Wednesday, 13 August 2014

Argentina's default - what's it all about?

Two weeks ago Argentina has once again declared default on its debt (the last time being 13 years ago during the infamous Corralito in 2001). This makes it their 9th default since they got their independence almost 200 years ago (Reinhart and Rogoff have the numbers: Argentina defaulted on its debt in 1827, 1890, 1951, 1956, 1982, 1989, 2001). In the slow summer months this is obviously the top story: New York Times organized a debate questioning the justice behind the default (since after all it was the New York federal court which ruled that Argentina must pay a small group of bondholders $1.5bn by the end of July), Kenneth Rogoff and Joseph Stiglitz propose solutions on Project Syndicate, coupled with the usual reports from The EconomistForbesWSJThe Economist (2), Financial Times, etc. 


What happened? 

After last minute talks being held in New York with a small group of its bond holders, colloquially referred to as "vulture fund" investors (see definition here) but usually called "holdout" investors, who demanded, by the order of the New York federal court, that the Argentine government pays them its $1.5bn debt obligation, the government refused to do so and was consequentially in default over its debt. 

The story gets more convoluted. The relentless group of holdout investors, led by US investor and hedge fund owner Paul Singer, represent only a small portion of Argentina's debt holders who didn't agree to a debt restructuring scheme after the 2001 default. Yes, the story originates in 2001. Back then Argentina defaulted on its debt during a major financial and fiscal crisis (the Argentine great depression, it was called). They simply stopped paying off their obligations to thousands of investors worldwide who were attracted to Argentine government bonds offering relatively high yields at the time (in the 90s). After facing an immediate credit halt, the government faced an enormous challenge in trying to refinance its debt and stand back on its feet. In 2005 they reached an agreement with the bondholders and began the process of debt restructuring. They exchanged 76% of their defaulted bonds for new ones with only 25% to 33% of face value of the old ones (investors had to agree to a huge cut). There was a second debt restructuring in 2010 which took the total to 93% of all defaulted bonds being restructured. The only ones who remained were the investors that were persistent enough in getting their money by court. 

So where do the "vulture funds" come in? In 2002 when Argentina stopped paying back their debts, many bondholders realized they were holding worthless assets and were trying to quickly get rid of them in order to cut their losses. Paul Singer, owner and founder of Elliott Management hedge fund bought off most of these bonds at only a fraction of their initial value, for $48 million. Today, they're worth over $800 million, provided that the Argentine government repays them in full. A hefty profit, isn't it? That's how the so-called "vulture funds" make their money - they buy worthless junk bonds for a cheep price from panicking investors and then get their money in court from the government who sooner or later has to repay them. It's standard practice actually. 

Which brings us back to July 2014 and the decision of the New York federal court for Argentina to meat its obligation to these investors. The problem was that the ruling of the judge Thomas Griesa forbade Argentina from paying its obligations to those creditors which accepted the debt restructuring of 2005 and 2010, until they meet their obligations to those who did not accept the restructuring (the holdouts and the "vulture funds"). The logic behind the decision is the "equal treatment" clause called pari passu, implying that borrowers need to treat all bondholders the same. It's not that Argentina didn't have the money to pay - they did, they've deposited $540 million in Bank New York Mellon which was supposed to transfer the money to the creditors. But the court ruled that Argentina could not pay the creditors which accepted the restructuring until it pays off those who rejected it. The court gave them a deadline of July 30th 2014 to arrange a way to repay these creditors. The Argentine government refused. 

Why did Argentina do this? It's not as if they don't have the $1.5bn to pay out to Paul Singer. The story is much more complicated. If they had repayed the money, thus respecting the court's decision, this would have encouraged other holdout creditors to demand full payment on their investment, which raises the price to $15bn. Furthermore other creditors who accepted the initial restructuring could do the same thing, and this raises the bill to over $140bn (30% of their GDP). It's easy to imagine if you're a holder of Argentine debt, and you see others being successful in getting paid in full via a court order, you might as well try it yourself. 

Now its easy to see why the Argentine government had no choice but to declare an unusual default.

Consequences 

This creates problems for other countries in debt restructuring schemes. Namely Greece and certain other European countries. Who is to say that Greek creditors wouldn't follow the example of Paul Singer and bring the whole thing to court. When it comes to your money, vast sums of it, you hardly care of the problems you're imposing on the economy of the debtor country. Just ask George Soros and does he care about the pains he caused Britain in 1992 (one can say that he does, he's into philanthropy now, isn't he?).

Argentina PD From 5Y CDS Spread Updated

But the moral hazard issue is much, much deeper. On one hand you're breaking an essential commitment in the debtor-creditor relationship - an obligation to pay the money back. If someone takes someone else's money and doesn't pay him back, that's called theft. This was what the "vulture" investors are counting on and this is why legally they're 100% right. No doubt about it. 

But on the other hand, if the government does pay to this small fraction of investors it creates a whole plethora of unwanted effects. Payment to them implies paying money to all other holdout investors and possibly those who already accepted the cut on their investment. And after all the "vultures" themselves didn't actually borrow the money to Argentina, they just bought highly undervalued bonds of those who did borrow money to Argentina. But legally, the obligation to pay is mandatory.

The "vulture" investors know this, the Argentine government knows this, all other investors are standing by, so we enter a very interesting bargaining game between the first two. And in this case it's fair to say there is no winner. The holdout "vultures" aren't happy as they're still not getting paid. The rest of the bondholders are being prevented by court to get their money. And as for Argentina, yet another default only pushes their country into further problems.

So what next? More negotiations between Argentina and the holdout investors where some settlement must be reached. In the meantime, the bonds are earning an 8% interest on missed payments which is only to the benefit of the bondholders. Apparently, they can wait. The law is on their side, no matter how President Cristina Kirchner tries to describe it. 

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