Samuel George on the systemic consequences of Argentina’s default 

Greece, decime que se siente…

Note: On December 10, Samuel George spoke on a panel in Washington DC that featured Cecilia Nahón, Argentine Ambassador to the United States, as well as Sergio Chodos, Executive Director at the International Monetary Fund. The post below summarizes his input at that event.

For as long as sovereign countries have issued debt, there have been complications and irregularities repaying that debt.

It has happened before—from ancient Greece to sixteenth century Spain to much of Latin America in the 1980s. It’s happening now, in however irregular circumstances. And it will almost certainly happen again in the future—maybe sooner then we think.

How curious, then, that the international financial system has yet to settle on a legal and politically recognized mechanism for resolving these complications.

In the corporate world, debt contracts are subject to bankruptcy and liquidation laws in which assets of a company serve as identifiable collateral. These laws also provide certain legal protections to stressed firms.

No such internationally recognized bankruptcy mechanism exists in sovereign defaults. As a result, over the thirty years, international creditors and sovereign borrowers have restructured debt on an ad-hoc basis, meaning debtors and creditors come together to form specific case-by-case arrangements.

These are the one-off agreements we hear of from time to time: The haircuts, the bond exchanges, the trade-ins. It’s the Brady Bond, for example, following the Latin American sovereign debt crisis of the 1980s, and they include the 93 percent of restructured Argentine debt from the 2001 default, as well as the Greek sovereign restructuring of 2012.

What made these agreements possible was a delicate balance of power between debtor and lender.

Each side had reasonably balanced advantages and disadvantages from a bargaining perspective that ultimately led them to the table to hack out an agreement everyone could at least live with.

Lenders recoup a degree of their investment, and borrowing countries can shed debt overhang. Nobody loves it, but everyone can move on with their lives.

So what was that balance and how did it take shape?

The key complication of sovereign debt is that is very difficult to enforce. The widely accepted notion of sovereign immunity holds a state exempt from civil suit or criminal prosecution; it protects most public assets both at home and abroad, regardless of any court’s ruling.

So a foreign judge can come to any conclusion under the sun—the question is how such a ruling could be enforced against a foreign, sovereign nation.

Prior to the Cold War, when the theory of sovereign immunity held nearly absolute, the only real answer was with cannons; this was the era of gunboat diplomacy when lenders would convince their governments to physically force another government to pay up. This approach was thankfully abandoned by the international community as both unethical and impractical.

Who needs lawyers?

By the mid-1950s we see a more restricted interpretation of sovereign immunity which held that if foreign states act commercially, they could be subject to US courts. This became particularly important given the proliferation of state-owned soviet and Chinese commercial interests.

By the 1980s, the uneasy balance between creditors and borrows in default began to take shape. It became easy enough for lenders to get a US judge to rule against international defaulters.

As Lee Buchheit, perhaps the world’s leading expert on sovereign debt, likes to explain, these judges are not economists, they are not necessarily financial or international experts. They have been trained to enforce the law and a bond is contract. They will ask a simple question: “Did you barrow the money? Yes? Ok, well, then you have to repay.”

So it became easier for creditors to get a favorable judgment, but again, with no bankruptcy court, it remained very difficult to collect.

Creditors had a ruling, but they had no money. Meanwhile, the state could avoid payment, but would remain in default, an outcast from the international financial community, unable to pursue that clean slate.

Each side had advantages, and each side had weakness in relatively equal amounts. Over the last 30 years, this delicate balance has forced the participants to the table to work out a debt restructuring scheme.

This was not a particularly stable system to begin with. It did not rely on binding legal findings, but rather on a delicate interplay between two poker players with mediocre hands

But it was the system we have been using and the 2012 Second Circuit Court ruling could throw it all to the wind.

On November 21, 2012, Judge Thomas Griesa of the Second Circuit Court decided in favor of 19 holdout plaintiffs, led by Elliot Management, and ordered Argentina to pay them US$1.33bn. These litigants had rejected offers to restructure, instead holding out for full payment.

(For background on the Argentine case, see “The Gringo’s Guide to the Argentine Holdout Crisis”)

There is nothing particularly unique about holding out. In fact, over the last 20 years a highly experienced, very well-funded group of hedge funds have specialized precisely on this tactic, and it has been used to successfully capitalize on debt crises in Brazil, Peru, and in Europe and African countries.

What makes the Argentine case unique is that Judge Griesa put teeth into his decision by declaring any further payment on restructured debt, without honoring debt held by the holdouts, illegal. So legally, at least in New York, unless Argentina pays the holdouts the full amount, they cannot pay anyone at all.

Game Changin’ Judge Griesa

This throws off the delicate balance between sovereign debtors and sovereign creditors.

Given the ruling, according to a Brookings Institute report, “Potential holdouts have been handed a much better enforcement technique than they had in the past.”

On the one hand, if holders of stressed sovereign bonds believe they may eventually cash in the securities at face value, the incentive to accept a haircut diminishes. Lenders will not accept a swap at market value if they think they can hold out for full face value.

On the other hand, this development suggests that if you do accept a haircut, if you as a lender do agree to restructure debt, holdouts could be able to subsequently block your ability to receive payment.

So even if any given investor does not have the resources to pursue a lengthy legal battle against a country in default, there is now more incentive to hold out anyway, let others fight the legal fight, and cash in for full value subsequently.

Any such trend would only prolong current and forthcoming sovereign debt crises, making it more difficult for debt-plagued countries to reemerge as stable and reliable players in the global financial system. This is a particular concern in the eurozone, which is not built to survive a sustained default by a member country—and where holdouts have already emerged as a threat.

To avoid triggering credit default swaps, Greece has pursued such haircuts on a “voluntary” basis. As in Argentina, Greece’s ability to end the debt crisis will depend on bondholders’ willingness to accept the write-downs—something they may now be less inclined to do.

There is no immediate solution in site

Many have trumpeted Collective Action Clauses that are now often included in international debt. These clauses, common in New York-issued bonds since 2005, allow a qualified majority of bondholders to enforce a write-down for all bondholders—thus limiting the influence of minority holdouts. So theoretically, if Argentine bonds had CACs, the 93 percent of bonds holders that accepted the haircut could enforce the swap on the holdouts.

This is an imperfect solution. On the one hand, as we have seen in Europe, firms specializing in holding out can obtain enough stressed debt to block the execution of Collective Action Clauses. In other words, if you need a 90 percent bondholder participation to enforce collective action, holdouts can block any action by obtaining more than 10 percent of the debt.

More fundamentally, however, the fear is that bond holders will be less likely to enforce the collective action clauses at all, precisely because they feel they can eventually hold out for full payment.

Any legal mechanism to adjudicate sovereign debt appears years away. On December 6, the United Nations voted in favor of a resolution to create a global bankruptcy process. But there is no clear reason to believe the UN will be more successful than IMF attempts to build one in the 2000s.

The bottom line is that many countries are still reluctant to cede that much legal autonomy to international organizations.

As it stands right now, it is tough to pick out a winner.

Buenos Aires remains outside looking in on international markets, while Argentine firms and sub-sovereigns face higher borrowing costs. None of the bond holders—restructured or hold out—are getting paid.

Even New York could come out a loser in all of this. The city has been the go-to spot for issuances of international debt, but some wonder if countries wont think twice about this after one New York judge steered a country of 40 million into default.

These are the most immediate consequences. But if we cannot find a solution to this quandary the biggest losers could be countries down the road, countries not even on our radar right now, the wind up in a debt crisis from which they cannot emerge.

Well…that is certainly one approach….

Samuel George is a Latin America specialist and author of Surviving a Debt Crisis: Five Lessons for Europe from Latin America

For more on the Argentine debt case, click HERE

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