Chronicle of a Debt Foretold

Policy Paper
May 2, 2011

Today’s debt crises among European sovereigns and US underwater mortgage holders both have much in common with a similar chronicle of debt foretold a decade ago.

In March 2001, not even a year before Argentina devalued its currency and stopped paying its foreign obligations, it was clear that the country was headed for disaster. Despite an IMF bailout package only months earlier, its benchmark bonds were trading at well under 80 cents on the dollar and yielding more than 900 basis points over US Treasury bonds, reflecting investors’ lack of confidence in the country’s finances. Its debt was rising faster than its ability to pay. With the peso’s value equal to the U.S. dollar and fully exchangeable by law, Argentina could not jumpstart growth by devaluing the currency.

With consensus growing that Argentina could afford no more than 70% to 80% of its current debt level, a small circle of courageous thinkers proposed a pre-emptive default. Charles Calomiris, the main architect, understood that the longer Argentina was saddled with an unmanageable debt, the worse off it—and those to whom it owed money—would be.1 He and others recommended that Argentina press for a deep restructuring under which creditors would forgive 20% to 30% of principal, which not coincidentally was about the amount that would get Argentina’s debt back to a manageable level. The new debt would be structured so that the faster Argentina’s economy grew, the more it would pay the bankers. In other words, the creditors would come to resemble equity holders who shared risk and reward. Argentina would pay more when it could most afford to—instead of under the current arrangement, when the less ability it had the more it was forced to pay.

Many bankers privately concurred that such a move was Argentina’s best—perhaps only—chance to turn around the crisis. Publicly, however, it was a political impossibility. No bank wanted to be the first to agree to part with what it was owed. The rest, of course, is painful history.

Despite the strong case that a smaller haircut earlier on would have prevented much bigger losses within months, the banks kept funneling money to Argentina. The combination of underwriting fees and the high interest rates on the new bonds only made the problem worse.2 In Fall 2001, a bank run forced the government’s hand; as Argentines demanded dollars, the government limited withdrawals and eventually broke the dollar peg. By the time Argentina’s only option was to default, foreign creditors ended up losing two-thirds of the money they had lent. This was more than twice what they would have lost in a pre-emptive default.

Argentina missed an opportunity by failing to pursue a seemingly radical but utterly sensible proposal: in effect, a stitch in time that could have saved nine. Argentina’s fate offers both a cautionary tale and a way out for today’s distressed debtors, particularly US mortgage holders and European governments. It also raises questions about how to emerge from a stalemate. 


Today’s Challenge
The challenges facing Europe and the United States are strikingly similar: debt that is widely recognized to be unsustainable; a relative lull following a wider financial panic; and an opportunity to rein the problem in before a new crisis ensues.

In southern European nations, where high debts have created a vicious spiral, preventing the kind of growth that would lift them into fiscal safety. Rescue packages for Greece (€110 billion in May 2010) and Ireland (€85 billion in November 2010) did not completely calm the markets, with good reason: the bailouts did not fully address the underlying problem of unmanageable debt levels.

As long as a country’s interest payments rise faster than its economy grows, it will be caught in a downward spiral whereby the debt overhang slows growth, and slow growth makes it harder to pay down the debt. Carmen Reinhart and Kenneth Rogoff have argued that when a country’s debt level rises above 90% of national gross domestic product (GDP), it slows economic growth by a median of one percentage point and by even more on average.3 Other researchers have suggested that the negative effect may kick in at as low as 70% to 80% of GDP.4

Italy, Greece, Belgium and Japan5 are well above the 90% threshold. Several other countries, including the United States, Portugal, and Spain, are in the 70s and 80s. Since the United States and Japan both have their own currencies, they have the option of using monetary policy to boost growth and exports. Both have done so. But the troubled European debtors, as part of the euro area, do not have that option.6 The result is pressure calling into question the future of the euro itself.7 The risks of failing to address the crises in the European sovereign debt market and in the US mortgage market are high. The economic troubles in Europe have implications not only for the futures of the highly indebted countries, but for the entire euro area –and indeed, for the future of the common currency.

In the United States, similarly, the stakes are high not just for the debtors and creditors in question, but for the knock-on effect of the housing market’s troubles on the US economy as a whole, where a drag on growth hurts the country’s revenues and fiscal balance. Roughly 11 million homes, or nearly a quarter of US mortgages representing $751 billion in negative equity, were underwater in the last quarter of 2010.8 These distressed mortgages are dampening the real estate and construction sectors, on which the broader economy relies. As long as distressed US homeowners are forced into foreclosure or short sales, the housing market will continue to stagnate, homeowners will hesitate to spend, and the economy will feel the effect. Until mortgage holders write off debt to the point at which homeowners can afford to live in their homes, the housing market will remain in the doldrums. Reducing the debt load would put a floor under the housing market and help the economy recover.

In both the European and US housing cases, the question is whether to attempt to muddle through, prolonging and possibly worsening the total impact of economic damage, or to find ways to dramatically reduce the debt overhangs in both the US and EU, ripping off the Band-Aid to allow healing, if you will. 


In hindsight, Argentina’s bondholders would have been better off with a solution earlier on. Ireland and Greece, both having received large recent loans, are in straits very similar to Argentina’s: suffering deflation, unemployment, and unrest. Their bailout packages, similarly, may end up being not necessarily a day late but definitely more than a dollar short.

If a debt restructuring and reduction is the answer, the challenge is how to make it acceptable to creditors. If the obvious solution was not politically palatable in 2001, why would it be any more so in 2011? What mechanisms could make it possible for an orderly debt restructuring to happen?

In 2001, the International Monetary Fund proposed creating a sovereign debt restructuring mechanism using the IMF’s articles agreement to give it legal force. Balking at the idea that the IMF as senior creditor—and thus not a disinterested party—would play such a leading role, the US Treasury and several private groups weighed in suggestions including the greater use of collective action clauses in sovereign debt contracts.9 Since then, European governments have embraced the collective-action clause approach to debt restructurings.10

In Europe so far, the discussion has focused mainly on whether private bondholders will share the losses of any future problems; it has danced around the question of whether private creditors would share the pain if existing debt were to go under. Germany continues to insist that private bondholders assume some of the risk, though it softened its stance in 2010 as part of negotiations to provide support to Ireland. As part of that deal, European governments agreed to create a new debt restructuring mechanism by 2013. But 2013 is not soon enough; investors expecting the possibility of a default two years from now would simply demand higher yields, accelerating the day of reckoning and intensifying the damage.

Plans to replace the existing €280bn ($396bn) European Financial Stability Fund with a €500bn European Stability Mechanism would still not be enough should problems spread more widely; Spain’s national debt is approaching €800bn, and Portugal’s is around €150bn. What is more, continued bailouts risk inflating moral hazard: creating perverse incentives for both borrowers and lenders to engage in risky behavior.11 And, as the Argentine case showed, they do not always succeed. In Europe, a failed bailout would be catastrophic politically in Germany—the country that is anchoring the euro area and whose taxpayers already have grumbled over the call for them to support weaker regional economies. Plans to solve the problem by relying mainly on austerity—which clearly is needed, but not as the sole pillar of policy responses—risk provoking significant social protest and making the problem worse by hurting debtor economies’ ability to grow their way to sustainability.


Possible Ways Out
Any workable solution must spread the risks and rewards among all of the parties involved. The over-extended homeowners and nations, along with the creditors that engaged in risky lending, both need to make concessions. There’s a collective action challenge here, as no creditor wants to be the first to agree to reduce its claims, nor part of a group that reduces its claims and leaves other creditors made whole. Thus, governments in the United States and European Union must play a significant role both in encouraging debtors and creditors to come to an agreement and in providing medium-term financial support.

To provide an incentive for partial debt forgiveness, creditors would receive a bonus: an equity-like stake in the debtors that would eventually be repaid. In the cases of both European sovereign debtors and US mortgages, making lenders into stakeholders would calm market volatility, boost the economy, and ultimately leave taxpayers better off. Think of the stakes the US government took in ailing financial services companies and GM, from which it is recouping its investments. The US government successfully sold a significant portion of the restructured GM in 2010 and is now projected to make $12 billion in profit on its bank bailout.12 The Congressional Budget Office now calculates that between dividends, interest payments and sales of stock warrants, the US Treasury has recovered all but $1 billion of its $245 billion investment in banks, and that the overall net lifetime cost of the Troubled Assets Relief Program is likely to be only $19 billion.13 A successful restructuring could have similarly minimal costs for governments.

Troubled Sovereigns
For sovereign debtors, there are two main options for an orderly restructuring:

  1. Swap existing debt for new bonds that reduce the total amount of debt owed, along the lines of the Brady Plan, which helped to restore economic health in formerly stricken nations by lowering debt burdens to a manageable level. Under the Brady Plan, which closed the “lost decade” of the 1980s debt crisis, banks reduced developing nations’ debt load by exchanging defaulted loans, which were trading at a fraction of face value, for a menu of new bonds. (In some cases, creditors traded debt for equity stakes in public assets, both through privatizations of state utilities and through swaps for environmental preservation, such as the Amazon rainforest.) As in the Brady Plan, creditors would be able to choose from a menu of bonds with different characteristics—some reducing debt burden through reduced principal; others through reduced future interest payments; some with fixed and some with floating coupons. Such a swap would be consistent with the Calomiris proposal, particularly if it included GDP-linked bonds as part of the menu. The faster the economy grows, the more these equity-mimicking bonds would pay in dividends.  GDP-linked bonds would have the advantage of creating a counter-cyclical buffer that would help to prevent future crises.

  1.  Provide official-sector funds for purchasing the debt at a substantial discount. Adam Lerrick and Allan H. Meltzer proposed such a solution in 2001, arguing that it would reduce a country’s debt to sustainable levels; keep lenders’ losses within predictable limits; head off panic selling; and provide a market-based solution. “The official sector would step back from its current role of guarantor of speculative capital to emerging economies and become a true lender of last resort that responds to market failure yet preserves market discipline,” the authors contended.14 

The two options above are not mutually exclusive. Indeed, they could be pursued in tandem while incorporating elements of an intriguing Red Bond-Blue Bond proposal suggested in May 2010. Jakob von Weizsäcker of the Belgian think tank Bruegel and Jacques Delpla of the Conseil d’Analyse Économique in Paris issued a proposal under which euro-area countries would pool their national debts into EU backed, highly liquid “Blue Bonds.” Countries would be limited to issuing Blue Bonds for a total of up to 60% of GDP in each country. Any debt above that amount would be issued as a national-level “Red Bond,” which would be junior to the Blue Bonds.15 Red Bonds, with higher yields varying depending on the credibility of fiscal policy, would be subject to orderly defaults, should a country’s finances deteriorate to that point.

Because they would create a much more liquid, larger fixed income asset pool with the added advantage of acting as an alternative reserve currency, the Blue Bonds would lower borrowing costs for the euro area. Offering a distinct but complementary benefit, the Red Bonds would provide a much earlier warning signal for cases where trouble is looming, and provide a much more accurate risk-reward calculus that would trigger adjustments much earlier in economic cycles, thus reducing the likelihood of future crises reaching such difficult to manage proportions.

The main sticking point behind adopting this proposal is Germany, which as Europe’s strongest economy, would be pooling its debt with that of weaker countries. Its taxpayers already have shown displeasure at Germany’s role in the Greek and Irish support packages. In reality, however, whether they like it or not, German taxpayers have a huge stake in the success or failure of other euro area nations. The consideration needs to be cost versus benefit: what would the cost of pooling the debt be versus allowing another country to fail—and thus threaten the stability of the euro and entire region (and indeed global) economy.

Adopting a restructuring that channels some of the troubled debt into a Red Bond-Blue Bond framework would have an added benefit: providing a face-saving way to restructure. A major obstacle to restructuring is that the debtor country government must admit that it is necessary. Part of the reason for Argentina’s crisis is that its government did not want to acknowledge the depth of its crisis. But if Europe were undergoing a region-wide creation of Red/Blue bonds, that would provide an additional impetus for restructuring. If the EU were to provide funds to repurchase troubled debt at a level set below face value, it would realize some reduction in the total amount of debt. The debt could then be re-issued under the Red Bond-Blue Bond framework, reducing the debt service and helping to create the conditions to facilitate recovery. If debt-holders are not able to come to an agreement that would ensure that enough of them would participate in the repurchase, a pre-emptive default might still be necessary to encourage investors to sell at the discounted level. 

Governments can also incentivize investors to go along with a debt restructuring by changing the way that banks account for losses. In many cases, banks often prefer to hold on to troubled bonds because they do not have to write down the value of the bonds and recognize losses until the bonds are sold. By changing such accounting rules, governments can nudge bondholders toward a faster resolution that ultimately will involve lower costs and faster recovery; in other words, they must seek to incentivize longer-term calculus over short-term motivations.

Another element in creating the conditions for a successful restructuring is the role of governments in responding to the interests of constituencies within their own countries. In Portugal, for example, French and German banks hold significant amounts of Portuguese government debt, which no doubt plays in to the stances of their respective governments toward restructuring. As the aftermath of the Irish, Icelandic, and Greek financial crises shows, taxpayers resent having to tighten belts significantly in order to repay foreign creditors. In any bailout, European governments and taxpayers are bailing out bondholders in their own countries as much as they are supporting a troubled debtor. 

Underwater US Mortgages
For the US housing market, the challenge is similar— how to spread the pain and the rewards—but politically the challenge is somewhat different. Above all, US homeowners do not want to see troubled mortgage holders rewarded for taking on more than they could handle. The stakes, however, just like the challenges, are too high to settle for muddling through and not seeking a cleaner, quicker way out.

Homeowners also would become renters under Daniel Alpert’s 2008 proposal for a national “work-out” of the residential real estate market. His controlled debt restructuring is a workable alternative to the long, drawn-out process of resolving delinquent, defaulted and underwater secured real estate loans, which he rightly viewed as prolonging and worsening the damage. In his proposal, banks would accept the voluntary surrender of deeds and then lease the homes back to their former owners, who would have the right to purchase their homes back at fair market value after a reasonable period. Alpert notes that banks would lose less money by renegotiating the principal of a loan than they would by foreclosing. However, because foreclosures stretch losses out into the future, many banks have preferred that route rather than taking immediate write-downs which would hurt quarterly profits.16 Just as in Argentina’s plight, short-term incentives are stronger than incentives to act in ways that would reduce total losses over the longer term.

The economist Dambisa Moyo proposed creating a real-estate investment trust of pooled foreclosed housing stock, managed temporarily by the government as an equity holder instead of just a creditor. Struggling homeowners would become renters.17 “A government realty trust would remove overvalued housing collateral that weighs on bank balance sheets,” Moyo argued. “It would firm up valuations of the equity of the homeowners who have been paying their mortgages and haven't been foreclosed. It would create a real floor in the housing market and stem the tide of losses.”

Along the lines of Moyo’s proposal, a 2010 draft New York Federal Reserve working paper similarly explored a way out of the woods by organizing participation in a mutual loss pool and creating an explicit, priced government insurance mechanism to cover tail risk. The pooling strategy, similar to the Blue-Red bond proposal, would lower costs and incentivize members of the pool to act more conservatively in heading off potential risk factors.18

In the United States, instead of foreclosing and selling properties, creditors would forgive the underwater portion of mortgages and temporarily become equity holders while struggling homeowners would become renters. By taking away “ownership” of homes in which many occupants started with little equity anyway, the proposal solves the political challenge of the neighbors next door who did keep up on their mortgages. Putting a floor on losses would enable a recovery in the housing market, with knock-on effects throughout the rest of the economy. Government equity stakes in the homes, like the temporary stakes in GM and financial services firms, would rise, reimbursing taxpayers. Going forward, creating and properly pricing a mortgage insurance mechanism would help to cushion against future unsustainable market swings.

In the current anti-government political climate, a government role in “bailing out” private mortgage holders is challenging at best. However, the successful bailouts of GM and financial institutions provide a promising precedent in the cost-versus-benefit equation.


There are, to be sure, risks involved even in an orderly “pre-emptive” default. Policy makers and investors fear that if a borrower defaults, bondholders would sell the paper so fast that it would create even more of a crisis.

A pre-emptive default would minimize the risk that would come with an uncontrolled breakdown like Argentina’s. Defaults that do not come as a surprise are less likely to be disruptive, according to a 2010 Citigroup study of financial contagion from the emerging markets financial crises of the 1990s. The report also argued that outright defaults (as opposed to a pre-emptive restructuring) are more likely to cause shock waves across other markets.19 Indeed, investors would hardly be surprised if European sovereigns default on their debts, according to a recent Barclays Capital survey showing that 70 percent of money managers, hedge funds, proprietary traders and corporate trading desks foresee restructurings or defaults in the next three years.20 By pro-actively seeking an orderly restructuring now, we have the opportunity to head off a more damaging crisis later.

Both the euro area and the US housing market need a stitch in time like the one Argentina failed to take: a way to reduce the outstanding debt. By making painful but necessary choices now for distressed US mortgage holders and European debtor nations, we have a chance to get things back on the right track at a much lower cost than if we allow things to drag out. By looking at options now—in a window of relative calm—we have many more options at hand than if we simply hope that the worst will not to come to pass.


1Circulated informally at first, these ideas were fully elaborated in Charles W. Calomiris, "How to Resolve the Argentine Debt Crisis" (Washington, D.C.: American Enterprise Institute for Policy Research, April 6,2001) Available online at See also Charles W. Calomiris. “Lessons from Argentina and Brazil,” Cato Journal 2003. Vol 23, Issue 1, pp 33-45 Available online at

2For an excellent extended account of the Argentine crisis, see Paul Blustein, And the Money Kept Rolling In (and Out) Wall Street, the IMF, and the Bankrupting of Argentina, PublicAffairs 2006.

3Carmen Reinhart and Kenneth Rogoff, “Growth in a Time of DebtAmerican Economic Review, Vol. 99, No. 2: 466-472.. Additional commentary on the report is available in The Economist, “Debt loads above 90% of GDP may impede growth,” August 11, 2010.

4See also Cristina Checherita and Philipp Rother, “The Impact of High and Growing Government Debt on Economic Growth: An Empirical Investigation for the Euro Area.” ECB Working Paper No. 1237 / August 2010

5Japan is a special case. Though its debt as a percent of GDP is very high, most of Japan’s debt is held by the Central Bank, and interest paid by the government to the bank is then refunded to taxpayers. The earthquake, tsunami and subsequent nuclear crisis might create a compelling argument for debt reduction; however, since the majority of debtholders are Japanese citizens, reducing the debt would be much less likely to boost the economy than in countries where the debt is held by foreign banks, and indeed would be destabilizing economically and politically.

6Paul Krugman. “Eurotrashed,” The New York Times Magazine, January 16, 2011.

7For an excellent discussion of possible scenarios for the euro, see John Llewellyn and Peter Westaway. “Europe will work,” Nomura Global Economics, March 2011.

8The Associated Press. “Analyst: 23% of U.S. mortgages underwater,” March 8, 2011.

9See also Michele Wucker, “Searching for Argentina’s Silver Lining,” World Policy Journal Winter 2002 Michele Wucker, "Passing the Buck: No Chapter 11 for Bankrupt Nations," World Policy Journal, vol. 18 (summer 2001)

10James G. Neuger and Simon Kennedy “Ireland Gets $113 Billion Bailout as EU Ministers Seek to Halt Debt Crisis,” Bloomberg, November 29, 2010.

11“Report of the International Financial Advisory Commission,” March 2000.

12Ben Protess and Eric Dash, “Clinging to a Federal Lifeline,” The New York Times, March 19, 2011

13CONGRESSIONAL BUDGET OFFICE. “Preliminary Analysis of the President’s Budget for 2012,” March 18, 2011. Available online at

14Griffith-Jones, Stephanie and Krishnan Sharma. (2006). “GDP-Indexed Bonds: Making It Happen”. United Nations Department of Economic and Social Affairs Working Paper No.21. See also Javier E. David “Worried About U.S. Debt? Shiller Pushes GDP-Linked Bonds”

15Adam Lerrick and Allan H. Meltzer. “Beyond IMF Bailouts: Default Without Disruption.” Quarterly International Economics Report, Gaillot Center for Public Policy, May 2001.

16Daniel Alpert, “The Freedom Recovery Plan For Distressed Borrowers and Impaired Lenders.” Westwood Capital, 2008. Available online at For additional discussion seeDaniel Alpert, “Why Own When You Can Lease?” The New York Times, July 31, 2009 See also Joe Nocera, “Shouldn’t We Also Rescue Housing?” The New York Times, October 17, 2008.

17Dambisa Moyo. “Holding Housing's Head Above Water.” Barron’s, December 27, 2010.

18Toni Dechario, Patricia Mosser, Joseph Tracy, James Vickery, and Joshua Wright. “A Private Lender Cooperative Model for Residential Mortgage Finance,” Federal Reserve Bank of New York Staff Reports. August 2010 Number 466. Available online at

19Geoffrey Dennis and Jason Press. “The Risks of Contagion,” Citi, February 23, 2010.

20Steve Johnson, “Investors fear default in Europe,” Financial Times. March 20 2011: See also “Issing - 'no getting around' a Greek debt restructure,” Thomson Reuters, March 23, 2011 via finanznachrichten