Sunday, November 23, 2014

Gouging the Gauchos

NEW YORK – Like individuals, corporations, and other private firms that rely on bankruptcy procedures to reduce an excessive debt burden, countries sometimes need orderly debt restructuring or reduction. But the ongoing legal saga of Argentina’s fight with holdout creditors shows that the international system for orderly sovereign-debt restructuring may be broken.

Individuals, firms, or governments may end up with too much debt because of bad luck, bad decisions, or a combination of the two. If you get a mortgage but then lose your job, you have bad luck. If your debt becomes unsustainable because you borrowed too much to take long vacations or buy expensive appliances, your bad behavior is to blame. The same applies to corporate firms: some have bad luck and their business plans fail, while others borrow too much to pay their mediocre managers excessively.

Bad luck and bad behavior (policies) can also lead to unsustainable debt burdens for governments. If a country’s terms of trade (the price of its exports) deteriorate and a large recession persists for a long time, its government’s revenue base may shrink and its debt burden may become excessive. But an unsustainable debt burden may also result from borrowing to spend too much, failure to collect sufficient taxes, and other policies that undermine the economy’s growth potential.

When the debt burden of an individual, firm, or government is too high, legal systems need to provide orderly ways to reduce it to a more sustainable level (closer to the debtor’s potential income). If it is too easy to default and reduce one’s debt burden, the result is moral hazard, because debtors gain an incentive to indulge in bad behavior. But if it is too difficult to restructure and reduce debts when bad luck leads to unsustainable debts, the result is bad for both the debtor and its creditors, who are better off when a reduced debt ratio is serviced than when a debtor defaults.

Finding the right balance is not easy. Formal legal bankruptcy regimes for individuals and firms have evolved over time to accomplish this.

Because a formal bankruptcy regime for governments does not exist (though Anne Krueger, the International Monetary Fund’s then-deputy managing director, proposed one more than a decade ago), countries have had to rely on a market-based approach to resolve excessive debt problems. Following this approach, the country offers to exchange old bonds for new bonds with a lower face value and/or lower interest payments and longer maturities. If most investors accept this offer, the restructuring occurs successfully.

But this implies a key problem: Whereas a bankruptcy court can force holdout creditors to accept the exchange offer as long as a significant majority of creditors have already done so (a so-called “cram down”), the market-based approach allows some creditors to continue to hold out and sue to be paid in full.

That is why, over the last decade, governments have augmented the market-based approach with a contractual approach that resolves the holdout problem by introducing collective-action clauses (CACs) that can also cram down on holdouts the terms accepted by a majority of creditors. These clauses became standard in sovereign bonds but were missing in those issued by Argentina before 2001, when the crisis hit. Though 93% of Argentina’s creditors accepted new terms for their bonds in 2005 and 2010 in two exchange offers, a small group of holdouts sued Argentina in the United States, and, with the US Supreme Court recently ruling on the issue, have now won the right to be paid in full.

The US court decision is dangerous for two reasons. First, the court ruled for the first time that a country cannot continue to pay those creditors who accepted a big reduction (or “haircut”) on their claims until the holdouts are paid in full. So, why would any future creditor who benefits from an orderly restructuring vote for it if its new claims can be blocked by even a single holdout creditor?

Second, if the holdouts are paid in full, the majority of creditors who accepted a haircut can request to be paid in full, too. If that happens, the country’s debt burden will surge again, become unsustainable, and force the government – in this case Argentina, which is servicing most of its debt – to default again on all creditors.

The inclusion of CACs in new bond contracts may help other countries avoid the holdout problem in the future. But even CACs may not fully help, because they are designed in a way that still allows a small minority of creditors to hold out and thus prevent an orderly restructuring.

Either super-CACs need to be designed and introduced (though it will take years to include them in all new bond contracts) or the international community may want to reconsider whether the 2002 IMF proposal for a formal bankruptcy court for sovereign borrowers should be resurrected. Holdouts must not be permitted to block orderly restructurings that benefit debtors and creditors.

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    1. CommentedClaudio Migliore

      If Ms. Kirchner had the ability to write like The Economist's editors, which she lacks in her own language, let alone in English, she would have chosen a title like "Gouging the Gauchos". An economist at a prestigious university should know better than that.
      Current debtholders, if we use for a second a judgmental term like gouging, are doing so to those poor souls who held the debt at the time of default and have sold out at depreciated rates. Against a sovereign debtor, they hold a black and white claim.
      As to the contents of the article, I believe Mr. Roubini is playing his own flavor of moral hazard, I dare say promoting more international bureaucracy whose value for the world should be carefully considered. The return on investment looks sky-high for the bureaucracies involved, but would the world be better off with another arbiter (one as blind and apolitical and just as we know all bodies politic can be) as opposed to benefiting from past mistakes and incorporating them into newer practices, as Mr. Roubini acknowledges is now happening?
      Argentina's rulers and money center bank employees who got performance bonuses fooled everyone else, courtesy of very imperfect markets for the last two centuries. Most of the fools are dead now but hose alive fall into three categories: those who renegotiated, those who held out but sold at vile price and, finally the population of Argentina. All of those fools were, of course, victims of their own greed, investors because they sought impossible returns and Argentines because they voted for artificial prosperity.
      Wouldn't the world be better served by a general understanding that lending to corrupt criminals is not a good idea even if the are wrapped in national flags? That might also help voters understand that the same corrupt individuals should not be voted in office.

    2. Commentedjim bridgeman

      But if you cannot get any kind of loan without a pari passu clause, because of repeated past egregious behavior toward lenders (over centuries!), then no amount of "international system for orderly sovereign-debt restructuring" is going to help. If such a system is in place without pari passu then such borrowers will simply be unable to borrow at all.

    3. CommentedNathan Weatherdon

      OK, but we don't want a stampede to crush level heads.

      That is a risk of forcing holdouts to accept terms taken by the majority. Perhaps a 70% majority? 90%?

    4. CommentedJonathan Lam

      Gamesmith94134: gouging the Gauchos
      “Either super-CACs need to be designed and introduced (though it will take years to include them in all new bond contracts) or the international community may want to reconsider whether the 2002 IMF proposal for a formal bankruptcy court for sovereign borrowers should be resurrected. Holdouts must not be permitted to block orderly restructurings that benefit debtors and creditors.”
      Perhaps, we do need another oversight on the sovereign debtor that sovereignty may not bankrupt and should be treated differently; and as those are named vulture funds purchased on discount with the older bonds must sustain on the welfare of the sovereign nations instead of clearing out of the assets on its sovereign debtors. Besides, holdouts trigger the role of CAC in liquidate the sovereignty under its bankruptcy; it can grasp the cash or assets of the debtor in oversea, but internally would be impossible. I doubt very much if US Supreme court would order to give Argentina Embassy to Mellon Bank. In reverse, how is the Argentina Supreme court order to nationalize the US communication network without paying US a dime? It is why I comment earlier in
      Gamesmith94134: Argentina’s debt conundrum
      “Inasmuch the lock law and the pari passu (“equal footing”) clause included in the bonds, I see technical default and sovereignty debt default are inevitable; since there is no firewall in safeguard the financial architecture and sovereignty when there is a credit-debtor conflict. Even though Argentina or BNY Mellon repeals in the Supreme Court, there would be ruling granted differently in regard of the holdout of the “vulture Funds”, or guilty on the technical transfer default; but the situation would be the same as the ECB to accommodate the PIIGS under the auspice of the Euros and each sovereignty could have lost its right to trade under the free trade agreement or simply dollars. Therefore, US Supreme court is not the proper resolution to the international financial architecture, and it is not.”

      Then, as I recommend on the CAC should be classified on the commercial papers that collect after bankruptcy court ruling; and sovereign borrowers should be separated on its entity that its purchasers are subject to the ruling by the international financial architecture rather than implementation on the market system. It is because it does not work even for the PIIGS. Perhaps, it time to take advantage of the FED’s low interest rate and the World Bank and IFC loans with assigned local currency by submitting the 3+1% offer to institutional funds who need a stable income or currency to sustain values; instead of giving to the hedge fund managers who purchased the discount bond and demand CAC in full fund return under the legal system. It is reasonable that our present local legal system does not have sufficient power to override sovereignty rights, even for US Supreme Court.
      So, I am calling on the WTO arbitrator groups to implement the 1% charge on the commercial funds in transcontinental transaction; and commission with IMF, World Bank and other international financial entity to wharf the litigation and bankruptcy ruling in further foreign funds that may not help the local economy in a long run. It is because they usually ignited the equitable to rise and productivity need time to nurture or mature; and it is how the rift of inequality rose under the Quantitative easing. It is how we lost the BRICS after the inflation or depreciation of its currencies. Besides, we do have questionable growth on US and dollars that its trade deficits and equitable after the changing tide on the housing in China and market system.
      Perhaps, I am making nonsense on the subject to the title on “Gouging the Groucho”. Does the sovereignty running on the market mean genocide is another possibility if the holdout is sanction enforceable like Cuban, Iran, even Russia? I don’t think so; but we must see a international financial system to thwart further damage in order to revive the global economy. Monopoly by FED might not work; if everyone else is stagnated on the disinflationary mode. Some may suggest to ‘let it rise’; but capital and labor are not synchronized and G6 are the debtor nations as well. So, market system must comply in its commercial and sovereign rules to survive; and another international financial system must be developed to assist and oversight.
      May the Buddha bless you?

    5. CommentedJonathan Lam

    6. CommentedEnrique Massot

      Argentina was ready to negotiate the aftermath of its 2001 since Nestor Kirchner assumed in 2003. As many as 92 per cent of creditors agreed to a reduction of their bonds value. The remaining eight per cent did not accept because their strategy--successfully used to gouge countries as poor as Peru and Congo-Brazzaville--is to buy distressed bonds for pennies and then sue for their full face value.
      Together with getting debt relief in 2005 and 2010, Argentina paid off its debt to the IMF in 2006; agreed compensation to half-nationalized Repsol; and more recently renegotiated its debt with the Paris Club. All the while growing the country's economy, improving health and education, and the lot of the poorest and the retired. Nestor and Cristina Kirchner continuously expressed their will to honour all the country's obligations, including the holdouts. However, they have also said they are not willing to sacrifice the well being of the population. And this is the fundamental difference of the Kirchners' governments with all the previous ones.

    7. CommentedSaleh Daher

      Professor Roubini ignores the fact that countries that cooperated with their creditors, such as Brazil and Mexico received major concessions on their indebtedness to help them get back on their feet. The reason holdouts have targeted Argentina is that Argentina has treated its creditors so badly. After the default, Argentina ignored its creditors for half a decade then made a take-it-or-leave-it offer. The 93 percent of creditors that took the draconian deal were intimidated by Argentina's hostility and refusal to treat creditors in a professional way. Had Argentina offered creditors a fair deal there would have been few holdouts. The fact that 7% of creditors chose to refuse Argentina's offer testifies to the level frustration created by Argentina.

      Creditors are realists; they don't waste their efforts pursuing litigation if they do not believe the country has the ability to pay. Nobody sued Sudan. Argentina is a phenomenally rich country impoverished by prodigiously bad government. Holdout creditors are not the cause of Argentina's economic troubles; they are symptoms of mismanagement.

      Keep in mind that Argentina has shown little respect for property rights, grabbing the assets of pensioners and foreign investors alike. Dr. Roubini ignores that Argentina is unique among countries by threatening to arrest some of his fellow economists for the crime of daring to publish economic statistics at odds with the government's corrupt numbers. Holdout creditors are holding a rogue country to account and doing the Argentine people and the world a great service.

        CommentedMarco Colagrossi

        In this article, as in mr. Daher comment, there's a well known fact about sovereign lending that is ignored. When a country goes bankruptcy, it may be bad luck or poor behavior as stated by professor Roubini, but surely it is because someone lent him too much. If individuals ask for lend without collateral (I.e. countries with a deteriorate balance account) or without a solid cash flow (i.e. countries with a poor tax collection system) nobody would give them a penny. Sovereign lenders tends to lend too much to pursue high yields even if by doing so they are a concause of the increasing risk in a future default.

        About mr. Daher comment, I just want to say that none of the actual holdout creditors was in the original companion of Argentina's creditors. Almost all of the 7% un-restructured bonds, and surely all the bonds that have gone in litigation, are held by vulture funds, who brought this bonds after the default at a discounted price in the secondary market only to sue Argentina.

        This means that, after all, creditors were ok with Argentina swap - despite is many faults and delays - and only creditors who wanted out sold in the secondary markets bonds.

        About Brazil and Mexico, I'm sorry, but they were a total different deal as most of the loans where syndicated bank loans and even the bonds were held mostly by large banks making the restructuring process way easier.

    8. Commentedjoey jay

      In "Upside Down: A Primer for the Looking-Glass World" one realizes reality for what it is....gouging has been done for centuries...and will continue...