Monday, September 20, 2010

Simon Johnson and Peter Boone -- "Brady Bonds for the Eurozone"

I was surprised to see that Simon Johnson and Peter Boone are advocating "Brady bonds" for countries such as Ireland and Greece.  Their article on this can be found here, and a useful March 2000 "primer" on Brady Bonds (published by Salomon Smith Barney) is available here.

The reason I am surprised is that these bonds are based on an accounting trick designed to mask what was really going on.  I hope Simon Johnson and Peter Boone are not advocating this because of the accounting.

Brady bonds were named after Treasury Secretary Nicholas Brady, who advocated an exchange of bank loans to developing countries in financial trouble for these bonds.  This program began in the late 1980s and continued into the 90s.  

The  principal of a Brady bond was collateralized by a zero-coupon Treasury bond.  In many cases, the Treasury issued this zero-coupon bond as a non-marketable special issue; in other cases, the zero-coupon collateral was obtained in the market by buying Treasury STRIPS.  (There was an internal dispute early on about the pricing of the non-marketable zero-coupon bond issued to Mexico, which became public and was both the subject of a Congressional hearing and a GAO report.)

Because the principal was collateralized by a Treasury security, the banks could hold these bonds at par on their balance sheets.  However, the value of a long-term bond is more dependent on the periodic interest payments than it is on the principal payment.  This was the accounting trick.  The loans had to be marked down but the bonds would not have to be, even if the payment of interest was subject to significant credit risk.  For the country restructuring its debt, a 20-year or 30-year zero-coupon Treasury could be obtained quite cheaply at the interest rates prevailing at the time.

I am not sure whether this scheme would work now, since accounting standards have evolved to force more mark-to-market valuations, and zero-coupons are of course more expensive for a given maturity currently because of the very low interest rate environment.  I also am skeptical of a policy relying on accounting mirage.

Simon and Boone need to make a better case addressing these points if they want to be convincing in their advocacy of Brady bonds.

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