“Dog-Eared” debt and the IMF’s sovereign restructuring ideas

Since April of last year, a small but growing cadre of lawyers, investors, regulators, and yes, even journalists, have been carrying around dog-eared copies of an International Monetary Fund paper (read: trial balloon) that revisits how the fund, the lender of last resort for many nations, might revamp its approach to sovereign debt restructurings.


The IMF prefaces its latest foray into sovereign restructurings by saying history shows official sector sovereign debt restructurings have been “too little too late” and when it gets involved, the public money used in a settlement too often just flows to private sector investors who take the cash out of the afflicted country.


The Fund tried this once before in 2002 under former First Deputy Managing Director Anne Krueger with the idea of establishing a Sovereign Debt Restructuring Mechanism (SDRM). This was two years after hedge fund Elliott Associates won a judgment against Peru in a case where it held out for better restructuring terms. It was a year after Argentina’s last and biggest sovereign debt default had occurred and progress in negotiating a deal with creditors was going nowhere. (That default was a sovereign record, only to be eclipsed by Greece in 2012.) The SDRM plan some 14 years ago died after the United States, the largest donor to the fund, decided against to withhold its support.


There are some similar circumstances today. Greece still has sizeable debt and a wrenching economic retrenchment. Argentina still has a fight on its hands.


Creditors such as Elliott and Aurelius Capital Management, the holdouts that Buenos Aires calls vultures for picking over the economy’s carcass, are  now armed with a U.S. 2nd Circuit Appeal Court ruling that effectively backs them into a corner. They have a choice: pay the holdouts their roughly $1.33 billion award (plus accrued interest) at the same time it pays the investors who accepted 25-29 cents on the dollar for their bonds or risk defaulting again because the payments system is under injunction. The case is based upon a pari passu, equal treatment, clause in the original bond offering, is up for possible review by the U.S. Supreme Court, prolonging the debt saga further, possibly into 2015. Meanwhile Argentina faces a balance of payments crisis that is helping to exacerbate investor concerns, globally, about the health of emerging markets. That said, fund managers are loathe to see Argentina being used as an excuse for the blowout losses in emerging markets.


“For the market to draw broad conclusions about emerging countries from what’s going on in Argentina is patently ridiculous. This country has basically not been following stable macro policies for a long time,” said Paul DeNoon, senior debt portfolio manager at AllianceBernstein in New York.


The legal victories by Elliott and Aurelius have kept Argentina shut out of international capital markets. The claims they hold against the government were ordered by U.S. District Court Judge Thomas Griesa. His October 2012 ruling, subsequently upheld by the 2nd Circuit,  raised alarm bells in this corner of the financial world and at the IMF. In a nutshell, pari passu means equal treatment. The fear is other investors will be emboldened by the ruling and use it to fight for better terms in a restructuring. Elliott and Aurelius haven’t collected yet.


The court fight drew in the U.S. government, which has filed a friend-of-the-court brief arguing that a ruling against Argentina could make it much harder for countries facing financial distress to get creditor support for crucial debt swaps. It avoided commenting on the actions of Argentina.


Now the IMF wants to hammer away again at the idea of a new kind of mechanism to address sovereign bankruptcy, for which there is no way to force payment. Sending gunboats just doesn’t cut it, not since before The Hague in 1907. The IMF held a public discussion on restructurings at last year’s fall meetings. It is expected that come June the IMF will release more details on what it has learned from its own research and public comments.


Arguably, it is the IMF’s experience with the Greek bailout and Europe’s sovereign debt crisis that has prompted this latest revisit. The IMF was forced to suspend its rules and lend money to a country that, at the time, didn’t necessarily meet the criteria that it would be able pay it back.


Former IMF Executive Board Member Douglas Rediker says it was misguided for the IMF to use Argentina and/or Greece as the catalysts for changing established market practice.


“If you take those as your two starting points, Greece and Argentina, as the catalysts for this broader conversation? They are pretty lousy to start with those, each one unique in their own way, as the reason why we need to re-open this conversation of the SDRM conversation of over a decade ago,” Rediker said at a public forum in Washington earlier this month, sponsored by EMTA, the trade association representing the emerging market debt trading community.


“I think that Greece is the catalyst for this conversation,” he said, adding: “We are talking about the Fund using catalysts for this conversation that are not necessarily appropriate for actually opening the conversation. Doesn’t mean the conversation doesn’t need to be had, but it does mean that there is some element of a leap of faith between Argentina and Greece and what’s on the table. It really requires you to take a leap that I think is probably unwarranted.”


And yes, Greece, a member of the euro zone, was reclassified in June by equity index arbiter MSCI to emerging market from developed market status.


Essentially, the IMF floated the research paper that explained a desire to  avoid future situations where its money is used to bailout private creditors. Instead it is exploring such ideas as a creditor bail-in as a condition for its participation in a restructuring.




Another idea they want to explore is bringing a country that is facing liquidity and market access difficulties in earlier for consultation, an almost pre-default kind of situation.


Just one problem, says Arturo Porzecanski, a professor of international economics at American University in Washington: “I think they will aggravate whatever problems there are.”


“Suppose that now when a government approaches the IMF, maybe they go to the emergency room. The first thing that they are asked is not to show their insurance card but to fill out their organ donor card. That would be a little upsetting. I think if this (plan) or a variant were to come to pass, investors and analysts would rightly have to push the alarm button that whenever there is even a hint that a government in trouble is going to approach the IMF or the European institutions for financial assistance. The presumption might be that before you get a single cent from us you have to restructure your obligations, have a stand-still, pre-program, who knows what. I think that is very self-defeating. It could induce panics. Instead of the IMF being perceived as part of the solution it could be seen as part of the problem,” Porzecanski argued at the EMTA panel in Washington.


He believes a country facing debt sustainability and market access problems will likely delay their approach to the IMF for fear of being forced to restructure. Instead they might try to wait it out longer in hopes a solution can be found without the IMF.


Contrary to the IMF’s premise, research from Moody’s Investors Service shows the sovereign restructuring mechanism as it stands now, whereby creditors form committees to negotiate with the governments for a reasonable workout, seems to work.


“The Case of Argentina is Unique”

“Our research of sovereign bond defaults over the 1997-2012 period shows that sovereign bond restructurings have generally been resolved quickly; without severe creditor coordination problems, and involve little litigation. The case of Argentina is unique in the historical context,” said Elena Duggar, sovereign risk analyst at Moody’s told Reuters.


On Moody’s website, which has a free registration, is a compendium of research on sovereign debt restructuring and defaults. Not everything is free, but much of it is available to the public including this report from April 10, 2013: The Role of Holdout creditors and CACs in Sovereign Debt Restructurings.

Moody’s says, on average, a sovereign takes 10 months to close a deal after announcing its intention to restructure and 7 months after the first offer or start of negotiations with creditors.


“Only 4 exchanges took longer than an year to resolve – Dominican Republic, Russia, Argentina, and Cote d’Ivoire,” Moody’s said, noting that in this 15 year study period, creditor participation averaged 95 percent and that only 1 of the 34 modern era sovereign bond exchanges resulted in persistent litigation: the case of Argentina.


Amid the mushrooming independent research papers outlining policy prescriptions and ideas, The Brookings Institute published a paper with a host of top names in the field as authors, including governments’ favored lawyer Lee Buchheit of Cleary Gottlieb Steen Hamilton. The slant of the report fell heavily on Europe’s debt woes and trying to fix a “holdout problem”.


Veteran emerging market debt portfolio managers and lawyers who work in this space would dispute there is even a problem with holdouts or the marketplace.


Ben Heller, a portfolio manager at Hutchin Hill Capital said as much at an earlier EMTA forum in New York last month.


“Some of us, I think, would dispute there is a holdout problem. Argentina, the problem is there was an original sin in that restructuring in that it was allowed to go forward with 70 percent participation. That is not a successful restructuring…. If there was a creditor committee that was recognized and listened to and any honest attempt by the Argentines to really have a successful restructuring rather than to avoid their responsibilities then both the creditors and the debtor would have insisted on 90 or 95 percent as a condition to the closing of that restructuring. Because a restructuring with 70 percent restructuring is a disaster waiting to happen.”


One leading theory in the marketplace now is that there will be greater use of collective action clauses by debt issuers. CACs eliminate the threat of holdout litigation by requiring that all creditors accept a restructuring if it is approved by a supermajority. Aggregated CAC’s allow the supermajority across all series of bonds issued by a sovereign to be counted in the voting. This would limit the ability of a holdout investor to only hold one bond out of many and sue for better terms or block a restructuring en masse.

See below for the International Capital Market Association paper on CAC aggregation proposal

ICMA Sovereign Bond Consultation Paper – Dec 2013

At the end of the day, the IMF is attempting to build a structure that formalizes a process rather than leaving it solely up to a negotiating process of governments and investor committees, legal advisors and market sentiment.


The April paper paid special attention to debt sustainability assessments (DSA) in order to better detect problems ahead of time and resolve them before a potential crisis erupts.


“I think that we can build a better mouse trap, but we cannot build a perfect mousetrap. It is impossible as there is a lot of judgment involved in the process,” Lawrence Goodman, president of the Center for Financial Stability, said during the EMTA panel in Washington,


He also chided the IMF’s effort for not paying enough attention to the private sector involvement (PSI).


“These DSA’s need to have a strategic objective of targeting private sector participation in the economy. After a debt deal, let’s face it, the private sector can be either a friend or a foe. If the right reforms are not put in place and acrimonious discussion and heated debate regarding forming a deal, then the private sector is not going to engage. Then what is going to happen? You are going to have capital flight and it makes the situation a lot worse,” Goodman said.


“The private sector needs a real seat at the analytic table and the negotiating table,” said Goodman.

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