Sovereign Debt: The Default Debate

by Elliott Morss, Morss Global Finance

Introduction

In my last piece, I compared the sovereign debt default processes of Argentina and Greece. Greece called its default a “roll-over”. Greece retroactively changed its loan agreements so that all creditors had to accept the 2012 “haircuts” of more than 70%. The Argentine default was much messier: even with two “haircut” offerings, about 7% of the original lenders are still holding out for full value.

An interesting debate has developed between those who believe all creditors should be required to accept sovereign default settlements and those who believe original loan agreement terms should be honored. This article looks at the arguments made by both sides.

The “All Must Accept Collective Action” Argument

There are several varieties on this argument. Nearly everyone agrees that there should be a way to resolve issues when unexpected things happen. And to this end, UNCTAD is working on a project financed by the government of Norway to develop a “workout” mechanism. There is clearly a need for something here. Unlike business and personal bankruptcies, there is no mechanism in place for governments to reduce unsustainable debt burdens. Keep in mind that government bankruptcies are quite different than private bankruptcies. In private bankruptcies, debts exceed assets. For governments, we are talking about cases where projected expenditures will exceed projected receipts.

Some take the arguments for collective action much further. They characterize a certain segment of lenders as “vultures” or “predatory hedge funds”. Here, they are talking about groups buy up original government debt at discounted prices and insist on full payment. 

Eric LeCompte, Executive Director of the religious anti-poverty organization Jubilee USA Network, supports forcing the “Vultures” to settle. Speaking on the Argentine situation, he said:

“Argentina may have a way to avoid paying the hedge funds but it won’t change how the court precedent equips predatory funds with a powerful ruling to force the poorest countries to pay in full. Essentially, the ruling legitimizes this extreme behavior and makes it more profitable across the globe. Poor people and legitimate investors still lose the most with this ruling.”

LeCompte goes further in urging private and public firms alike to forgive loans they made to the poorest developing countries (more on this later).

The anti-Vulture crowd is quite strident. The following comment was made on my previous article comparing the Argentine and Greek defaults:

“Elliott Morss fails to discuss the predatory, parasitical nature of Argentina’s eight per cent of creditors–the ones who are now threatening to sink the country’s debt restructuring process of 2005 and 2010 accepted by 92.4 per cent of creditors. The nickname that associates their practices to that of vultures is appropriate. Those speculators circle countries that are on their knees after a default or in near default situations.

They pick decomposing carrion that are junk bonds at heavily discounted prices. Next, they look for a sympathetic court that will back their claim to 100 per cent of the bonds face value. In the case of Argentina, Judge Thomas Griesa’s ruling instantly removes the market risk, forcing Argentina to reimburse the bonds’ 100 per cent face value. As such, Paul Singer’s NML Capital and Aurelius Capital Management who never lent money to the country stand to get $1.5 billion in principal and interest for a $48-million, 2008 investment.”

LeCompte notes that not all holders of the original debt are vultures in the sense used here. Some (including Italian pensioners) were original lenders who have refused the debt settlement offers.

J. F. Hornbeck has written probably the most balanced piece on the various bondholder groups and their motivations:

“Litigation and settlement strategies differ among bondholder groups. Institutional funds representing corporations and investment banks tend to negotiate for the best terms available in an exchange, most of which end up settling given the high opportunity cost of litigation. Retail (individual) investors often part with their bonds in the secondary markets early in the process.

Hedge funds specializing in distressed debt typically purchase highly discounted bonds, eschew offers with large haircuts, and sue for full recovery. Their “holdout” strategy can be highly profitable for investors with patience…. Historically, this strategy has worked well when holdouts dwindle to a small portion of total creditors, making it financially feasible for sovereigns to settle.”

The Anti “All Must Accept Collective Action” Argument

Those who oppose forced settlements argue that legal agreements between lenders and borrowers should be respected. They argue further that the so-called “Vultures” play a useful role: they provide a market for lenders who want to get out when things turn bad. They point out that these “Predators” are willing to take much higher risks than other lenders and accordingly need to see a higher return to make it worthwhile.

An Interesting Historical Aside

As mentioned above, unforeseen things happen and there should be a way to make orderly adjustments for them. And in that regard, Diego Gauna, an Argentine economist, referred me to a new book, “Lending to the Borrower from Hell: Debt, Taxes, and Default in the Age of Philip II (Princeton University Press). Authors Mauricio Drelichman and Hans-Joachim Voth point out that Peter II defaulted four times but never lost access to credit markets.

“A complex web of contractual obligations designed to insure repayment governed the relationship between king and bankers. The same contracts allowed great flexibility for both the Crown and bankers when liquidity was tight. The risk of potential defaults was not a surprise; their likelihood was priced into the loan contracts.” 

The authors document that risk sharing, allowing for unforeseen things happening, were built into Peter’s loan agreements. This is rarely done today. Argentina did build into its 2010 debt settlement an upside adjustment: warrants were issued that would increase in value if Argentina’s GDP increased more rapidly than anticipated. And the IMF pays out its loans in tranches: governments must achieve certain agreed-upon targets to get IMF loan monies disbursed.

My Conclusions

Allowing one borrower to change a financial contract without the approval all the lenders should be done only in very special circumstances such as “unforeseen events”. What qualifies as an unforeseen event? Certainly not what happened in Greece: it is not easy to feel sorry for the lenders (mostly banks). There was plenty of advance warning on the Greek collapse. For anyone lending to Greece, Caveat Emptor.

Table 1 provides economic performance data for Greece. Anyone taking the time to look at these numbers should have seen that by 2009, the wheels were most definitely coming off. And yet, the five-year bond rate at the end of the year was still a modest 6.5%. What were these investors thinking? And it did not help that the European banking regulators were allowing banks to count sovereign debt the equivalent of Euros when calculating reserve ratios.  Amazing!

My reaction: if you are that foolish or that much of a gambler, you deserve what you get.

Table 1: Greek Economic Performance and Borrowing Rates
Source: IMF, Investing.com
* The bond rate has fallen to 4.4% only because the European Central Bank is an active buyer of Greek debt.

And yet, for Greece to retroactively change the loan terms in a way that forces all lenders to accept “haircuts”…

“Pari Passu” Clauses Are Two-Edged Swords

Certainly countries can write anything they want into their original loan agreements. And to make the agreements more attractive, they often add “pari passu” clauses. In essence, these clauses say all creditors should be treated equally. And it was the pari passu clause in the original Argentine loan agreement that resulted in the US Court’s decision that creditors who accepted the 2005 or 2010 settlements should not get paid unless the holdouts also got paid.

But there is a second problem the pari passu clause could cause Argentina. The country wants to settle with the holdouts; the holdouts will not accept the terms offered in the prior settlements. But if Argentina makes a more attractive offer to the holdouts, those who have settled can sue for “equal treatment”. It is a very messy situation.

Forgiving Loans to the Poorest Nations

Consider next LeCompte’s suggestion that loans to the poorest developing countries be forgiven. I have sympathy for his point when applied to certain loans made by donors such as the World Bank and USAID. If these loans required countries to do certain things that do not work out, they should be forgiven. Consider the following example.

Back in the ‘70’s, Congress believed that rich urbanites were the primary beneficiaries of aid monies. So USAID and World Bank put their heads together. The result was the “New Directions Mandate” that targeted aid monies on helping the rural poor. No funds were made available to support urban growth that I, and more importantly Jane Jacobs, believe is the “engine of development”.

The strategy was a complete failure. A recent Wall Street Journal article reports:

“Over the past 60 years at least $1 trillion of development-related aid has been transferred from rich countries to Africa. Yet real per-capita income today is lower than it was in the 1970s, and more than 50% of the population – over 350 million people – live on less than a dollar a day, a figure that has nearly doubled in two decades. Even after the very aggressive debt-relief campaigns in the 1990s, African countries still pay close to $20 billion in debt repayments per annum.”

This debt should be forgiven.

A similar case could be made for the IMF 2010 standby loan to Greece focusing on austerity. It clearly failed and the chief economist for the IMF admitted as much. The result? The unemployment rate in Greece now exceeds 27%.

Conclusions

For global markets to work properly, incentives should be in place to keep governments from borrowing excessively. And when problems do develop, it is valuable to have risk-takers willing to buy debt from investors not wanting to risk defaults.

But there will always be times when unforeseen events occur. And in such cases, there should be ways to resolve them that are better than what is now in place. For example, the rulings of a US Appellate judge have effectively stymied Argentina’s efforts to resolve its debt problems. This makes no sense. Handling sovereign debt defaults will always be a messy business but something should be done to modulate the global anarchy that now exists.