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Capital Markets

Argentina's creditors brace for lowball offer

Argentina is facing an invidious situation. It has strong motives to resolve the default on its foreign debt but its offer could be strangled at birth. Many creditors seem unwilling to accept it. The proposed bond exchange, the world's largest ever, is just the beginning of the road back to international acceptance.

NEARLY THREE YEARS after Argentina declared a moratorium on its foreign debt, the country finally looks as if it is going to launch a bond exchange in an attempt to cure the default. Most people involved now expect some kind of offer before the end of the year, although few observers are confident that it will achieve much success.

Part of the reason is that most of Argentina's bondholders seem determined to reject the country's offer out of hand. The Global Committee of Argentina Bondholders (GCAB), which claims to represent more than 500,000 retail investors and 100 institutions holding some $37 billion in Argentine debt, says that there's virtually no chance they will recommend that the offer be accepted.

The stage is being set for what could be a worst-case outcome: Argentina finally trying to resolve its debt situation, and then finding itself rebuffed by its unimpressed creditors.

Argentina, after initially accepting a lowest-offer bid from Lazard to act as its financial adviser, in February mandated Merrill Lynch, UBS and Barclays Capital to lead manage what they hope will be the largest bond exchange ever seen.

Since then, teams at the banks have been working hard on getting the deal structured – no easy matter, with bonds issued in seven currencies and eight jurisdictions – and backing it up with debt-sustainability analyses. Cleary, Gottlieb, Steen & Hamilton is providing legal advice and invaluable experience: it has worked on all the distressed sovereign bond exchanges so far.

Reputations on the line

Rato: under his leadership,
the IMF is taking a much
harder line on Argentina
than previously

The banks involved, which are not able to talk on the record, know that they're putting their reputations on the line. They certainly want the exchange to be accepted by 67% of bondholders: that's the level at which their fees go up. Base fees are 27.5 basis points, rising to 35bp once two-thirds of bondholders accept the deal. If they do, the banks will share more than $170 million in total fees. Meanwhile, for the first time, there seems to be a strong political desire in Argentina for a deal to go ahead. The cyclical rebound – which contributed to 8.8% growth in 2003 – is slowing down, president Nestor Kirchner's (pictured) popularity is waning, and 2005 is the year in which the government's debt amortizations really start to kick in. Kirchner has probably gained as much political capital from rhetorical creditor-bashing as he ever will.

At this point, it's becoming increasingly important for Argentina to start reintegrating itself into the international markets once again, opening itself up to much-needed capital inflows.

Both Argentina and its creditors are hopeful that a successful exchange would prompt a large influx of capital. Argentines alone hold between $150 billion and $200 billion offshore; if Argentina regains financial stability, a lot of that money could find its way back home. That's what happened in Russia. Once it restructured its defaulted bonds, tens of billions of dollars of Russian flight capital returned to the country as new investment.

"When you leave default behind, you have a very important change of expectations: there is a psychological bonus," says Angel Gurria, the former finance minister of Mexico (and Euromoney's finance minister of the year in 1999), who now represents European retail holders of Argentina's debt. "That's what happened in Mexico: once we removed the uncertainty, it was another story."

Peter Hakim, president of the Inter-American Dialogue, says: "I'm not getting a sense of 'come invest in Argentina, we're a strong, growing, powerful economy'. And they can't do that until they solve the debt problem."

What Kirchner needs if he is to win re-election in 2007 is a sharp uptick in economic activity, something that virtually every country that has concluded a debt restructuring has enjoyed as soon as the deal is done.

He also needs the money that a restructuring would make available. "Starting next year, capital payments and amortizations on performing debt pick up quite nicely," says Alfonso Prat-Gay, governor of the Argentine central bank. "If you don't have a deal with private creditors, the chances of being able to roll over all of it are rather slim."

The performing debt mainly dates back to the aftermath of Argentina's devaluation, when depositors and financial institutions were given government paper to compensate them for their losses.

It might seem counterintuitive that Argentina paying international bondholders is going to make it more likely that it will be able to roll over domestic debt. In fact it does make some sense.

If Argentina successfully restructures its debt this year, the coupon payments on its international bonds are likely to be very small, at least to start with, because all the bonds are going to have step-up coupons, and maturities will be pushed out at least 20 years. But international investors are going to be much happier looking at Argentina again, which means that more money will start flowing to the domestic markets.

Elusive returns

Argentina, if it does manage to do a deal, will immediately find itself with a large weighting in all the emerging-market bond indices. Most important, it will figure more prominently in JPMorgan's EMBI Global, a standard benchmark for fund managers.

At the moment, only eight Argentine bonds, with a face value of less than $10 billion, are in the EMBI Global, which means that Argentina has a weighting of less than 1.8%.

Post-swap, all the new dollar-denominated bonds will be eligible, which means that even without a price increase, Argentina's weighting could easily surpass the 10% level.

Institutional investors will stay away from Argentina at their peril. It will almost certainly be one of the highest-yielding countries in the index and, so long as it doesn't default all over again, will provide bondholders with the kind of returns that have been increasingly elusive in emerging markets of late.

"I will invest in Argentina again when, firstly, there's clarity as to Argentina's contractual obligations in terms of debt servicing, and, secondly, there's clarity as to the risk of diversion of funds," says Mohamed El-Erian of Pimco, the world's largest emerging-market fund manager, with $14 billion in assets under management.

The second condition is essentially a legal one, and there are a lot of good reasons to believe that Cleary Gottlieb will be able to prevent bondholders' coupon payments from being attached by holdout creditors (see Litigation risk for years to come).

It's the first condition that is crucial: once Argentina has restructured its international bonds, foreign investors will be able to start investing in domestic Argentine debt with a lot less uncertainty than they have at present.

That will help keep Argentina's primary surplus at high levels, since more of the country's debt will be rolled over. And that, in turn, will make Argentina's creditors, both official and private, better disposed towards the country. In that case, Everybody wins.

Still, it is not going to be easy to get there from the current position. For one thing, as Pimco's El-Erian points out: "Argentina is trying to rewrite history in having a debt restructuring without the involvement of the IMF."

It has long been an article of faith in the international capital markets that bondholders, just like the Paris Club, will never agree to a country's debt restructuring unless an IMF programme is in place. Such a programme constitutes official confirmation that the country is on a reasonably positive macroeconomic course, and that the international community is bringing a certain amount of pressure to bear to ensure that it stays that way.

Playing hardball

The new-look IMF, however, under the leadership of former Spanish finance minister Rodrigo Rato, is taking a significantly harder line on Argentina than Rato's predecessor Horst Köhler did.

Unable to come to an agreement with the country on such matters as utility rates  – not to mention the crucial question of whether the country was actually engaging in good-faith negotiations with its creditors – the Fund decided in August not to disburse the $728 million loan that would have essentially rolled over the amortizations due from Argentina.

In the past, faced with IMF intransigence, the Kirchner administration has played hardball, saying that if the IMF won't continue to loan money to Argentina, then Argentina won't continue to repay its debts to the IMF.

This kind of ultimatum has worked before – this time Argentina took a different tack, and repaid the IMF its $728 million despite the absence of an agreement.

"I don't think any creditor thought of the situation where Argentina paid back the Fund in net terms," says El-Erian. The strategy took Argentina's bondholders by surprise. Hans Humes, co-chair of GCAB, is sardonic: "I give credit to Argentina for being innovative," he says. Essentially, Argentina is now paying to the IMF money that private-sector bondholders had been eyeing for themselves. If Argentina continues on this course, the amount available for bondholders will steadily decrease, and GCAB's idea of what Argentina can afford will get smaller and smaller.

Argentina, of course, has not explicitly said that if bondholders don't accept its offer a large chunk of the money available to repay foreign creditors will go to the IMF – it doesn't need to.

But the present situation, where Argentina is paying down IMF debts even as its private-sector obligations continue to accrue past-due interest, does serve to increase the pressure on bondholders to accept any deal that the country puts to them.

Time is not on the bondholders' side: "A deal that is acceptable but not ideal, sooner, is a lot better than one which through attrition is better  but takes you a year longer," says Gurria.

If that's the case, then a not-ideal deal now will certainly be more attractive than a similar deal in the future, launched after a significant amount of the money that is owed to the IMF has already been paid.

No loss in trying for better

Humes, however, does not quite see it that way. "Argentina, by making offers without sounding out creditors, is creating a trailing put option," he says. "Once they improve the deal unilaterally, like they did in June, I know what the worst-case scenario is. I don't lose anything by trying to get better."

It certainly seems improbable, to say the least, that any future deal will be worse than the one presently on the table, and outlined in an SEC filing registered at the beginning of June.

This offer, valued at 25 cents on the dollar on a net present value basis, dangles a carrot in front of bondholders: if more than 70% of them accept, coupon rates go up significantly. The benchmark Par bonds, for instance, will pay 2.08% interest for the first five years, rather than 1.35% if fewer than 70% of bondholders tender into the deal.

Even so, 2.08% interest and a market value of 25 cents on the dollar is not the kind of offer to make any bondholder salivate. Retail bondholders, who are keen to get their principal back in full, will have to wait 35 years to do so, by which point it is fair to assume that a very large number of them will be dead.

And even excluding retail investors, it's hard to see how Argentina's present "final" offer – even if sweetened by a few billion dollars in extra incentives for bondholders to accept it – is going to succeed.

Argentina seems to think that it can go ahead with a deal in which fewer than 70% of its bondholders sign up: "if only 50% accept, you have solved 50% of the problem," says one source involved in the exchange.

Indeed, this source even lays out a plan where the initial exchange is accepted by a mere 40% to 50% of bondholders, and is then followed by a second offering that gets another 25% to 30% on top, once holdouts see that Argentina is paying holders of the new bonds while remaining unsympathetic to holdouts.

The problem with this idea is that an exchange with 40% or 50% uptake will be considered a failure by everybody who matters. Argentina, although it shouldn't, is likely to tender all of the bonds it owns as a result of the $30 billion megaswap in 2001, giving it a substantial headline figure before a single bondholder has agreed to any deal. Those bonds were meant to be cancelled as part of the megaswap, not stored somewhere so that the government could vote them in the future. And there's a general opinion that all of the bondholders in Argentina – primarily the pension funds – can have their arms twisted by the government so much that their participation should not be considered a real vote in favour of the offer.

Since Argentine bondholders would account for most of the participants in any exchange with less than 50% take-up, the international vote – what El-Erian refers to as "real participation" – would constitute an unambiguous rejection of the offer.

"An unsuccessful offer – economically, it doesn't do the trick," says Gurria. "It only increases uncertainty."

And it's not even a foregone conclusion that Argentina's pension funds are going to participate. "For this to be successful, Argentina needs to get the domestic pension funds on board," says William Rhodes, vice-chairman of Citigroup. That hasn't happened yet.

Citigroup, along with other owners of Argentine pension funds, is trying to negotiate with the government.

Although they would obviously like a deal to be done, they also want certain promises about accounting standards, tax treatment and the like.

 Given the funds' de facto veto power over the exchange, they find themselves in a strong negotiating position and could conceivably derail any deal before it is even launched.

Even with the domestic pension funds on board, however, Argentina is going to have to get a much higher participation rate than it seems to be expecting before most observers will start to consider the exchange a success.

Bond exchanges are largely an opinion game: they are a success just insofar as they are perceived to be a success. "For a successful restructuring, the majority of your creditors must no longer consider you to be in default," says El-Erian. If capital market players think the exchange failed, it will have failed.

In a recent position paper, GCAB says that "the official sector should advocate a minimum participation rate of 90%  for any exchange offer."

This seems unlikely, to say the least: the official sector is trying its hardest to be as hands-off as possible when it comes to negotiations between Argentina and its bondholders.

But it does give an idea of the kind of participation rate that the market is expecting to see – after all, 90% is a level that both Ecuador and Uruguay managed to achieve without too much difficulty.

Price pop

Replicating those countries' success, however, won't be easy. Uruguay had access to enormous amounts of goodwill in the international capital markets, the strong support of the IMF, and offered a 0% principal haircut.

Ecuador surprised the market with a much more generous offer than it was expecting, leading to a large self-fulfilling pop in the price of the bonds on the day that the offer was announced.

Argentina's bonds, in contrast, are trading at a substantial premium to the value of its June offer: even with $5 billion or so in sweeteners, a bondholder might be better off selling the bonds in the secondary market.

There's no point, after all, in accepting an offer from Argentina when you can get a better deal from an institutional investor who's willing to hold out a bit longer, maybe until a new government comes into power. After all, with debt negotiations, the only truly final offer is the one that both sides accept.

In order for Argentina to solve the problem of its debt overhang, it is probably going to need at least 85% participation in its exchange offer – and that means that it is going to need the majority of its retail investors participating.

Retail investors, however, are likely to be Argentina's biggest headache. Between them, the Swiss Bankers Association and Italy's Association for the Protection of Investors in Argentinean Shares represent some $23 billion of debt – and both of them are adamant that Argentina's present offer is clearly unacceptable.

Without substantial retail participation, almost nobody will consider the exchange to be a success, and the Argentine government will have not only irate creditors but also the Italian government arrayed against it.

And retail investors are probably the hardest nut for Argentina to crack. Institutional investors who bought at par sold their holdings as the debt declined in value; by the end of what has been described as "the slowest train wreck in history" very few original holders of the dollar-denominated debt remained.

Large foreign holders of Argentine debt, such as Gramercy Advisors, bought low and will probably make a profit on any deal that Argentina comes up with.

In the eurozone, however, retail investors bought, and held, and held, and held. Many put a substantial proportion of their savings into Argentine bonds, and are spitting fire at what they see as the fraud and duplicity of the Argentine government. It is going to be extremely hard to persuade these investors to accept a payment of 25 or even 30 cents on the dollar, especially if they can't expect to get their money back within their lifetimes.

The fact that Argentina does not currently have an IMF agreement certainly doesn't help: if Argentina's present economic plan isn't good enough for the notoriously indulgent Fund, then it is unlikely to be good enough for the average Belgian dentist.

European retail bondholders are going to have to hold their noses and accept some kind of offer eventually. But, says Hakim: "People have a way of living with intolerable situations for far longer than people ever thought they could."

If retail investors do agree to an exchange, they're going to have to take substantial losses. Can one say, at least, that they deserve to be paid in full, in accordance with the contract they entered into with the country?

Hakim thinks for a minute, and replies with a quotation from Clint Eastwood's Western movie Unforgiven.

The scene features Gene Hackman pleading for his life with the killer played by Eastwood, saying: "I don't deserve this... to die like this."

Eastwood is unmoved. "Deserve's got nothin' to do with it," he says.

Then he pulls the trigger. 

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