On December 3 Robert Gray, chairman of the debt financing and advisory group at HSBC Bank, flew from New York to Mexico City on an urgent mission. He wanted to persuade Augustin Carstens, Mexico's undersecretary of finance and public credit, to insert so-called collective action clauses into the country's future bond contracts. These CACs are meant to make it easier to carry out a debt restructuring because they prevent a handful of stubborn bondholders from thwarting a settlement by holding out, blackmail-fashion, for unrealistic terms.
But Gray wasn't just peddling collective action clauses. He was also desperately trying to forestall a more radical solution to debt restructuring -- one that happened to be championed by the U.S. Treasury and the rest of the Group of Seven countries, as well as the International Monetary Fund. The sovereign debt restructuring mechanism is, in effect, bankruptcy for countries. Gray and other bankers object to SDRM for several reasons, but the chief one is that they fear it would shift more of the burden -- and the cost -- of debt restructuring off of the IMF onto banks and bondholders.
Carstens turned Gray down flat. The Mexican official pointed out that he would consider collective action clauses only if he could be certain that they wouldn't increase Mexico's borrowing costs by implying to investors that the country was more likely to default. Says a spokesman for Carstens: "The inclusion of CACs in bond issues must be directed not only at some issuers but rather at all issuers. In this way, emerging sovereign issuers will not face higher costs."
Gray came home empty-handed, but scuttling SDRM has become a more pressing priority than ever for banks like HSBC. "Investors, creditors and the issuing countries don't like SDRM, and since they are the market, the G-7 can't ignore them and force the issue," says Citigroup senior vice chairman William Rhodes. Hearteningly for the anti-SDRM faction, it appears to be gaining ground in its campaign to squelch sovereign bankruptcy, even in the face of its formidable sponsors.
What's more, the December 6 resignation of U.S. Treasury Secretary Paul O'Neill -- who was a surprisingly ardent and early supporter of SDRM -- ought to further fortify the opposition forces. "Paul O'Neill was a catalyst for the SDRM proposal," notes Charles Dallara, managing director of the Institute of International Finance, the international bankers' association. But he adds that "the problems with SDRM are far greater than with any single official." As if to underscore SDRM's support within the G-7, German deputy finance minister Caio Koch-Weser says of efforts to find an alternative to massive bailouts, "We forced the pace, in particular with the U.K., and developed a common European position."
The stakes in scrapping sovereign bankruptcy are high, not only for banks and bondholders but also for the IMF, as well as for emerging markets themselves. Much more than dueling acronyms is at issue in the face-off over SDRM versus CAC. Consider just one figure: Emerging-markets debt crises in the 1990s cost the G-7 $218 billion in bailouts.
The new X factor in the battle over SDRM, of course, is O'Neill's replacement as U.S. Treasury secretary: John Snow, former CEO of East Coast freight railroad operator CSX Corp. and a onetime deputy undersecretary of the Department of Transportation. Less prone to blunt pronouncements than O'Neill, Snow is seen as having been tapped by the Bush administration to be its spokesman-in-chief for tax cuts.
Indeed, Snow's overwhelming priority will no doubt be domestic issues. "Snow represents a fresh opportunity for the highest levels of Treasury to look at sovereign debt restructuring," says Michael Chamberlin, executive director of the Emerging Markets Traders Association. "The negative is that the new Treasury secretary will have more important things on his plate. But the bottom line is that O'Neill's resignation will take some of the wind out of SDRM's sails."
If Snow, who has a Ph.D. in economics as well as a law degree, has a glaring deficiency in his otherwise impressive résumé, it is a lack of international experience, so he is hard to read on SDRM. The current Treasury undersecretary for international affairs, John Taylor, supported SDRM at his boss's behest but said in private that he had grave reservations about it. Whether he would be asked to stay on was unclear in late 2002.
In any event, it's a safe bet that sovereign bankruptcy issues will be well down the Treasury's priority list. And yet without the U.S.'s wholehearted support, the other members of the G-7 and the IMF have scant chance of imposing an SDRM regime on countries and the capital markets.
Nevertheless, as Washington so often demonstrates, bad ideas can take on a momentum of their own. The G-7 has set a deadline of April for presenting a fleshed-out version of its SDRM proposal to its shareholders. Thus the anti-SDRM forces aren't relaxing -- as HSBC banker Gray's mission to Mexico attests. On that very same day, investors and bankers met in New York to finalize a letter to G-7 officials laying out their objections to SDRM, and money managers dined with senior IMF officials to discuss their problems with the plan.
Bankers and investors were goaded into action last September, when O'Neill and the other G-7 finance ministers called on the IMF to produce a concrete proposal for some sort of sovereign bankruptcy mechanism by the following spring. What prompted the finance ministers' initiative was their fear that the G-7 would be forced to provide ever bigger and more frequent bailouts to emerging markets.
Not only did these rescues cost the G-7's citizens hard-earned tax dollars -- a point made often by O'Neill -- but they also usually failed to stave off the defaults they were designed to prevent. Moreover, they engendered moral hazard: Banks and bondholders came to count on bailouts whenever emerging markets got into trouble and so invested recklessly.
The G-7 finance ministers, with O'Neill in the forefront, concluded that they had to limit bailouts and find a way to make debt restructuring less painful for all concerned, but especially for the taxpayers back home. So their aides came up with two solutions to the problem.
Anne Krueger, the IMF's second-in-command, cobbled together a rudimentary draft of SDRM. "There is an obvious demand for a new and improved international financial architecture," Krueger told Institutional Investor last summer. "This is a sensible way to make a major step forward." Her idea was to create a new supranational legal apparatus to give the IMF the power to declare a payment standstill when a developing country could no longer pay interest or principal on its debt, thus protecting that country from creditor lawsuits. The IMF would also provide distressed countries with financial assistance -- though not a bailout as such -- while they negotiated a debt restructuring with creditors.
Option No. 2 was CACs. Here the thrust was to prevent a minority of creditors -- such as vulture investment funds -- from blocking a restructuring in the calculated hope of wresting more generous terms. One problem with CACs is that it would take decades before all emerging-markets bonds would contain them. And they don't provide for aggregation of claims across different types of debt; in other words, sovereign bonds would have to be restructured separately from bank debt.
Despite their shortcomings, CACs look a lot better to most market participants than SDRM. For a start, bankers see the sovereign bankruptcy regime as self-dealing by the IMF: Under SDRM the Fund's now informal preferred-creditor status (the IMF customarily gets paid before commercial creditors) would be stipulated by law. And since the IMF would determine how much debt a country could sustain, the agency would in effect be deciding the financial losses to be apportioned to banks and bondholders in a restructuring.
"The only people in favor of SDRM are the G-7 because they're paying for the bailouts, and the markets don't want SDRM because they want the bailouts," says Adam Lerrick, a professor at Carnegie Mellon University and an influential thinker in conservative Republican circles.
Wall Street's sell side would prefer CACs because they're more market-based than SDRM. In addition, CACs don't subordinate the claims of private investors to those of the IMF. Many buy-siders, however, don't want to waste time developing workable and marketable CACs until SDRM -- which would supersede the clauses -- is off the table.
For their part, emerging markets are mostly against SDRM. They, too, are partial to the concept of bailouts, and they worry that SDRM would reduce the amount of private financing available and increase their borrowing costs. They also believe that embracing CACs would stigmatize them as borrowers, unless the G-7 and other developing countries did likewise. "We would be less reluctant to accept CACs if there was more conviction in the buy side that this was the way to go," Mexican central bank governor Guillermo Ortíz said last summer.
Last month seven Wall Street trade associations that had occasionally met among themselves and with G-7 policymakers and emerging-markets officials overcame their parochial squabbles and banded together in a "Gang of Seven" to fight SDRM. The group, all with disparate interests in debt restructuring, include the Bond Market Association; the Emerging Markets Creditors Association, representing money managers; the Emerging Markets Traders Association; the Institute of International Finance; the International Private Markets Association; the International Securities Markets Association; and the Securities Industry Association.
The Gang of Seven has publicized the case against sovereign bankruptcy in op-ed pieces in major newspapers and speeches by such respected financiers as former IMF chief Jacques de Larosière and Federal Reserve Bank of New York president William McDonough, as well as by key emerging-markets policymakers like Pedro Malan, Brazil's former Finance minister.
All this chatter, combined with strenuous objections raised in private meetings, has already caused the IMF to water down its original SDRM proposal by circumscribing the agency's central role in the process. The Fund has abolished the payment standstill, or stay, which was intended to protect a bankrupt country from lawsuits by vulture investors. "After numerous discussions with the private sector, we have come to the conclusion that the sort of stay we had previously envisaged was less than necessary and probably was an unwarranted intrusion into creditor rights," says an IMF official.
The IMF's concession, though substantial, hasn't mollified investors. The agency retains responsibility for determining how much of a haircut investors should suffer on their bonds, and it also still wields the power to force the will of the majority of investors on holdouts in restructurings.
Not placated, the anti-SDRM troops stepped up their offensive in December. On December 3, just days before Treasury secretary O'Neill resigned, members of the Gang of Seven met in the office of Abigail McKenna, an emerging-markets portfolio manager at Morgan Stanley Asset Management and head of the Emerging Markets Creditors Association. After a vigorous and protracted discussion, they agreed on the wording of a lengthy statement to G-7 policymakers that laid out in detail their critique of SDRM. The letter, which was signed by the entire Gang of Seven, argued that SDRM could undermine the market: "Capital markets are built on the fundamental principle of enforceability of contracts, and SDRM represents a radical departure from this fundamental principle. It would appeal to those political forces in emerging markets that look for easy alternatives to policy discipline."
That same day, a team of IMF officials, led by first deputy managing director Krueger, hosted a dinner at New York's Plaza hotel for a few asset managers involved in emerging markets, including Alliance Capital Management, Morgan Stanley, Salomon Asset Management and TIAA-CREF. The purpose: for the IMF officials to hear buy-side objections to SDRM -- and perhaps calm a few tempers. Buy-siders had long felt ignored by policymakers and were concerned that investment banks were pushing SDRM alternatives like CACs that would generate advisory or underwriting fees but not necessarily preserve bondholder rights. "It was a huge change in the IMF that they appreciated the distinction between the buy side and sell side," says Morgan Stanley's McKenna.
The night before O'Neill's resignation, Treasury undersecretary Taylor braved New York's first snowstorm of the winter to address the annual meeting of the Emerging Markets Traders Association at Salomon Smith Barney headquarters. His theme: the ostensible benefits of CACs. He concluded the question-and-answer period by saying that he would direct the fee-hungry bankers to emerging-markets countries that were ready to issue bonds incorporating CACs. "This is a real market opportunity for investment bankers in the room," Taylor said, mock tongue-in-cheek.
"Taylor's remarks were consistent with the private sector approach," says EMTA head Chamberlin. "What Taylor was really saying to us was that clauses sound good -- now show us the beef." In other words, if bond clauses can be shown to work, SDRM won't be necessary. "I want to emphasize that we, the G-7, have not endorsed SDRM; we endorsed work on a proposal so we can then consider it," notes Taylor.
Coincidence or not, O'Neill, the staunch SDRM supporter, resigned the next morning, cheering opponents of sovereign bankruptcy. But their optimism may be short-lived. Many investors aren't convinced that the Treasury secretary's departure sounds the death knell for the proposal. "O'Neill wasn't fired because of SDRM," notes one. Adds Mark Dow, an emerging-markets fund manager at Boston-based MFS Investment Management, "The Bush economic team shake-up may make for more coherence, there may be changes in priority and emphasis, but it is unlikely to change direction significantly."
Timing could be a critical factor here. In September, three months before O'Neill left, the IMF was given the green light by the U.S. and other G-7 countries to move forward with SDRM. Admits one IMF staffer, "If O'Neill had resigned before September, we could have kissed SDRM good-bye."
O'Neill wasn't the only supporter of SDRM among G-7 finance ministers. European policymakers have always been more inclined to favor interventionist policies than their American counterparts; most remain convinced that sovereign bankruptcy is the best way to eliminate the moral hazard created by big IMF bailouts while preserving the Fund's shrinking capital base. The IMF has only $65 billion available for new loans -- not all that much, considering it spent $35 billion bailing out Brazil and Turkey last year.
The G-7's and the IMF's continued support for SDRM means as a practical matter that if investors and bankers can't inveigle key emerging markets like Mexico, Russia and South Korea into issuing CAC bonds, the Fund and the Europeans will forge ahead with SDRM. Bankers will also have to get recalcitrant investors like Morgan Stanley's McKenna to drop their opposition to CACs. "Our priority now is to get the buy side in the U.S. to see that CACs are not a threat," says HSBC's Gray.
The buy side, however, is holding fast to its position that it will not accept CAC bonds until SDRM is well and truly dead. "There is little point in issuing CACs if they are made superfluous by a new bankruptcy process in two years," argues William Ledward, a portfolio manager at Fiduciary Trust International in London.
Displaying a historical mistrust, many buy-siders are suspicious of the sell side, saying banks are only interested in fees from underwriting CAC bonds. Investors worry that the clauses will apply only to bondholders and will leave the banks' trade lines and other commercial credit lines untouched. "There is a disconnect between asset managers and high-level bankers, who are pressuring issuers on CACs," says one hedge fund manager. "The sell side is pursuing short-term interests and trying to play nice with the G-7, but it is working against the long-term interests of their asset management arms." Issuers, meanwhile, are getting mixed signals from bankers about the costs and benefits of CACs.
Even as European officials endorse SDRM, they've been aggressively trying to jump-start CACs on the side. In early September European Union members agreed to include CACs in bonds that they issue in non-EU jurisdictions, including New York; no CAC bonds have yet been issued. "We will use this clause if we do an issue in the U.S. market," pledges Peter Nyberg, head of the financial markets department at the Finnish Ministry of Finance. "The idea is to get the ball rolling elsewhere." A representative of the Italian Treasury confirms that they are "considering the technical aspects of CACs."
Conceivably, a still inchoate third alternative could descend on the debt-restructuring debate like a deus ex machina and break the impasse over CACs. First mooted by French central banker Jean-Claude Trichet, this proposal calls for issuers, intermediaries and policymakers to subscribe to a yet-to-be-defined code of conduct during a debt crisis. These Robert's Rules of restructuring -- combined with CACs -- would then serve as an alternative to SDRM.
Bankers and investors active in combating SDRM figure that if they present G-7 and IMF policymakers with a package of alternatives to it, including a code of conduct and a consensus version of CACs, as well as an extensive critique of SDRM, they'll be able to sway the officials' thinking before they meet to discuss the idea in April. It just may work. "There are a lot of attractive features to a private sector, decentralized approach to this, so I would like to see the proposal," says Treasury's Taylor. "It sounds promising."