The debt-crisis crisis

It wasn’t perfect, but a pact among the U.S. Treasury, the IMF and Wall Street saved many a sovereign debtor. Now that it has collapsed, policymakers can’t agree on how to cope in the “postbailout” era. Crisis-in-point: Argentina.

It wasn’t perfect, but a pact among the U.S. Treasury, the IMF and Wall Street saved many a sovereign debtor. Now that it has collapsed, policymakers can’t agree on how to cope in the “postbailout” era. Crisis-in-point: Argentina.

By Deepak Gopinath
August 2002
Institutional Investor Magazine

Allan Applestein is an avuncular 70-year-old grandfather from Aventura, Florida. He made himself a multimillionaire by developing an automated chicken feeder. Now he may just hold the key to resolving the Argentinean debt crisis.

Back in 2000 and 2001, Applestein bought $245,000 of Argentinean government bonds. They were meant as a personal investment, one that turned into a disaster. “We were deluded by the government,” he says. “Economy minister Domingo Cavallo and president [Fernando] de la Rúa made statements that Argentina would never default on its loans, and I was naive enough to believe them.”

Buenos Aires, of course, defaulted on its $141 billion debt in December, and Cavallo and de la Rúa were hounded from office. So Applestein is now doing what any red-blooded American investor would do under the circumstances: He’s suing Argentina, seeking full repayment of the bonds. When word of his suit spread, Applestein says, he was inundated by so many calls, e-mails and letters that he decided to expand his litigation into a full-blown class-action suit on behalf of all of Argentina’s foreign bondholders. (He’s separately suing the Province of Buenos Aires for nonpayment on a batch of its bonds.)

“Argentina has assets all over the world,” points out Applestein. “If we get a judgment, so long as we could do so legally, we would be compelled to pursue those assets.”

Welcome to sovereign debt crisis management in the “postbailout” era. Now that the International Monetary Fund and the U.S. Treasury Department have largely abdicated their customary, and highly controversial, role of automatically bailing out countries whenever they get into financial trouble, the workout process has by default fallen largely to the free market -- and it has become a free-for-all. Nor is order about to break out, as is evident from Argentina’s protracted struggles. The IMF and Treasury have put forward rival schemes for systematizing the workout process, but neither approach is considered a panacea. The IMF proposed a corporate-style bankruptcy procedure for countries that would forestall litigation while an independent body supervises debt restructuring. The U.S. Treasury is pushing for the introduction of bond clauses designed to prevent a small minority of bondholders from impeding a debt restructuring.

Meanwhile, Applestein and other bondholders -- some far more cynical in their motives and methods than he -- go after Buenos Aires on their own. Applestein may not be quite the financial naïf that he purports to be: The Harvard Universitytrained lawyer and biochemist made a fortune in agribusiness and now oversees the $2 billion-plus DCA Grantor Trust. His class-action suit is the first of its kind in a sovereign debt restructuring.

The very fact that an individual investor holding a comparatively diminutive chunk of Argentina’s $95 billion in bond and commercial paper debt could pursue his own solution to the country’s default -- and feel that he had no other recourse -- attests to the brave and scary new world of workouts. What’s more, although few experts give Applestein’s case much chance -- sovereign nations are notoriously difficult defendants -- it could tie up the whole restructuring effort. As a lawyer familiar with the case points out, “Applestein’s class action could complicate a behind-the-scenes approach.”

The big institutional investors that dominate the Argentina Bondholders’ Committee strongly oppose the suit. “We are not supporting the suit because Applestein is not representative of the class,” says George Estes, an emerging-markets analyst with Boston-based asset manager Grantham, Mayo, Van Otterloo & Co. and a member of the committee.

Of course, resolving sovereign debt crises has already become a more complicated tactical proposition than it was in the notorious Latin American default-a-month era of the 1980s. Then commercial banks were countries’ biggest creditors, and the banks were susceptible to government suasion. They could be coerced and cajoled into undertaking elaborate debt restructurings that kept countries afloat. Now the vast bulk of emerging-markets debt is held by widely dispersed and difficult to identify bondholders who don’t readily kowtow to government officials.

Indeed, in the absence of any reliable mechanism for resolving sovereign debt crises, so-called vulture investors that buy distressed countries’ debt at steep discounts and then press to be paid off in full have been able virtually to hold governments hostage. The vultures are circling Argentina now.

One is lawyer Michael Straus of Birmingham, Alabama based Straus & Boies, who sits on the Argentina Bondholders’ Committee board as a representative of Red Mountain Finance, an investment firm that he and Jay Newman of New York hedge fund Elliott Associates founded in 1996. The pair have sought to use U.S. and international courts to force full payment of their holdings of debt from Côte d’Ivoire, the Democratic Republic of Congo, Ecuador, Panama and Poland.

Straus and Newman potentially pose a credible legal threat to Buenos Aires. The pair achieved notoriety when they successfully sued Peru in New York for full payment of $20 million in debt that Elliott had purchased for $11 million on the secondary market in 1996. Four years later, the firm collected $58 million: the face value of the bonds plus interest.

The vultures have few friends. This May U.K. Chancellor of the Exchequer Gordon Brown warned that vultures were undermining a high-profile effort by the Group of Seven to give the poorest countries debt relief. “We particularly condemn the perversity where vulture funds purchase debt at a reduced price and make a profit from suing the debtor country to recover the full amount -- a morally outrageous outcome,” Brown railed.

To Anne Krueger, first deputy managing director of the IMF, Elliott epitomizes everything that is wrong with the current ad hoc approach to debt restructuring. “The threat of disruption remains likely to deter countries from seeking a necessary restructuring for longer than is desirable,” said Krueger, a conservative former Stanford University economics professor and World Bank chief economist, last fall.

For their part, Newman and Straus reject the contention that they are spoilers. “There are no examples I know of where someone who bought debt below par blocked a restructuring,” says Straus. “I view this as a misplaced concern that only diverts attention from the official sector’s and/or the borrowers’ roles in precipitating financial crises by failing to monitor or control excess indebtedness.” Both dispute the vulture label.

Neither will comment on their strategy with respect to Argentina. Some analysts, though, suggest that the country’s bonds, trading at the equivalent of 20 cents on the dollar, are still too expensive as a vulture play. The target: 12 cents.

The vultures would be largely out of luck if Krueger’s proposal for a corporate bankruptcylike approach to resolving sovereign debt crises were adopted. But when it was proposed last fall, the plan set off a firestorm of debate over mechanisms for debt workouts that continues unabated. Perhaps the closest thing to a debt crisis consensus that exists today is that we have entered the postbailout era, one in which rescuing distressed countries with large dollops of cash is no longer the reflexive response of policymakers. The U.S. and other G-7 governments are abandoning the bailout model. U.S. Treasury Secretary Paul O’Neill has labeled bailouts a waste of taxpayers’ money and a subsidy to reckless private investors.

“The policy is not to be bailing out countries where there are no sustainable policies in place,” says John Taylor, Treasury undersecretary for international affairs and the administration’s point man on sovereign debt issues. “Since the Bush administration took office, we have noted the need to limit official sector support to reduce crises that have been growing in magnitude and to reverse the decline in private capital flows.”

Krueger may be at odds with her old Stanford colleague Taylor about debt restructuring mechanics, but she sounds a very similar note in arguing that the IMF, and by inference the U.S., can no longer be the world’s rainy day fund: “Our resources, even our resources combined with the other international financial institutions, are relatively small contrasted with the order of magnitude of the problems which could be out there, and as that happens there is no way that you can always fill the hole.” The Fund has about $84 billion available in toto to assist countries that get into debt difficulties; for perspective, some $160 billion in net private capital is expected to flow to emerging markets this year alone.

Controversial though it may have been, the old debt management regime will, as a practical matter, be difficult to replace. Columbia University economics professor and well-known free-market champion Jagdish Bhagwati famously likened the TreasuryWall StreetIMF triad in its cohesion and clout to the cold war military-industrial complex. Prompted by Treasury secretary Robert Rubin, with Wall Street support, the IMF officially rescued country after country -- and, unofficially, holders of those countries’ bonds -- during the 1990s, most conspicuously during the Asian financial crisis.

But the Bush Treasury has espoused a more hands-off philosophy on sovereign debt. It was O’Neill, ironically, who proposed to Krueger and her boss, IMF chief Horst Köhler, at a breakfast last September that the agency look into corporate-style bankruptcy for countries as a substitute for bailouts. A few days after his meeting with Köhler, O’Neill told the Senate Banking Committee, “We need an agreement on international bankruptcy law so that we can work with governments that, in effect, need to go through a Chapter 11 reorganization, instead of socializing the cost of [their] bad decisions.”

O’Neill’s hands-off policy has its exceptions. Partly in response to geopolitical concerns, the U.S. has been quick to aid Turkey -- twice for $28 billion since May 2001. Even Argentina got $8 billion in August 2001. Now with Brazil beginning to wobble, having caught the contagion from Argentina, the no-bailout policy will again be put to the test.

Krueger’s plan would revamp the entire debt restructuring process. Originally, she proposed that countries should be able, with the IMF’s concurrence, to declare payment standstills and impose capital controls while negotiating debt restructuring terms directly with creditors. The trigger would be an IMF determination that a country’s debt was unsustainable. Casting itself in the role of omnipotent bankruptcy judge, the IMF would decide how much of a loss -- how big a haircut, in investor lingo -- bondholders would take.

To facilitate this process, IMF members, including the U.S., would have to amend the organization’s charter. Moreover, the laws governing creditor rights in countries where emerging-markets debt is issued, such as the U.S., would have to be amended to allow the IMF to supercede local courts.

Krueger sees her plan as the best way of preventing investors from stampeding to the exits when a country gets into dire straits, thereby increasing the severity of the crisis -- at a time when the Fund can no longer be counted on to come to the rescue with a big bailout. “There is a coordination problem now, an incentive [for lenders] when things look shaky to get out first, so I think a mechanism like this is desirable,” she says.

Just the same, many bond investors fear that the IMF’s bankruptcy idea and other proposals to supplant or supplement conventional bailouts merely shift the burden of defaults more heavily onto them and make it too easy for countries to restructure debt.

Had the Krueger plan been in effect a year ago when Argen-tina’s debt problems began to reach the crisis point, Buenos Aires could have gone to the IMF and requested a payments standstill and protection from creditor lawsuits while it negotiated a debt restructuring.

Krueger responded to critics of her proposal in April by tempering it to circumscribe the Fund’s role. “Fund-light,” IMF staffers called it. Creditors, not the Fund, would decide whether a payments standstill would be extended, and a neutral agency, not the IMF, would supervise debt restructuring negotiations. Of course, this leaves open the question of which “neutral” agency would be the bankruptcy arbiter. And the IMF would still retain control over the whole process.

“The way Krueger has organized [the bankruptcy plan] is very advantageous to the IMF,” says a G-7 official. “Is that empire-building, or is the IMF following its mandate? The Fund wins in either case.”

Adds one fund manager, “The real goal is to protect the IMF: Unless the IMF gets countries like Argentina to take it out of the hide of creditors, the IMF won’t get paid.”

More mainstream private sector critics also question the IMF’s designs. Bankers and investors express concern that ready recourse to a workout mechanism might lessen the stigma of default for governments, prompting them to borrow imprudently. They’re also quick to point out the conflict of interest inherent when the IMF, itself a major country creditor, acts as arbiter of sovereign bankruptcy proceedings.

“The Fund is not only a creditor, but it is also a preferred creditor,” says William Rhodes, Citigroup senior vice chairman and an expert on sovereign debt workouts. “The Fund has often criticized the commercial banks for overlending to emerging markets. However, they also talk of the need for private sector participation in resolving country crisis situations where the Fund is lending.”

Treasury Undersecretary Taylor’s alternative approach -- rejiggering bond contracts to encourage creditors to cooperate in restructurings -- is both less sweeping and more cautious than Krueger’s. It’s also more expedient. “Both proposals are ways of getting at the same thing,” says Taylor deputy Randal Quarles. “We felt contracts were the most likely to get us there fastest.”

What Taylor proposes is that developing-country borrowers incorporate three types of clauses in bond contracts: a majority action clause that would prevent holdouts among creditors -- so-called rogues like Elliott -- from disrupting a restructuring; an initiation clause that would allow for payments to be suspended during a restructuring; and a representation clause that would set the rules of debtor-creditor negotiations. Existing debt would be swapped into bonds containing the clauses -- one reason investment banks find this approach appealing -- or rolled over at maturity into bonds containing the clauses. The vast majority of bonds could be covered within a decade, estimates the Treasury.

Major banks, always uneasy with drastic departures from the status quo, see Taylor’s proposal as the lesser of two evils. The Institute of International Finance, the influential bankers’ lobbying group, endorses the Taylor plan. “There is much more willingness to see a negotiated arrangement between the public and private sectors based on contractual changes” than a whole new bankruptcy regime, says Citi’s Rhodes, one of the institute’s vice chairmen.

Both Krueger’s and Taylor’s proposals remain on the agenda, jockeying for primacy. The G-7 produced an “action plan” on debt restructurings this spring that declared the contesting plans to be “complementary” and said that they should be pursued on a twin-track basis. Nevertheless, the G-7 did allow that Krueger’s scheme would take time to implement and urged immediate work on Taylor’s proposal. Market participants have largely endorsed Taylor’s plan.

In June the heads of the IIF, the Emerging Markets Traders Association, the Bond Market Association, the Emerging Markets Creditors Association (which represents the buy side), the Securities Industry Association and the International Primary Market Association issued a joint statement supporting the wider use of collective action clauses in sovereign bond contracts. “We are concentrating on the most effective market-based approach, which is broader use of collective action clauses,” says IIF managing director Charles Dallara. “Fund-light depends on construction and activation of a comprehensive framework and is likely to trigger a restructuring when a shorter-term rollover of trade and interbank lines may be sufficient.”

Emerging-markets countries are a lot less enthusiastic about the Taylor proposal. Concerned about higher borrowing costs if they were to include the clauses, a few have asked the U.S. to set an example by putting them into its own bonds. Explains former Mexican Finance minister José Angel Gurría, a veteran of countless debt negotiations: “Developing countries would look at this exercise with greater conviction if everyone were doing this. If we are the only one with clauses, then [developing-country debt] becomes a super junk bond category.”

Mexican central bank governor Guillermo Ortiz is no less emphatic in rejecting the Taylor prescription. “We would be less reluctant to accept collective action clauses if there was more conviction on the buy side that this was the way to go,” he says. Says Brazilian deputy central bank governor Beny Parnes: “We prefer a gradual market-based approach; we believe in stability. Sudden changes can be disruptive.”

Taylor’s proposal provides a carrot and a stick in the form of cheaper IMF loans, on the one hand, and less ready access to them, on the other. Critics, however, say neither is enough and that both involve complications. The break on loan terms might entail amending the IMF’s articles of agreement, which would require the approval of a U.S. Congress hostile to the Fund. And cutting off countries that don’t go for the bond clauses could prove to be catastrophically self-defeating in a debt crisis.

“I don’t believe collective action clauses or a statutory mechanism would have avoided the debacle in Argentina,” says Caroline Atkinson, a senior fellow at the Council on Foreign Relations and former Treasury senior deputy assistant secretary for international affairs under both Rubin and his successor, Lawrence Summers.

Columbia University economist Jeffrey Sachs, who has long advocated a bankruptcy mechanism, criticizes the Treasury for dismissing the Krueger approach. “You need a bankruptcy process to avoid countries being dragged through years of crisis,” he says.

Some observers conclude that the best solution is simply for bondholders to get together and set up their own independent bankruptcy forum. But don’t suppose that, for better or worse, this would sideline the IMF. “Even if debtors and creditors want to get together, the creditors need some idea of what is a likely growth rate going forward and what’s sustainable by way of debt service,” maintains Krueger. “That is the Fund now, and that will inevitably be the Fund in all circumstances.”

How much of a role in resolving debt crises remains for the Fund may be decided by events in Argentina, whose travails inspired the search for a new debt restructuring approach in the first place. If Buenos Aires and bondholders are able to complete a restructuring relatively quickly and painlessly, with a minimum of disruptive litigation, policymakers may decide that gradually adopting collective action clauses may be all that’s required.

But more than six months after defaulting, Argentina has yet to begin serious negotiations with creditors, and that has encouraged bondholders like Applestein to take matters into their own hands. Two other modest creditors, privately held Lightwater Corp. and Old Castle Holdings, have filed complaints in New York for $7 million and $700,000, respectively. “All they will have achieved is wasting money, pissing off the Argentines and ending up back at square one -- with a judgment but no money,” mutters a hedge fund manager who is a member of the Argentina Bondholders’ Committee.

Still, although obstacles abound, the possibility remains that a vulture investor could obtain better restructuring terms through litigation than Argentina’s other bondholders. “It is not out of the question that someone can get lucky again,” grants Owen Pell, a litigator with New York law firm White & Case.

Nor are U.S. bondholders the only litigious ones. In late July an Italian lower court complicated debt negotiations further by ruling that ten individual Italian holders of Argentinean bonds could freeze $2.5 million of Argentina’s assets in Italy. The group’s lawyer, Mauro Sandri, plans to file a new lawsuit on behalf of the 250,000 Italians who own Argentinean debt. Sandri says he is getting 3,000 phone calls a day from bondholders.

Perhaps the biggest hurdle for vultures, though, is that government officials and international policymakers are ready and waiting -- in ambush, in effect.

“Argentina is clearly better prepared than Peru,” points out Whitney Debevoise, a partner at New York law firm Arnold & Porter. “There may not be an element of surprise this time around.”

Vultures are one thing. But is Buenos Aires ready for an Allan Applestein?