By admin 
Oussama Nasr is a former derivatives banker living in Beirut.
You may have seen it headlines on the huge pile of long-defaulted international bonds collect about the invasion of Israel. Here’s why that’s not as crazy as it seems at first.
But first we should probably explain exactly how Lebanon’s Eurobonds, with a face value of more than $30 billion, ended up trading at 6 cents on the dollar.
Chronicle of a predicted default
After a brutal 15-year civil war that ended in 1990, Lebanon undertook a massive reconstruction program largely financed by the issuance of US dollar-denominated bonds. These bonds were always rated below investment grade, gradually moving closer to the very poor triple-C level, as the country’s debt ballooned, political stability evaporated, its appeal as a tourist destination waned, and tax collection practices continued to tighten. to non-existent.
These catastrophic conditions were offset by two factors that helped keep the country financially afloat:
(i) the availability of support from a number of friendly countries in Europe and the Gulf.
(ii) the presence of a huge, industrious community of expats who – rain or shine – would transfer about half a billion dollars a month to their relatives in the old country.
However, as the financial situation continued to deteriorate and the rating agency downgrades followed, the bonds naturally traded at gradually widening spreads.
In early 2020, the country could no longer bear the pressure to service its debts and simultaneously defaulted on all its outstanding international bonds worth a total of about $31 billion. At that point, the bonds began trading on a price basis, gradually falling from around 40 cents on the dollar to just under 6 cents in recent months.
They have jumped back to almost 9 degrees Celsius in the past month after Israel began its massive campaign against Hezbollah, the country’s dominant militia and its most powerful political party.
Given the magnitude of the collapse since 2020, this may seem miniscule, but it is a remarkable and interesting jump.
(It should be emphasized that trading volumes are extremely is low, and that the ability to liquidate a meaningful block of bonds at this new price is questionable. Nevertheless, we assume that the price of 9c is “correct”.)
The country’s endemic corruption, lack of governance, persistent political instability and continued lack of a significant tax base meant that few savvy international investors were interested in Lebanon’s Eurobonds. at almost any price.
As a result, Lebanese banks continue to hold a substantial share of the total debt stock, and only a few specialist money managers and hedge funds have the enthusiasm to gamble on the potentially mouthwatering returns that could follow an eventual restructuring.
Why 6? Why 9? Why not zero?
So what does a price of 6 cents – or alternatively 9 cents – actually mean for a government bond that has defaulted?
It should be noted that only countries such as Cuba, Sudan, North Korea and Vietnam (before the reforms) traded their debts at comparable prices. Lebanon, even in the midst of a devastating economic collapse, total political paralysis and actual war, can boast a significantly higher standard of living than those countries, especially when its huge unofficial economy and the unrecorded share of overseas remittances are properly taken into account .
To simplify things immensely, you can think of the price of 6 as the probability weighted average of two outcomes: one in which the country remains a dysfunctional, almost failed state – in which case the debts would eventually become virtually worthless – and the other in which at least a hint of prosperity and stability returns, and a kind of debt training takes place. eventually reached, which could raise debt to around 20 cents (but realistically probably not much higher).
According to this analysis, the probability of the first outcome would be almost 70 percent, while that of the second outcome would be the remaining 30 percent.
If this model is broadly correct, the more recent price of almost 9c would be consistent with a reduction in the probability of the first outcome to 55 percent and an increase in the probability of the second outcome to 45 percent.
In other words, the market now implies a 15 percent higher probability (in absolute terms) and a 50 percent higher probability (in relative terms) for the scenario that Lebanon will become a semi-prosperous, semi-peaceful state – even while Israel’s ground operation continues unabated, the country’s economy is paralyzed and civilian casualties are increasing.
Is this increased optimism in any way consistent with the most recent political developments in the country? The credit rating agencies don’t think so. Here’s what Moody’s said in a report earlier this month:
The unfolding conflict on Lebanon’s own territory is exacerbating an already very bleak credit picture and undermining the Lebanese government’s efforts to stabilize the economy through increasing dollarization. The displacement of the population due to the conflict will exacerbate weaknesses in the country’s already stressed health and social conditions. Moreover, degradation of infrastructure and public services further undermines any prospect of economic recovery in the short term.
That the FATF has now placed Lebanon on the “grey list”. is another blow to hopes that the financial system will soon return to health.
But bond traders appear more optimistic. The new price of 9c suggests that at least some have settled on the scenario that the possible elimination or serious neutering of Hezbollah will bring about a measurable improvement in the country’s governance, in the country’s willingness to implement long-awaited reforms and sign an IMF agreement, and ultimately its ability to restructure its foreign debt.
So how realistic is this?
The plausible(ish) scenarios
Here are five possible paths for the debt burden of Lebanon and Lebanese countries, of which only the first two are positive.
1. Israel continues to have success against Hezbollah, in effect amputating the organization so badly that it no longer dominates Lebanese politics and loses its ability to hinder necessary reforms. Lebanon continues to implement these reforms, signing an IMF agreement and successfully restructuring its foreign debt.
2. Hezbollah recovers from its initial setbacks and fights Israel to a standstill in Lebanon, similar to what it achieved in 2006. This strengthens Hezbollah’s position in Lebanon and makes the party stronger than before. Nevertheless, Hezbollah becomes more integrated into the Lebanese body politic and begins working with the movement to implement reforms, sign an IMF deal, and ultimately restructure the foreign debt.
3. Same as (2) where Hezbollah is even stronger than before the ground offensive. But this leads to no reforms, no IMF agreement and no restructuring of the external debt.
4. Israel continues to have success against Hezbollah and ends its dominance in Lebanese politics; but the remaining Lebanese factions appear incapable of national reconciliation and unable to sign an IMF agreement, so there is no debt restructuring.
5. Israel is inflicting serious damage on Hezbollah, but the organization remains the most powerful political group in Lebanon and is able to continue to obstruct reforms, obstruct an IMF deal and thus hinder any debt restructuring.
Anyone who has lived in the Middle East knows to discount the bullish scenarios and is therefore understandably skeptical about whether the rally in Lebanese government bonds can continue.
Give me options
Many FT Alphaville readers will already know this, but the best explanation for the seemingly bizarre price action in Lebanese bonds can be found in options theory.
The value of an option typically increases – sometimes quite measurably – when the underlying asset experiences increasing volatility. This especially applies to options that are heavily out-of-the-money. These are cheap because the chance of them getting good before they expire is so fantastically unlikely. But if they do, the payouts can be astronomical.
And in most options pricing methodologies, greater volatility mechanically increases their value because it increases the chances of unlikely outcomes.
Suppose you bought a one-year call option on Microsoft with a strike price of $100, while the spot price is $80 and the stock’s volatility is 20 percent. Subject to reasonable further assumptions regarding the stock’s dividend yield and risk-free rate, we can calculate that the initial value of this option is slightly higher than $1.
In fact, the option is very cheap because the chance that the spot price will exceed $100 at expiration is low, given the current price of $80 and the volatility of 20 percent. In fact, it is about 85 percent likely that the option will expire out-of-the-money and you will lose your premium. In other words, you will suffer a 100 percent loss. However, if the spot price do above $100, the winnings can be big. For example, if Microsoft hits $105, you realize a 400 percent profit.
What is more relevant to the situation of the Lebanese Eurobonds is that we can also calculate this if the spot price applies does not deviate but volatility increases from 20 percent to 30 percent; for example, the owner will double his money. If volatility doubles to 40 percent, the option increases fivefold in value.
Now comes the ‘killer insight’: a deeply troubled equity or debt instrument is analogous to an out-of-the-money call option at least on the following two points:
(i) it is very cheap and therefore has a (modest) chance of returns in the hundreds of percentage points, like the Microsoft call option above,
(ii) there is a high probability that the country will end up with a negative interest rate of 100 percent, or something close to that – the expected outcome if Lebanon proves completely unable to reconcile internally, implement the necessary reforms and restructure its external debt.
One would therefore rightly expect Lebanese bonds to become more valuable as the country becomes more unstable, something that has undoubtedly occurred since the beginning of the Israeli invasion and the assassination of Hezbollah’s leaders. Hassan Nasrallah.
This could easily explain the price increase from 6c to 9c. And from here, who knows.