - these are official lenders to LDCs and have the most senior claim. Even if a country defaults on, or repudiates, its external commercial bank debt, it, by and large, chooses to continue to pay its official obligations. This is not because, as in the case of a corporation, it is contractually bound to do so; rather, the future costs of repudiating its official debt can be thought of as being ordinally greater than those of repudiating private loans. Figure 5 gives the payoff structures again at terminal dates of official, senior debt; all claims on a country's assets are residuals after this claim has been satisfied. In principle, it matters that the terminal dates, or maturities, be the same for the diagrams thus far presented to "aggregate" into 'a 45* line through the origin - i.e. the sum of all claims on an asset should be the asset's value itself. Although the discussion so far has implicitly assumed this, it is by no means necessary when the generalization is made to valuing these claims at any point in time. This, as demonstrated elsewhere, is possible simply by including contingent claims of various different maturities, exhaustively into the valuation and "adding up" the results. Commercial bank credits and loans can be considered, therefore, as subordinate debt -- i.e. junior debt which has rights on assets only after the official debt has been paid off. This is implied not by contractual provisions, to restate the issue, but simply by the order in which, given some assumptions about the various costs of default and/or repudiation a country will choose to renege on its debt obligations. -8- Some Implications of the Claims Structure: Leave aside for the moment the entire issue of renegotiations under certain states which change the division points (i.e. Vd and Vf) and possibly, the value of the assets of a country (though the structure of the claims does not change). This will be studied in a following section of the paper. Then, the fortunes of a country, i.e. the states of nature revealed at future dates, can cause the value of the assets to rise to arbritrarily high levels or fall to almost nothing. Assume that the value never, in forseeable circumstances, falls absolutely to zero. Although this is unnecessary for the analysis to go through, it is realistic in the case of the country and not in the case of a coproration. Then, the possibility of repudiation and/or default causes the claim structure to take on the shapes in Figures 3, 4, and 5, and it is clear that if the country can influence Vf or Vd, its residents can gain. That is, Vf and Vd will be determined endogenously as part of a solution to a decision problem faced by country's managers, rather than contracted stipulations. As a consequence, debtholders are left at the mercy of a country's fortunes (which they are possibly willing to bear, given the right price, for it is an exogenous risk) and the value of their claim is determined by the actions of its manager. This endogenous risk, which is akin to the moral hazard problem (addressed earlier in the section on growth opportunities) plays a greater role as the riskiness of the debt increases. In the corporate world, various safety covenants are specified in bond contracts, to guard against adverse actions -by stockholders, or managers who are maximizing equity values. 'These include restrictions on dividend payouts, investment policy guidelines, the -9-. issuance of new debt or stock, etc. kAost importantly, safety covenants ensure that bondholders can call bankruptcy on the corporation if it fails either to meet debt payments or is observed to be undertaking actions that signal that the firm is passing value to equity holders at the expense of bondholders (such as selling off assets and using the cash to pay dividends). Such restrictions, in line with the earlier discussion, must be enforceable and the adverse actions taken by the firm must be observable. The structure of claims on a country's assets susggests that a lack of safety covenants and future costs of repudiation would ensure that managers would have incentives to repudiate debt immediately. No debt would b( issued in this case, for debtholders know this will happen. Costs to the country of repudiation are relatively uncertain, and there is little historically to judge these by. Therefore, in order that the seniority structure of claims on a country's assets by maintained, additional covenants are required. The more risky debt is thought to be, the more necessary are these covenants. In this analysis, safety covenants on country debt are interpreted as any restriction debtholders place on what shape a country's economic policy must take. IMF conditionality, policy loans and others substitute for the contractual restrictions corporations tace when they issue debt. The discussion*above places this analogy into perspective for although it is not perfect, the impact is, by and large, the same. What must be clarified is that the reasons why these covenants exist in the first place is exactly those adverse incentives discussed earlier which the claim structure imposes upon those who have an influence on the value of the underlying assets. Further- nore, the conflicts of interest arise not only among equity claimants and deot claimants but also among the various classes of debt claims. The repudiation -1 U- option defines the debt claim classes (i.e. seniority) and in that its exercise or valuation over time can influence who gets paid how much; it defines also when and how conflicts (or convergence) of interest can arise among these claimants. When commerical banks or the I1 or all creditors as a group impose restrictions (or try to do so, anyway) they and the country explicitly recognize how the benefits and costs rrom these restrictions will be shared. A stable set of agreements can only be reached if the distribution of net returns is set in a mutually acceptable way. Countries, therefore, would e willing to agree to restrictions on policy alternatives if it means that in this way their residual asset value increases to a level greater than that they would have remaining if they repudiated. Asset Claims and Options: Repudiation not only leaves the value of loans to banks at zero, it also reduces the present value of the country's assets. The latter, in the sense of availability of access to trade and foreign capital markets is best viewed, again, as a set of options. By repudiating its external debt, a country essentially gives up options on future assets which, while held, are valuable. before repudiation, the country holds many such options that make up a part of its asset value and the ability to give up, or trade, these options afYords the country and its creditors a degree of tlexibility. ;ovenants, in a similar sense, can be viewed as the giving up by a country of its right to undertake certain types of policies which benefit it and redound negatively on its creditors. Think, therefore, of a country option portfolio as consisting of certain right, (out not obligations) and abilities, to undertake a variety of actions. banks realize that a country holds these options and- that there is value attached to them wnich benefits the country. In order to lend for a given term, a given amount at a stated cost, countries are asked to give up, in credible fashion, a set of these options. This immediately lowers the total value of assets, but increases the value of debt claims. The net loss must come from the shareholders or residents of the country. Among the options that a country may be asked to give up, for example, is that of deciding how much current consumption it can undertake, at the expense of investment. The analogy with dividend payments from the return stream of a corporation's assets is obvious: returns from a country's assets can be reinvested or used tor current consumption, i.e., paid out to the country's residents. Going so, however, reduces the value of assets in comparison with reinvestment. Uebtholders, in all states, prefer that the value of a debtor's assets remain as nigh as possible, for if and when it falls below par value of the loans, the debt becomes risky, or ratner, default becomes even likely. Viscal restraint is a common prescription in most adjustment schemes and can be interpreted as the installation of bond covenants. Clearly, reduction in consumption expenditure makes deot safer, and this is oovious; but the analysis suggests that there are good reasons for transferring this value over to debtholders (banks) even at the expense of shareholders (residents). Another restrictive covenant may be that banks, the Iri or both may require that net foreign exchange earnings reach certain levels, i.e., the country must maintain specitied debt service ratios. If exports are largely -12- determined by exogenous factors, this requires that imports be reduced; consumption may have to be steered towards domestic goods and capital goods imports may fall as well. Although the country effectively gives up its option to set its trade deficit where it pleases, the more important impact is likely to be that the import reduction will come largely from restricting capital goods imports. This is clear from the earlier discussions wnere it became clear that, given the ability to do so, countries woula underinvest in tre face of risky debt. No doubt covenants and conditionality can only go so tar. but this interpretation suggests that the effect really is to define the contingent claims which make up the liability side of a country's balance sheet. furthermore, tae analysis suggests that the more important reasons for the existence of covenants are that a "market" for debt is possible (as discussed earlier, when monitoring and uncertainty were discussed) and that the games creditors and debtors play which reduce total asset value, are to an extent, mitigated. Lacking covenants, one would expect that countries would borrow and consume out of debt, i.e., pay out dividends, rather than invest in growth opportunities. This is not to imply a qualitative judgement about what is preferaole, but only that the incentives clearly would bias country behavior towards immediate consumption. Thus, whether the real rate of interest charged on external deot is negative or not and wnether the country nas investment opportunities which yield, in an expected value sense, returns higher than this interest rate, the effect is either to reduce or increase this more fundamental effect. it would then not be a surprise to see that countries with risKy external debt reduce their savings rates and increase consumption, i.e., the consumption function would shift out in the presence ot -13- debt. Now reconsider the claim structure on a country's assets. Contingent claim valuation mehods allow a useful interpretation of these claims as various positions taken in options. Uptions themselves can be interpreted as a special form of contingent claims, and simply by matching asset claim structure to a replicating portfolio of options positions allows each claim to be precisely valued in terms of tne asset value, at any point in time. Unce again, consider the terminal payoff functions as described in figures 1 and 2. (Although the more relevant figures are 3 and 4, they comprise a more complex set of options positions and so will be considered in the following paper in detail.) The equity interest of the residents of the country can be viewed as a call option on the value of the underlying asset base. if this value is greater than Vf at maturity, they pay off their debt in its entirety and retain the residual. When it is lower than Vf, but greater than Vd, they pay off (in this simple sense, where reserved equity value as in figures b and o is not considered) their debt by transferring the assets to creditors. The creditors then receive in return for their debt, wnatever the value of assets is at that time. Clearly this would only happen if this value were less than or equal to the value of the debt. The commercial banks then own a call option with exercise price Vd and have sold a call option to the country with exercise price Vf. They have created what, in the jargon, is called a "vertical spread." It is clearly a hedged portfolio whereby they can lose no more than the value of the debt, but can gain no more either. in other words, they have created a limited liability portfolio. Asset value can clearly go negative, especially when borrowing in involved. But commercial banks, with their spread portfolio establish a bottom limit and -14- in this sense, their loans are similar in effect to equity, when the underlying asset value is between Vf and Vd. Suggestions of converting debt to equity are thereby rendered meaningless for creditors already own partly risk free debt, ahd partly equity; the debt is risk free (and like pure bonds) when asset values are greater than Vf and is close to being pure equity when asset values lie between Vd and Vf. The point is that any options portfolio consisting of the simple options (i.e., calls and puts) can be thought of in this way, that is, a portfolio consisting of (constantly rebalanced) proportions of equity and risk fred debt. Say asset value is less than Vd; then default by the country ensures that commercial bank creditors get nothing. Asset value passes on to the senior claimant, in this case the official lenders. This contingent claim can be represented as a portfolio which consists of "owning" the assets of the country but with a short position (i.e., having sold) a call option, with exercise price Vd to the commercial banks (who in turn have bought this call and sold another to the country's residents). Note that so far the repudiation option has not been considered in this framework. The impact of this option is to change the clope of the line between Vd and Vf as described earlier. How much a country is willing to pay on its debt upon repudiation is represented by the slope 6 which lies between zero and unity. Suffice it to say, at this point, that the impact of this can be represented by a security called a 'warrant'. The valuation of such a contingent claim is quite straightforward, but the methodology is relatively intricate for it changes the distribution of the asset claims. This is left for an accompanying paper. Having placed the various claims on the assets of a country in the -15- framework of options, it is now possible to value each as a relative value, in terms of a country's assets. The important thing to note is that options valuation does not need a general equilibrian framework, and requires only that total volatibility of the returns from the underlying assets be known. There is no need to calculate expected rates of return, nor is there a need to know the covariance of this return with other worldwide assets, i.e., in order to value these claims it is not necessary to know the S of a country's earnings with respect to the rest of the world. The interest of this paper is not in valuing these securities, but in drawing implications for the behavior of the various holders of these option under different circumstances. Although a number of such infrences were drawn earlier, the paper now looks at how the options elements embedded in LDC influence the behavior of countries and lenders when debt becomes (or is viewed as having become) risky. In fact, since this method of looking at country debt allows "valuation" of safety covenants themselves it is possible to gauge how lenders and borrowers would behave when debt is risky under the implied policy restrictions. That is, policy restrictions themselves contribute to how much value is transferred by one party to another and especially when debt is risky, this transfer would influence the behavior of governments. Specifically, they may be induced to repudiate if, uader certain states of the world, the transfer is "too great"; they also would follow investment policy which ensures that the transfer will be reduced in the future. On the other hand, if debtholders call the country in default as soon as an interest payment is missed, they may in fact end up reducing the value of their claim in certain states. There are mutual gains to recontracting which change the total value of the asset, and leave all claim holders better -16- off in an expected.value sense. This is discussed in greater detail below, but first the basis of what constitutes the repudiation option are presented. How this option can be valued and its similarity with other contingent claims is examined and these concepts are later used to see more precisely how the mutual gains from recontracting etc. accrue. Option valuation can also help to decide the split of this gain. This is discussed below as well, but more detail must await some actual numerical valuations. The analytical framework needed to calculate the actual prices of these contingent claims is developed in a subsequent paper. The Option to Repudiate: When a corporation defaults on its debt obligations, its bondholders (and Bank creditors) take over ownership of its assets, in lieu of further contractual payments. Countries, however, hold the right to refuse further payments on their external debt (or at least to reduce them to arbitrarily low levels, or postpone them) albeit at a future cost. There exists presently, no accepted way of transferring the rights to the entire value of a country's assets over to lenders in the event of an exogenously imposed or willful default. Lenders stand to lose the entire outstanding value of -their holdings in a country upon repudiation. The option to repudiate is valuable to the country, in that it allows it the right, but not the obligation, to give its lenders nothing in return for cancelling its external debt obligation, in certain states of the world. Unilaterally imposed revokation of debt will obviously occur when it 'pays' a country to do so, and since there clearly are circumstances in which this would be the case, the option is valuable. -17- When banks make loans to countries, they must recognize that part of what constitutes the value of the loan to a country is this option (among the others discussed earlier). In rational markets, banks will demand a payment as compensation for having 'sold' this option while countries might be willing to pay for it. The risk of a loan to a country therefore, depends not only on exogenous states of nature which can make the assets of a country less valuable but also and upon the value of this option. That is, the riskiness of a loan, over and above the other factors, is embodied fully in the value of the option to repudiate. In order to think about what would constitute this value, think of country borrowivg essentially as bonds bought by banks. Then repudiation is the ability to exchange these bonds (sold by the country), at any time for another asset worth zero. That is, repudiation is effectively the same as buying back the bonds at a zero price, and therefore fulfilling the country's external debt obligation. Clearly, the bank may be loathe to write off its debt, even if this happens, since there is always the possibility that at some time in the future a new management will elect to pay its past obligations (so that it may borrow again on international capital markets). But from the current government's point of view, a repudiation has the same effect as a buyback of its bonds - its bondholders are left with nothing while it gains the nominal remaining principal and bears the costs of loss of ability to trade on credit, lost acceis to capital markets, etc. Whether the country chooses to buy back these bonds at a zero price, or at some other value determined unilaterally, is immaterial. The essential feature is that one can think of repudiation as the option to "call" a bond at zero (or low) exercise price. -18- Corporate bonds often have such a built-in feature; those that have call provisions as they are called, sell for lower prices (all other things the same) than those lacking this option. The bond-issuing firm holds a call option to buy back the bond at a given price, usually for a stated number of years, after which the option expires. In the case of a country, the option expires only on maturity of the debt. Longer lasting options are obviously more valuable for they give the holder more flexibility over a longer period. Thus, the repudiation option on longer term debt is more valuable than on shorter term debt. Furthermore, the more the value of debt, the more valuable it is; again this is intuitively obvious for then it buys back a more valuable asset at zero price. And the more volatile is the price of the bond (think of interest rate volatility which directly links with bond price volatility) the more valuable is this option; it gives the holder flexibility precisely when flexibility is important. These fundamental effects (among others) are used later to derive behavioral implications but do explain already why it is that bonds with explicitly stated call provisions, having reserved some rights for the issuing firm are less valuable to investors - just when they become more valuable (as interest rates change, or states of the world change) the issuing corporation reserves the right to call them back at some lower price. Similarly, think of the banks as private holders of developing country debt. Just as individual investors who hold bond with call provisions demand that they be compensated ex anta for the loss of flexibility, (or transfer of certain contingent claims to the corporation) so do banks. They are not in the market for these loans in order to hand out free options for that would be a losing proposition: rather, the value of the option to -19- repudiate is possibly well recognized, although not explicitly priced, and banks would be expected to demand a payment up front for this option which they effectively have sold to the country. At a zero exercise price, though, it is always more valuable to exercise the option immediately; i.e., the country , it would seem, ought to buy its debt back as soon as. it is issued, thereby repudiating the entire sum. The longer it waits, the more debt it has paid off. But this is clearly not reasonable. The repudiation option would presumably have a cost associated with its exercise, i.e., exercising the option changes the value of the assets owned by the country, since the original value included the expectation that future borrowing would be possible. This is unlike regular traded options and so it must be thought of in a slightly different way. As the debt is paid off, the underlying asset which the country buys back at a zero exercise price drops in nominal terms, for unlike bonds, countries also pay part of the principal on their borrowings. The debt, therefore, is like a sinking fund. However, as time pases, and payments are made, the costs to the country of repudiation do not diminish - whether the country repudiates all or part of its debt, access to trade credits and capital markets diminishes in identical ways. Thus, the option to repudiate, given a constant nominal amount of debt, drops in value over time. Note, however, that if the underlying volatility of interest rates, or its external earnings stream rises, the option becomes more valuable, but this is not time-dependent. Debt capacity in this sense can be interpreted, when the repudiation option exists, as that amount of debt in excess of which it is more beneficial for a country to exercise the option than to hold on to it in the hope that it will become more valuable later - i.e., the point at which the option is worth -20- more dead (i.e., exercised) than alive is a functin of how much debt the country has outstanding. In order to increase debt-capacity, the country must demonstrate in a credible fashion that the value of the repudiation option is such that it pays the country to refrain from exercising it. One way to do this would be to invest in a way such that its future earnings stream is more heavily tied to export markets and export credits. This inreases the costs of repudiation and represents therefore a lowered option value - a credible commitment is always such that the option to repudiate (or expropriate, etc.) moves furLher away from exercise value. This means that the commitment must ensure that the value of exercising the option now rather than later is negative. In the following sections, this way of thinking about riskiness in country debt is expanded to provide a framework for analyzing debt reschedulings. Recontracting, which is what reschedulings amount to, is a way of changing the distribution (and amount) of return streams and asset value such that the option value embedded in each claim is either lowered or increased, depending upon which makes the new contract more sustainable. Repudiation, Claim Structure and Reschedulings: How the value of the underlying assets of a country are to be split up at maturity date of the debt, as described earlier, determine (endogenously. in the case of a country, exogenously in the case of a corporation) the lower boundaries at which the country would default on its commercial bank debt and on its official borrowings. The repudiation option just discussed defines in effect the upper boundary of asset value at which it will pay the country to -21- call back its bonds without compensasting its bondholders (i.e., banks). These boundaries are given by some optimal decision rule followed by the country; the exact points of the boundaries are beyond the scope.of this analysis. In order to value the options discussed thus fare explicit consideration of these boundary conditions will be necessary but qualitative implications can be derived without reference to what exactly the terminal payoffs are. This section is divided into two parts. First since the asset claims structure itself induces the various holders of LDC debt to behave in predictable ways, under the assumption that each is trying to maximize the value of the respective claim, the incentive to gain at another claimants 'expense' is studied. Then, the idea that jointly determined future actions can increase the size of the pie, i.e., asset value, is considered. The cri-ical role that the repudiation option plays is explicitly recognized and treated in an options trading framework where front-end fees and the like are thought of as options prices. Recall that commercial bank debt was interpreted as a subordinated (to official loans) claim. That is, any payment of debt must first be made to official lenders; if anything is left over the junior debtholders have first claim on this; and finally the residual accrues to the country's residents. No,e that this occurred not because of any contractual stipulations but because of the way in,which LDCs would pay off their debt. This structure ensures, however, that like safety covenants, senior or official debt is more valuable than an equal proportion of an undifferentiated debt issue. Intuitively, the debt is safer because it must be paid off first - as part of an undifferentiated debt Issue it would have to split with the rest of the -22- bondholders. If official creditors gain because of the claim structure, someone must lose. Since commercial banks recognize that such a seniority structure exists, they demand to be compensated for the subordination of their claim with perhaps a higher interest rate. If the debt is properly priced, the cost of this feature must be borne by the country itself. Given any asset value therefore, the claim structure ensures that the country will bear the cost of transferring some risk away from senior bondholders to commercial banks, so long as it holds the option to repudiate its junior debt. If it is willing to commit that repudiation will not involve a complete loss, part of the gains from subordination that an official debtholder enjoys will be paid by commercial banks. This is because now the commercial banks hold partly equity (as discussed earlier) and must share in the costs of the covenant. This essential characteristic of subordinated debt, or the type of debt held by commercial banks, gives it properties quite unlike the standard garden variety bonds. Because commercial bank loans can be considered as a portfolio of two call options, one long and the other short, it is possible that the value of the loans at any point can be an increasing function of the volatility of the underlying assets returns. Recall that option values unambigously increase with this volatility since they are protected on the down side; any increase in the variance of the price of the underlying asset will increase the likelihood that the option will be more valuable) and so if the call option held long is more elastic with respect to variance than is the one held short, this result will obtain. However, senior debtholders only hold a short position in call options; this means that under certain circumstnces, the debtholders as a group will exhibit conflicting interests -23- with respect to changes in the country's investment policy. While commercial banks may occasionally want the country to invest in risky projects, offical lenders never will. Note also that if the elasticity of the short call option implicit in the commercial bank debtholding is greater, with respect to volatility than is the elasticity of the long position, the interests of both commercial banks and official creditors will coincide; i.e., both will want the country's managers to invest in less risky investments that the managers themselves wish. These implications which are relatively clear in an options framework are not obvious lacking contingent claim analysis. Furthermore, note that in the context of the framework as it has been set up, official debt is never worthless. Countries always have an incentive to pay as much of it as is possible. Commercial bank debt, though, under repudiation (or under exogenous default) can become valueless. At maturity, so long as asset value is non-zero, official creditors get something while commercial banks get nothing - the country simply sells off its assets, pays the resulting cash to official creditors and commercial banks are left with nothing. Consider what commercial banks in this framework (and not official creditors) would want to do. The best lenders with senior status can do is to call default and take over all the assets of the country. The best junior debtholders can do is to extend the maturity of their debt. This increases the value of their long position in the call option; since they are more senior in claim than the country itself, barring repudiation, they gain because there is a non-zero chance that states of nature will occur which make their claim regain some value. As it stands they get nothing; if they extend the maturity of the debt, they stand to gain. The latter strategy dominates. Commercial bank debt in this situation has a value which behaves -24- much like the value of equity claims. There is no need to "convert" debt to equity; when it gets risky, it is equity. Consider now debt which has periodic interest (and possibly principal) payments. When any one of these payments is missed, the debt is theoretically in default. In this situation, banks can either consider the debt as having been repudiated or try and force the country to sell off assets to repay the debt in full. If the latter were an enforceble penalty, or if the costs to the country of repudiation were high enough, the country would always prefer to make the payment rather than suffer the costs of failure to do so. On the other hand, the maximum value a lender's debt can take, at any point in time, is the value of the assets. If default implies that full restitution be made to the lender, then that is the best possible postion, under the circumstances. Under corporate law, this is precisely the structure of incentives. For a country, however, the lender also loses upon default or repudiation. Therefore, there are mutual gains or losses to making or missing a payment, which is quite unlike the corporate case. Corporations often end up in bankruptcy even when there is substantial value left in the underlying assets, for the inteests of bondholders are to call default as soon as it seems to become a possibility. Quite the contrary should be expected to occur in the case of a country - when it seems as if a payment may be missed, there should be a wild scramble to renegotiate the contract in a mutually beneficial way. But how is the next payment to be made? Clearly, assets must be sold as international markets, or reserves must be drawn down (which is exactly akin to the sale of equity for reserves are like retained earnings and retained earnings can be distributed to a country's residents or used for -25- investment purposes, just as proceeds from a sale of equity can) or further new borrowing must be undertaken. By and large, the sale of assets to make the next interest (plus principal) payment is not in the interest of creditors or debtors - it unambiguously reduces the value of assets in place, thereby increasing the probability that debt will again become risky in the future. The status of the new borrowing, in terms of its claim structure then becomes important. So long as commercial bank lenders do not have the right to manage a country's assets they would insist that any new debt be subordinated to their own. But, consider the case where the new debt is issued by the same commercial banks. Here, they are indifferent about the subordination issue, for they hold both claims, old and new. But who gains from the new debt issue? Clearly, the official lenders gain, for their debt is now safer. The country loses, for the value of its residual claims is now subordinated to an even greater amount of debt; it loses less than under default or repudiation, however. And the commercial banks it would seem, are left indifferent. But in the case of a country, this is not entirely right. There are mutual gains from increasing the value of a country's debt in such situations for the resulting new borrowing can be used to make the upcoming payment. Since commercial bank debt has embedded within it, a call option as does the resident's claim, the increase in time to expiration (till the next payment date) adds value (the worst that can happen is that the next payment will not be made, but then debt is no worse off, while if the state of the world improves, it could be better off). This gain does not come free, however. Something must be given up, and this leads naturally to the next part of the analysis where the repudiation option is once again considered and an explicit description is given of reschedulings. -26- In order to lead into the analysis of debt restructurings, note that in all the cases analyzed above, the senior claim holders, i.e., the official lenders always gained by new debt-issues that were subordinated to theirs, so long as the country did not increase the riskiness of its investments. But this is the critical issue. By taking adverse action on its investment decisions, a country can most heavily influence the value of the highest priority claim - it is the only claim that holds a short position in options. No doubt, the impact on commercial bank debt can also be negative, but as described above, the interpretation of this lendig as a "vertical spread" position in options implies that the banks. are partly hedged aga.nst such adverse actions by the country. In essence, the country can choose to take the most volatile of its investment options, and exercise these. This means, that given a choice among investments of say, similar net present value, it would be induced to choose the most risky ones. This point has been discussed earlier, and is a direct consequence of the fact that the residents claim is fundamentally a call option on the value of the assets. If the volability of the return stream of the investment option is high enough, it may in fact pay the country to-invest even in negative NPV projects. Clearly, since the senior claim holders, (i.e., official banks) tend to lose the most in this case, they would be most vigilant in keeping track of a country's policies. Not only that, if and when the commercial bank debt become risky (or the country came close to missing a payment), it would be in the interest of official creditors to step in and impose conditionality. That is, it is not just that official creditors have, in a sense, more 'clout' with countries (because countries have more to lose when official debt is called in default) but that it is in the best interests -27- of the official holders of country debt to take r:?ttrictive action. A priori, one would then expect that restructurings, and restrictions placed on how a country goes about financing its debt payments would come first from official lenders, purely because of self-interest. The amount of official lending as a proportion of a country's total external borrowing may be small, but as a proportion of the creditors lending may be quite large - they stand to lose, especially in the case of some Latin American countries, a substantial proportion of their total assets. Furthermore, these senior creditors would also be expected to resort more to safety covenants and policy restrictions on their loans than would commercial bank lenders. In other words, the push for "policy" loans and 'structural adjustment' loans would come from official creditors not simply because these are in the best interest of the country, but because such loans place implicit and explicit restrictions on how a country may invest and how it may finance its external obligations - and this benefits largely these creditors themselves. Any such restrictions on policy that a senior debtholder can convince a subordinated debt claimant to impose on its borrower country redounds mostly to the benefit of the former. Of course, in certain circumstances, as discussed above, it increases the value of the commercial bank claim as well; when these interests coincide as they could when the debt becomes risky, one would expect the formation of a coalition among senior and junior debtholders to protect their claims. Risky debt in the sense in which it is used here means that the country comes close to exercising-its repudiation option. At the margin, as conditions worsened for a country, the costs of repudiation at this point seem not so large in comparison with the -28- costs of continuing to pay off the debt. Banks then face two choices - either let the country repudiate and lose the remaining face value of their loans, or recontract in such a way that the probability of repudiation diminishes. Repudiation is an option, and it will only be exercised if the value of doing so is positive for the country - i.e., when the benefits exceed the costs in expected value. As such, it has, at each point in time, a threshhold value, called the exercise boundary beyond which the option is better left alive for it still retains the possibility of increasing in value. Intuitively, this exercise boundary is simply a relationship between value of debt outstanding, its time to maturity, the expected costs of defaulting and the underlying volatility of the country's earnings stream which defines the benefit-cost difference in present value terms. If the value of the option is less than its exercise value, it pays to exercise it; otherwise, it pays to keep it alive. Lenders realize that this option value changes both with the amount of debt outstanding and with the time left to maturity. At any time when the value of the option falls below its exercise value, it is in the interests of both parties to push it back up - the country again holds a more vtluable option, the bank's debt is no longer valueless. How might this be done? Note that the fundamental issue here is to exchange one option for another. That is, the current repudiation option, if below exercise value, has a high probability of being exercised, while a new option with a different time to maturity and a different underlying asset value can be constructed such that it is worth more alive than dead. Since thus far, the option to repudiate has been thought of as a call option, it is immadiate that increasing the amount of.debt (i.e., changing the exercise -29- value of the option, and the current value of the option) has an ambiguous effect. (Although this can be settled unambiguously by looking at some more detailed analysis of options valuation, it is beyond the scope of the present paper). Nevertheless, changing the nominal value of the debt, changes the two- values by different amounts - in fact, the option value is more elastic than is the exercise value of the option under conditions where the option value is close to exercise value. Thus, increasing the debt amount, which is exactly equivalent to delaying one (or more) payments reduces the chances that the option will be exercised. Note, furthermore, that the option to repudiate will only be considered'for exercise at or just before each payment due date. There is no sense in exercising it just after (for then it should have been done before, and the payment need not have been made) not is there reason to repudiate in between payments - there is always the (non-zero) probability tht the state of the world will change in favor of the holder of the option during this time. Lengthening the maturity of debt unambiguously increases the value of the option and thus one would expect that part of the recontracting negotiation would increase the average term 6f country debt. Taken together, these two choices could benefit both partiP - but again the split in the benefits need not be symmetric. The country now has a more valuable option, in that if it chooses to repudiate immediately after the recontracting, it would retire a higher debt value at zero additional cost. Therefore, it would seem that if the.renegotiaton were to result in the country receiving this new option free of charge, it is getting something for nothing. This would not be a stable situation in which to bargain. It therefore must be willing to pay something for the exchange of these options - this can be interpreted as the -30- net difference in price between the two options. A rescheduling fee can be interpreted as just such a mechanism. The repudiation option can be exercised at any time, and simply increasing the margin over Libor (or the U.S. prime) does not constitute a credible scheme by which banks can collect the option premium - it must be paid up front. A front-end fee, before any new loan is made, can be thought of in a similar fashion. The repudiation risk is embodied in the value of an option and value this option has at time of negotiation must, in equilibrium, be paid up front. If the debt could only be repudiated at maturity (for example, a discount bond with no regular interest and/or principal payments) the implicit interest rate charged could reflect the repudiation risk. Clearly, this cannot hold true with interest paying (and sinking fund) instruments which carry with them not just the potential risk of default, but also that of repudiation. -31- Va"ue of commercial bank loans D-- Vd V Asset Value Fig.1 - Note: The sloping line is at 450. Also, the payoffs (vertical axis) as represented here occur at maturity of the debt. -32- Value of residents claim (equity) Vf Value of Assets Fig. 2 Note: This diagram represents payoffs at maturity of debt. -33- Value of resident claim l-e - -450 1-8 45/ Vd Vf Value of Assets Fig. 3 Note: Residual value accruing to country, at maturity of debt, under potential repudiation. -34- Value of commercial bank loans e v d vValue of Assets Fig. 4 Note: Value of commercial bank debt at maturity, under potential repudiation. -35- Value of official loans V Value of Assets Fig. 5 Note: Again, these are terminal payoffs. -36- REFERENCES Black, Fisher and J. C. Cox, "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions", Journal of Finance, May, 1976. Fischer, Stanley, "Call Option Pricing When the Exer-ise Price is Uncertain and the Valuation of Index Bonds", Journal of Finance, March, 1978. Kharas, Homi, "Constrained Optimal Borrowing by LDCs", Domestic Finance Study, p. 75, The World Bank, 1981. Margrabe, William, "The Value of an Option to Exchange One Asset for Another", Journal of Finance, March, 1978. McDonald, Donogh, "Debt Capacity and Developing Country Borrowing: A Survey of the Literature", IMF Staff Papers, August, 1982. Myers, Stewart C., "Determinants of Corporate Borrowing", Journal of Financial Economics, November, 1977. SSadeq:mec