Argentina has embarked on the biggest bond default in history, and for all the country’s attempts to do so in a transparent and orderly manner, the process is not looking very pretty so far.
A comprehensive Argentine debt restructuring has been a question of when rather than whether for some months. And as far as rating agency Standard&Poor’s is concerned, at least, the key date was November 6. That was when the sovereign announced that it was going to swap its outstanding bonds for new loans, issued under Argentine law and collateralized by tax receipts. The new loans have lower coupons than the bonds, are illiquid, and have extended maturities, although the principal is unchanged. Domestic investors don’t want to take a capital loss.
Even though the exchange is voluntary, S&P considers that its very existence constitutes a default. David Beers, S&P’s head of sovereign ratings, says: “If you’re doing a distressed debt exchange – if we’re talking about some borrowing entity in financial distress, which Argentina unambiguously is – and if you ask the creditors to accept terms less favourable than that which they are presently getting, then that constitutes a default under S&P’s methodology.”
The swap might very well constitute a legal default as well. Argentina’s bonds include standard language saying that they will remain the most senior of the country’s obligations, and rank pari passu with any new issuances of the Argentine government. But because the new loans are collateralized, they’re the first to get paid out of Argentina’s tax receipts, making them senior to all outstanding bonds.
Restructuring step by step
If bondholders are concerned about one issue above all others, it’s that of equal treatment: that international bondholders don’t get treated worse than domestic bondholders and that holders of Eurobonds don’t lose out to holders of Brady bonds. But already, says one bondholder, “there is a seniority issue. There is not equal treatment. That raises questions on negative pledge clauses, on pari passu clauses.”
Some bondholders have already received legal advice saying that they can accelerate any bond they like – if they can muster 25% of its holders to vote in favour.
Such a drastic action – it would make the whole principal and interest amount on the bond due and payable immediately, plunging Argentina into a payment default – is highly unlikely in the near future. For one thing, there exists a certain amount of goodwill between bondholders and the Argentine government, which has historically been one of the most open and transparent of emerging-market borrowers. For another, it’s far from clear that any group of activist international bondholders can account for 25% of any given bond issue.
A lot of large international bondholders would never vote for acceleration just as a negotiating tactic. Many of the bonds in international hands are Brady bonds still held by the banks that lent to Argentina in the first place; this will be their second restructuring of that debt, and there’s a good chance the reason they never sold it is that they didn’t want to take the balance-sheet loss. If Argentina structures a par-for-par exchange, which seems likely, then they’ll probably be happy.
Then there are the banks with large operations in Argentina, such as BSCH, BBVA, JPMorgan Chase and Citigroup. “Our firm has a much greater stake in Argentina’s prosperity than in Argentina going off the rails,” says a senior banker at one of these. “So all things being equal, we’re going to want to help them.”
And because Argentina’s default has been so clearly flagged in advance, virtually all international fund managers have been extremely underweight Argentina for some time. There has been a natural flow of Argentine debt from foreign into domestic hands, where Argentine country risk is taken as a given, rather than as a variable to be adjusted according to circumstance. Dresdner Kleinwort Wasserstein now estimates that 57% of Argentina’s bonds are held by locals.
It is partly for this reason that Argentina has embarked on its controversial two-phase restructuring programme. Both phases are open to both foreign and domestic investors, but no-one expects any meaningful foreign participation in the first part of the exchange.
The idea seems to be that Argentina will get the ball rolling with a large domestic bond swap, which could attract well over $30 billion of the country’s $95 billion in outstanding bonds. It will then be able to point to a certain amount of net present value reduction that domestic bondholders have already accepted when it enters into talks with its foreign creditors.
Domestic banks in trouble
Much more important, from Argentina’s point of view, is the role the domestic swap plays in shoring up the country’s banking system. Argentine banks, which are all committed to staying in the country for the long term, have been loaded up on government debt over the past year as fewer and fewer other investors have been willing to buy it. A large write-down in their holdings could lead to the devastation of the banking system – the one thing Argentina wants to avoid even more than a devaluation or a default.
So the domestic swap has been structured largely for the banks’ benefit. At the moment, Argentina’s bonds are on the banks’ books at market rates: in the low 30s, for instance, for the benchmark 2008s. The new loans, however, precisely because they are not tradeable, can be booked at par, strengthening banks’ balance sheets significantly, and reducing the risk of a run on the banking system.
Of course, the banks are not completely out of the wood. The illiquidity of the new instruments, and the fact that short-dated bonds will be extended in maturity by three years, means that the banks could still have a lot of trouble raising the liquidity to match their assets to their liabilities over the next couple of years. But bank runs are confidence games, and if the broad Argentine population believes that the banks have been shored up by the domestic swap, then that’s sufficient to prevent a run.
The Argentine government doesn’t just manage to protect its banking system with this structure: it also manages to get control of tens of billions-worth of its own bonds. They won’t be cancelled when they’re swapped for the new loans. Rather, they will be held by the central bank, and will then be tendered on the first day of the second bond restructuring. Since the first goal of the second swap will be to reach a 67% or 75% acceptance level, the Argentine central bank’s huge holding will come in extremely useful.
But though the legal structure of the domestic swap seems ingenious, the financial structure is much less so: one strategist calls it “prehistoric”. Just about all non-collateralized bonds are eligible (that excludes the Par and Discount Brady bonds, principally, as well as bonds with a rolling World Bank guarantee). The coupon on the new loans is capped at 7%, or 70% of the coupon on the old bond, whichever is lower. For floating-rate bonds, the coupon is capped at 300 basis points over Libor, or 70% of the coupon of the old bond. Coupons will be paid monthly from March 31; until then, interest capitalizes. All bonds maturing before December 2010 are extended for an extra three years, at 7% interest for fixed-rate bonds and Libor +300bp for floating-rate bonds.
What all this means in practice is that depending on which bonds you happen to hold, your reduction in net present value can range from the relatively modest (around 35%) to the swingeing (almost 90%). The numbers change according to the discount rate or yield curve used, but initial figures released by Dresdner Kleinwort Wasserstein put losses on the 2003 Eurobonds at 87%, while the 2010 bonds saw losses of just 35%. The worst-affected bonds are short-dated instruments that are hit hard by the fixed three-year maturity extension, and the new step-up 2008s, 2018s and 2031s, whose coupons are now capped at 7%.
The value of banks being able to book the new loans at par is easily seen when looking at Dresdner Kleinwort Benson’s expected loan value for the new instruments: the highest is 26.14 for the 2027s and the lowest, for the 2031s, is just 11.67.
What doesn’t make a lot of sense is why the difference between the two is so great. Since each bond is swapped into a uniquely different loan anyway, there seems no reason to make some swaps a lot more attractive than others, as the present system does.
Advice after the event
It may or may not be a coincidence that this first phase of the bond swap does not have a lead manager, and was announced without the advice of any bank. Jacob Frenkel, president of Merrill Lynch International, along with his Sovereign Advisory Group, was appointed by the Argentine government at the beginning of November to advise on “macroeconomic policy and the design of strategies aimed at economic growth and stability, including strategies for debt management and the analysis of liabilities”. But somehow that managed to exclude what will almost certainly be the largest bond swap in history, one which also garnered Argentina a default rating from S&P.
Later in the month, Merrill Lynch, along with Deutsche Bank and Salomon Smith Barney, was appointed as an adviser on the forthcoming bond issue. All the same, says Frenkel: “I’ve not been involved in the local debt exchange. We, as the group of three banks, were appointed to deal with the restructuring of the international debt. We have had – I have had – nothing to do with [the first phase of the restructuring].”
As far as anybody knows, this first phase of Argentina’s debt restructuring was launched not only without any kind of investment-banking advice but also without any consultation with bondholders, multilateral agencies, or anybody else. It would not be the first time that Argentina’s finance minister, Domingo Cavallo, had decided to do something drastic without any consultation simply because it seemed like a good idea at the time.
It’s this very lack of dialogue and consultation that most worries international bondholders. Although they admire the professionalism of much of the finance ministry’s staff, they are certainly concerned about the unpredictability of Cavallo.
On November 20 the finance minister released an open letter to bondholders in which he said that “the menu of options available for the debt reprofiling exchanges will be comprehensive and equitable, and will be prepared with the benefit of a constructive dialogue with our creditors”. He went on to say that the government’s advisers – Deutsche Bank, Salomon Smith Barney and Merrill Lynch – would help design “a more formal consultative process”.
But Argentina’s bondholders aren’t taking anything on trust from Cavallo. The Emerging Market Creditors Association (EMCA), which was set up largely with the contingency of an Argentine default in mind, has already set up a sub-group, tentatively called the Argentine Bondholders’ Committee, or ABC.
The ABC has reason to be worried: Argentina has now appointed not only Salomon Smith Barney, the chief architect of the Ecuadorean default exchange, but also law firm Cleary, Gottlieb, Steen&Hamilton. Cleary is home to Lee Buchheit, a man one bondholder calls an “evil genius” for his expertise on the subject of exit consents – legal manoeuvres that can leave bondholders feeling battered and bruised.
Exit consents were used to devastating effect in the Ecuador exchange: all bondholders tendering their old bonds for new ones were asked to vote at the same time to alter many of the clauses in the old bonds’ documentation. That left any holdouts (and there weren’t many) with pieces of paper stripped of many of their rights.
Putting pressure on the holdouts
So far, there is no evidence that Argentina will go as far down the exit-consent road as Ecuador went. On the other hand, there’s no evidence it might not go much further: Ecuador, for instance, didn’t strip the old bonds of their sovereign immunity clause, as it could have done and as Argentina could yet do. It’s possible that Argentina could reclassify the governing law on the bonds to Argentine law, making it more or less impossible for bondholders to sue for their money.
One source closely involved in the Ecuador deal says: “Ecuador was in a very, very desperate situation. And to the extent you engage in wholesale exit-consenting and covenant-stripping, which we did in Ecuador, our judgement was that only through those sorts of measures were we going to manage to get a sufficiently high degree of participation such that holdouts wouldn’t be material. And we were right.”
Argentina isn’t in as desperate an economic situation as Ecuador was. But the Argentine situation is much more complex, and many more things can go wrong. In general, the stronger the exit consents, the higher the participation rate, whether the bondholders like it or not. So there’s certainly an incentive to be brutal when it comes to finally launching the offer.
“What Argentina’s about to do is extremely complicated,” warns one banker. “It’s not a happy situation for them. It could drag on for a long time. I would be very surprised if it’s clean, and it’s going to be a dramatic thing for that country. How it affects the emerging-market asset class will be much more driven by the principles on which the exchanges occur, and what sort of implicit sanction those are given by the official sector.”
Creditors lack a single voice
Chief among the complexities is the sheer size and breadth of Argentina’s international creditor base. Foreign investors hold some $41 billion of Argentine debt, and they range from stolid European banks to aggressive US hedge funds; from a relatively few large fund managers to a huge number of European retail accounts, especially in Germany and Italy. Some of these investors mark to market and some don’t; some bought at 35 cents in the dollar and others bought at par; a few have sophisticated hedging strategies while many just want their money back. European retail investors, in particular, are going to be extremely difficult to locate and to persuade to enter into the swap.
That makes it unlikely that Argentina’s consultations with creditors will ever rise to the level of formal negotiations. “Their investor base is so diverse, with each agenda so different, I’m not sure whether they should negotiate,” one banker told Euromoney before his bank was awarded the mandate for the swap. “What are you trying to negotiate? The terms of the bond? Who are they negotiating with, and what are they negotiating about? How do you hold the whole group together?”
Another huge problem facing the bankers putting this deal together is convertibility: the one-to-one peg between the Argentine peso and the dollar. Convertibility was implemented by Domingo Cavallo, and it’s unthinkable that he would abandon it as part of the swap. But, says the head of syndicate at one New York bank that pitched for the mandate but didn’t win it: “If you ask bondholders what Argentina needs to do, they say restructure the debt, do a 30% to 40% haircut, and get rid of convertibility.”
Merrill’s Frenkel sees no need to even talk about whether or not to abandon convertibility: the Argentine people have already settled the question. “The issue is a genuine discussion of what is the best prescription, and it’s not a textbook question,” he says. “We must understand we’re talking about a country with a specific context, with a specific economic history. And if the people in this country as well as the policymakers feel that the monetary machine of stability that they have today has served them well and they don’t want to endanger it, I think we need to ask ourselves what other policy instruments one can have in order to bring about growth and stability, without criticizing what the exchange rate regime delivers.”
Many bondholders don’t see it that way: they see the prospect of default without devaluation as the worst of both worlds. Argentina loses its access to international capital markets, but it gains no competitiveness and remains tied to a monetary regime that has exacerbated negative growth and inflation figures for the past three years.
Loss of confidence and high interest rates now threaten a domestic payments crisis. Taxpayers are withholding payment for as long as possible. Meanwhile deposits leak from the banking system and the provinces are making payments with funny money.
Hoping for more IMF support
The people who matter most in this debate are probably not the policymakers in Buenos Aires, the fund managers in Boston or the bankers in New York: they’re the officials at the IMF and the US Treasury in Washington. Debt exchanges need a combination of carrot and stick in order for them to work; Cleary Gottlieb can probably provide a suitable stick, but it’s up to Washington to provide a carrot.
What Argentina will be looking for is some kind of IMF sweetener to the new bonds, possibly in the form of interest or principal guarantees. That way, when offered the exchange, bondholders not only know that it carries the imprimatur of the IMF, they also know that they are exchanging pure Argentine sovereign risk for a mixture of Argentine and IMF risk. Since the IMF is triple-A rated, that’s a pleasant upgrade.
But the IMF will be reluctant to commit funds for the lifetime of the new bonds – which will be at least 30 years at the long end – and in any case won’t have anywhere near the $20 billion or so that would be needed for a full principal guarantee for all international bondholders. What’s more, the US Treasury, which continues to play the leading role in IMF decisions in its hemisphere, has changed drastically since the interventionist days of Robert Rubin and Lawrence Summers. While president George W Bush has been making vaguely supportive noises about Argentina, nothing concrete has come of it yet.
And technical complexities aside, the bond swap will not fly unless and until Argentina and its advisers manage to persuade the rest of the world that it will put the beleaguered Latin American nation on a growth path again. That, given Argentina’s recent history and confidence collapse, could be the hardest sell of all.
A lot of people have made a lot of money in recent years betting against Argentina. It could be very hard indeed to make them change their minds.
Voters apportion the blame
Avid newspaper readers, ordinary Argentines are intensely aware of their country’s crisis. Buenos Aires taxi drivers and doormen can have sophisticated conversations about complicated topics, including debt swaps, restructurings, plummeting credit ratings, defaults and devaluations. But like their economists and politicians they have no idea how the country will solve its current predicament. And they are angry at their leaders – who are now asking for more sacrifices through adherence to the zero-deficit plan – blaming them for creating the mess in the first place.
Elisa Landín is an elderly woman and a member of the Mothers of the Plaza de Mayo, the human rights group that became famous for its protests against the 1976-83 military dictatorship. Every Thursday afternoon, wearing a white handkerchief around her head, she attends the rallies that still take place in the plaza in front of the presidential palace. “The swap plan, the zero-deficit plan, default, devaluation – I don’t understand the economics any more,” she says. “All I know is that we can’t pay this debt. It is strangling us. I blame those who took it on, all the bad politicians and economy ministers we’ve had since the start of the dictatorship. Cavallo is one of them.”
Andres Buey Fernandez is a Buenos Aires lawyer. He says his childhood friend, a supreme court judge, has just voted to lift the house arrest of former president Carlos Menem, who is under investigation for illegal arms sales and other corrupt practices during his 10-year rule. The flamboyant Menem is widely blamed for many of Argentina’s current problems, including doubling the national debt and encouraging a culture of corruption. Even so he has just announced that he will run for president in 2003.
Buey Fernandez shrugs his shoulders. “The problem in this country is the poor leadership of the political class,” he says. “They haven’t told us how we managed to accumulate all this debt in the first place while at the same time we were making billions from the privatizations of the early 1990s. Where did all the money go? Now the current government has not given any perspectives on how we get out of this, and so people are not prepared for the sacrifices they will have to make. Also, the provincial governors from the Peronist opposition have been phenomenally selfish – I would like to see them resolve the problem. Whatever happens, I just hope that the rich will bear their share of the cost, and that includes creditors, who have been paid phenomenally high interest rates.”
Buey Fernandez is not alone in his disgust with politicians. In recent congressional elections, some 40% of voters filed blank or protest ballots.
Others, resigned, take solace in the long view. “Maybe there is something healthy in all this; maybe we really need to hit bottom first,” says Martin Diaz, once a Tower Records store manager, now unemployed. “Maybe then we can clean out some of these corrupt people. Maybe then people will stop pretending that this is a European country instead of a south American one.”
Simon Clark
