Nothing frightens global financial markets more than a nation defaulting on its debt repayment. However on August 1st 2014, when Argentina defaulted on its debt for the second time in 13 years, it didn’t adversely affect world markets. The reason being, unlike its default in 2001, the current default is more appropriately a “legal default” rather than a financial default.
Argentina was forced to default as a result of certain private interests, who legally won the right to halt Argentina’s ability to repay. These private individuals who can easily trap a nation into a financial crisis are a serious threat to a world that’s growing more financially inter-connected than ever before.
Argentina’s Tale of Boom and Busts:
For Argentina, the current crisis is far less worrisome than some of the earlier situations it has had to endure. In the 1976 crisis, the annual inflation surpassed 600%, two decades later in 1989, inflation hit 5000%, many supermarkets across Buenos Aires then announced prices on the intercom rather than printing price tags on their products.
The current crisis finds its root in the 2001 financial default. Argentina, Latin America’s 2nd largest economy thrived mainly on export of meat, wheat and other farm goods. High commodity prices ensured good income for farmers and good export income for the government. However uncontrolled borrowing and corruption and a crash in commodity prices led to Argentina defaulting on its $ 100 Billion debt, the world’s biggest ever sovereign default.
What ensued was complete chaos, mass unemployment, the Argentine currency Peso was devalued, bank accounts and deposits of common citizens were frozen. Argentina saw five Presidents take office and leave in just two weeks.
However, the economy quickly rebounded. In 2003, Nestor Kirchner the late husband of current Argentine President Cristina Fernandez took office. He led the nation’s recovery, restarting shut down factories under co-operative schemes, generating jobs through infrastructure works etc. By 2006, Argentina was able to repay in full their loan due to the IMF, $ 9.8 Billion in cash.
In order to address the concerns of those whose loans the government had defaulted in 2001, the Argentine government held a debt restructuring program in 2005 and again in 2010. Argentina was able to convince nearly 92% of all bond holders to agree to a 70% reduction in total returns.
However, two hedge funds NML Capital and Aurelius Capital Management led by billionaire Paul Singer, refused to accept any reduction and demanded that the Argentine government pay them in full what they legally and consciously agreed to. Leading to a long prolonged court process which ended with a US District court freezing the account through which Argentina pays its debt.
The court has now directed Argentina to pay Paul Singer and his associates in full first before proceeding with any payments to anyone else.
Vulture Funds/Holdout Investors Paul Singer
The US court’s decision was splashed across papers in Argentina. President Cristina Fernandez appeared on a national emergency broadcast, announcing that she would not pay these ‘vultures’, and that the courts decision in favour of Paul Singer amounts to ‘extortion’.
Vulture funds or Holdout Investors are private equity and hedge funds that invest primarily in distressed security and bonds. They generally purchase debt at a discounted price from the secondary market and then force the debtor to pay either in full or a price greater than the price of acquisition. These security or bonds could be sovereign, corporate or individual.
In order to ensure they receive payment, they go into lengthy litigation, freezing bank accounts, real estate, taking possession of both moveable and immoveable property etc.
Paul Singer and his vulture funds acquired the current Argentine bonds from the secondary market at prices even lower than what’s offered after the 70% cut. They were sold mostly by firms who had lost faith in Argentina’s ability to ever repay any significant amount of what’s due. If they are to be paid in full, they would receive $ 1.3 Billion.
Paul Singer is especially infamous for his vulture funding achievements. In 1996, he spent $ 11 Million to purchase bank debt backed by the Peruvian government. By 2000, he forced the Peru government to pay him $ 58 Million to settle the debt repayment, a return of 400%.
His legal success now allows other bond holders to make use of the Rights Upon Future Options (RUFO) clause. As per the RUFO clause, if the Argentine government pays anyone more than what has been agreed to, as per the debt restructuring program, then those funds who agreed to the cut will also have a right to claim to be paid on par or in full.
How Obama can save Argentina:
The entire current crisis can be completely diffused if US President Barack Obama chooses to do so. As per the authority granted in the US Constitution under the ‘Separation of Powers” clause, Barack Obama could use the principle of “comity” to send a note to the District Court informing that the present lawsuit interferes with the President’s sole authority to conduct US foreign policy.
Both the case and its verdict would be dismissed. This clause has been used earlier against Paul Singer by President George W Bush with respect to vulture funding in Congo.
However, despite announcing his support for Argentina, Obama is yet to send that note. This is not the first time Obama has come face to face with Paul Singer.
In 2009, barely a year into office, Obama and his administration came head to head with Singer and his vulture funds. Paul Singer had taken control of the bankrupt Delphi Automotive, the sole supplier of auto parts to General Motors and Chrysler. He now threatened to shut down parts supplies unless the US Treasury paid him billions including $ 350 Million in cash. After weeks of negotiations, Obama was forced to oblige when GM and Chrysler, both already bankrupt and on the verge of closing were left with parts to carry on production for just five more days.
The US Treasury paid $ 12.9 Billion in cash along with subsidies from the Treasury auto bailout fund.
Paul Singer, the cold hearted capitalist, followed up by announcing the closure of 25 of the 29 Delphi units in the US and moved 25,000 jobs offshore.
Anti-Vulture Funds Law:ANTI- VULTURE FUNDS LAW:
The above experience was the reason behind the US administration passing the ‘Stop Vulture Fund Act’. In 2009, the Act was passed by Congress. It seeks to limit the amount of profit a secondary creditor can win through litigation.
The Act prohibits any American citizen or company to engage in vulture fund investments. It also prohibits any court from accepting any suit which in turn could be an act of extortion. It allows the debtor to clearly prove that his debt has been purchased with an intention to litigate and extort and hence seek dismissal of such law suits.
Only five countries in the world have such a law in place to protect sovereign debt, corporate and individual debt, USA, UK, Belgium, Australia and France.
India doesn’t have such a law in place that directly deals with vulture funds. However following the Laws of Champerty Maintenance, which is a colonial era statue, it is considered illegal to purchase debt with the sole intention of litigation, a clause which can be easily stepped over, if the creditor can prove that the debtor is intentionally defaulting.
In order to bypass the current stalemate and pay it’s bondholders, Argentina has introduced a bill in Parliament seeking to swap the old US issued bonds with new bonds payable in Argentina. Even if the bill is passed and creditors agree to a bond swap many challenges remain.
The Bank of New York, which acts as the trustee for the bond payments has to oblige with the current court order or else it will be held in contempt of court, making it difficult for Argentina to get back the funds frozen in the account. At the same time a bond swap will also make it difficult for Argentina to ever again issue bonds from the US to raise capital.
It’s most unlikely that a solution will be reached at the earliest and Argentina may have to prepare itself for a lengthy litigation process. However the current crisis stands out for the role played by vulture funds globally and how governments must make sure it protect itself from such individuals.
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