Argentine Default Bad Test Case for Sovereign Debt Negotiations

Messy bondholder fight could complicate future defaults.

Argentina's default three weeks ago, and the ongoing legal battle that led up to it, raises practical, theoretical, and moral questions about the ad hoc process that ensues when a country doesn't repay its creditors.

"We're at a moment where a lot of people have been stopped short and are asking: Is this really the way we want restructurings to go forward?" asked Mark Weidemaier, a sovereign-bond expert at the University of North Carolina at Chapel Hill.

The fight between President Cristina Fernández de Kirchner's government and hedge fund NML Capital, a subsidiary of U.S. billionaire Paul Singer's Elliott Management, climaxed in late July when negotiators couldn't reach a last-minute deal preventing the country from defaulting for the second time in 13 years. But what seemed like a coda was only a crescendo in the saga. Kirchner is now desperately trying to get The Hague to invalidate a 2012 New York court decision requiring the country to pay its holdout creditors.

As the case lumbers forward, setting records for contentiousness along the way, market watchers are pondering what it portends for other nations. And people following the fight closely still fiercely debate who is at fault: the politically motivated Argentine president acting against her country's interest or the greed-crazed hedge funds that will stop at nothing to get paid?

The responsibility debate highlights a more fundamental question of fairness underlying sovereign-debt negotiations: When should a country be able to walk away from its debts? After a bit of economic bad luck, a natural disaster, a war, a corrupt ruler? How much of the bitter medicine of setting a country straight after an economic crisis should be swallowed by investors and how much should be borne by the government itself and, ultimately, its citizens?

Argentina isn't the only country hounded by investors to repay old debts. Take Grenada. Taiwan's export credit agency sued the small island nation, making a similar argument to that of the hedge funds in Argentina's case. Grenada defaulted in March 2013 but its troubles began nearly a decade earlier. Twin hurricanes Ivan and Emily walloped the Caribbean nation in 2004 and 2005. The storms inflicted damage worth twice the country's GDP, devastating its two main moneymakers, tourism and nutmeg -- a crop that takes 13 years to regrow and reach peak harvest, according to the IMF.

Grenada has yet to reach an agreement with its creditors. Its bonds were trading at 50 percent of face value before the default and are now at 30 percent, said Stuart Culverhouse, chief economist with Exotix, a brokerage firm that focuses on frontier markets. Investors might count themselves lucky if they get 50 percent at this point. The IMF said last month that the country's debts were worth 110 percent of GDP at the end of last year. The government of Grenada did not respond to requests for comment.

There's no international court to decide when a country can walk away or law governing debt-repayment negotiations. If an individual or company goes broke in the United States, they can plead their case before bankruptcy court and ask for protection from their creditors. In some circumstances, they can effectively write off that debt. The process is much more complicated for a country, even though the stakes are higher because the borrowing decisions of a few leaders affect the entire population. The temptation for politicians to over-borrow, and leave future leaders to deal with the resulting belt-tightening, is seductive. And yet there's no external check on how much a government can borrow. A country is free to sell all the bonds investors will buy.

When a government decides that it can't make good on its debts, it must face those generous investors again -- and ask them to accept less than the country is contractually obligated to pay under the bonds' terms. The government suggests a figure, bondholders reject it, and haggling ensues, in some cases for years. That process is called "restructuring." After much negotiating back and forth, most investors usually take a new bond worth less than the original because it's better than nothing. Once a majority of bondholders sign onto the deal, the new bonds are issued.

The process is messy and political and every new default presents unforeseen complications. Now, some observers worry that the Argentine case has upended what scant process exists. On July 24, as Argentina spiraled toward default, the IMF's chief economist warned about the ramifications for the global financial system.

"There is a cost to the world in the sense that we need resolution systems which work well when countries are in trouble and one of the implications of this Argentina episode is that there is much more uncertainty as to how we'll be able to restructure debt for other countries in the future," IMF head economist Olivier Blanchard said in Mexico City.

Hedge fund NML's successes against Argentina in court threaten to further complicate an already disorganized process more akin to wrangling a price in a street bazaar than a legal proceeding. People who want to get paid sooner accept less. Some investors hold out and demand more. The government usually caves eventually and the deal is done.

The New York court that ruled in favor of the holdout creditors in the Argentine case also stopped the country from paying the 93 percent of bondholders who had already accepted less, known as "a haircut" in financial speak. That may dissuade investors in other cases from taking a haircut if a court can invalidate the deal later.

"The whole idea of a settlement was that you get certainty. Now you've lost that certainty," said Anna Gelpern, a Georgetown University law professor and expert on debt contracts.

Gelpern, the IMF, and others are worried that Judge Thomas Griesa's 2012 ruling that all bondholders must be paid simultaneously may have thrown a wrench in the works. Argentina couldn't keep paying the bondholders who'd accepted earlier deals, the judge ruled, without also paying the holdout creditors, NML Capital, in full. The case ended up in Griesa's court in the Southern District of New York because Argentina's bonds were written under U.S. law, a choice Argentina made to give investors more certainty that it wouldn't do exactly what it's now doing -- flouting the contract. Argentina is now trying to change that by getting bondholders to turn in their American bonds for ones governed by Argentine law, in order to circumvent Griesa's ruling, but bondholders are unlikely to accept that deal.

Whenever countries fall on hard times and renegotiate their debts, they essentially push aside the law and say to bondholders: "Look, we can't pay, so let's make a deal." Some legal experts say that the Argentine case sets a precedent that will make it easier for a few creditors to hold up the whole negotiating process.

"Going forward, any government that tries to restructure its debt now has to deal with the possibility that there will be this interminable fight with a creditor group," Gelpern said.

Now distressed-debt investors, so-called "vulture funds," may feel emboldened. The funds buy up cheap bonds when a country is already in financial straits; then they can go to court and use a favorable judgment to chase a country's assets around the world. NML Capital famously convinced a court in Ghana in 2012 to detain an Argentine navy ship. The frigate, called the Libertad, was eventually liberated, but Argentina got the message. President Kirchner started flying in a chartered plane out of concern that the presidential aircraft, Tango 01, would be seized by creditors.

Activists worry about far-reaching consequences if creditors were to deploy such tactics against much smaller countries with fewer resources to wage a legal fight like the Argentine government did. Eric LeCompte, head of the Jubilee USA Network, an organization promoting debt forgiveness for developing countries, says an international process to protect debtor countries is needed.

"Argentina is the first victim from the court's ruling," he said. "It looks like Grenada and the Democratic Republic of the Congo may be the next victims."

Hedge funds looking to collect on bank loans upwards of 20 years old are pursuing the Democratic Republic of the Congo, which was then called Zaire. A New York district court ruled that the DRC must pay Themis Capital and Des Moines Investments a total of $69 million -- $50 million of which is interest. Tara Lee, a lawyer with DLA Piper who is representing the DRC, said the case could be overturned on appeal.

DRC's legal fees are paid by the African Legal Support Facility, a fund created by the African Development Bank to help African countries defend themselves against "deep-pocketed international investors." A lack of local government capacity and poor legal representation when first drafting bond contracts often put African governments at a disadvantage, the bank argues.

Dennis Hranitzky, a lawyer with law firm Dechert, helped NML go after the Libertad in Ghana. Now, he represents the DRC's "vulture" investors. He says the more powerful Argentine case law was a recent Supreme Court ruling that got far less attention.

"If we ever find ourselves in a position where we have to enforce in the Congo case -- which we hope won't happen; we hope to reach a settlement -- I would expect the Supreme Court's discovery decision is likely to be quite helpful," Hranitzky said of the June decision.

Argentina's predicament prompted calls for a systematic way to settle these disputes. Economist Joseph E. Stiglitz argued in the New York Times that it is now time to consider a global system for debt restructuring. But in the past, governments have shied away from adopting a process run by an international arbiter because it would require them to yield important negotiations to a third party. On the other side of the argument, many traders and experts argue that a World Bank- or IMF-led solution would only muck things up further.

Many bond market veterans don't see the Argentine case as a game changer.

"Argentina is an anomaly," said Gabriel Sterne, head of global macro investor services at Oxford Economics Ltd. and a former IMF and Bank of England economist. "It would be wrong to think that Argentina has too much implication for sovereign debt and sovereign crises."

History seems to be on Sterne's side. Elena Duggar, a sovereign-debt expert with credit ratings firm Moody's, examined 34 instances since 1997 when nations renegotiated their debt. Her findings: The process took an average of seven months and most cases didn't end up in court.

"The case of Argentina was the only one where you had persistent litigation," Duggar said. Her analysis looked only at bond negotiations where loans were the underlying factor. Cases such as Grenada's and the DRC's were excluded.

And so far, bond buyers seem to agree. Despite all the uncertainty the IMF warned about in July, foreign investors are still piling into developing countries' bonds. The IMF estimates that foreign holdings of emerging-market debt have more than doubled in the past few years, expanding from $400 billion to $1 trillion worth of bonds since 2010. Investors are also venturing much further afield -- to countries like Ivory Coast to Pakistan -- in search of higher returns. Burma is even dusting off its financial records in hopes of issuing bonds on the international market for the first time.

"Since there have been loans to governments, political, economic -- and at times even military -- considerations have been more important than legal ones," said UNC law professor Weidemaier.



The Re-Baathification of Iraq

The Islamic State has conquered much of Iraq with the help of Saddam’s cronies. Now the men America once discarded could help win the country back.

The Islamic State has conquered broad swaths of Iraq thanks to a surprising alliance with secular veterans of Saddam Hussein's military. But now that partnership is fraying -- giving Washington its first real opportunity to blunt the terrorist group's advance without relying solely on American airstrikes or ground troops.

The group of ex-Hussein loyalists, known alternatively as the Naqshbandi Army or by the acronym JRTN -- the initials of its Arabic name -- helped the Islamic State, formerly known as ISIS, win some of its most important military victories, including its conquest of Mosul, Iraq's second-largest city. It has also given the terrorist army, which is composed largely of foreign fighters, a valuable dose of local political credibility in Iraq. JRTN, which was formed as a resistance group in 2006, is made up of former Baathist officials and retired military generals, and is led by the former vice president of Hussein's revolutionary council, Izzat Ibrahim al-Douri, who was once one of the most-wanted men in the country during the U.S. occupation.

ISIS and JRTN aren't natural allies. The former wants to erase Iraq's current borders and establish a caliphate, while the latter has been a largely secular movement that seeks to regain the official power and influence it held before the U.S. invasion in 2003. But they are aligned in their opposition to, and hatred of, outgoing Iraqi Prime Minister Nouri al-Maliki's Shiite-dominated government. Each side wants him to go, and JRTN recognizes that ISIS stands the best chance of violently overthrowing the Iranian-backed regime in Baghdad.

"The Baathists and ISIS had a marriage of convenience at the start of the takeover of Mosul," said Letta Tayler, a senior researcher with Human Rights Watch and a former journalist, who has reported extensively from Iraq on ISIS's human rights abuses and persecution of Shiites and religious minorities. "Baathists got muscle from ISIS, and ISIS got local legitimacy through the Baathists."

But now that marriage may be fraying, to the possible benefit of Washington and Baghdad. Signs of late are pointing to a growing divide between the top leadership of JRTN and the Islamic State, whose brutal terror campaign has brought down the wrath of the U.S. military. If JRTN were to break with the Islamic State and help the Iraqi government and U.S. forces fight the terrorists, it would go a long way towards stabilizing the country and perhaps lead to a broader political reconciliation in which Sunnis who once helped run the country might be given powerful posts in a more inclusive Shiite-run government.

That would present a palpable, if not painful, irony for the United States, which went to war 11 years ago to depose the Iraqi dictator and then implemented a far-reaching "de-Baathification" campaign that rid the Iraqi government and armed forces of hundreds of thousands of experienced Sunni technocrats and military commanders.

U.S. officials have been closely tracking the Islamist-Baathist alliance for months. Almost as soon as Mosul fell, on June 10, it was obvious that JRTN forces had been waiting for their arrival. Reports from the scene said ISIS fighters quickly disappeared and were replaced with armed men loyal to the Baathists and former generals. The group already held sway in key Iraqi cities, including in Tikrit, which fell on June 11. But Mosul was the real prize, and a key strategic point because it's a historic seat of power for the ruling Sunni elites who want Maliki gone.

After taking the city, the Islamic State, then known as ISIS, installed a Baathist and former Iraqi army general, Azhar al-Obeidi, as the new governor. And another former general, Ahmed Abdul Rashid, was named governor of Tikrit, where he has been credited with leading an ISIS-Baathist defense against the Iraqi Army, analysts said. ISIS's new allies were an ideal political face for their occupation. JRTN's leaders "have a long history of running Iraq, so it just feels right and natural to the people that they should be in charge," said Kenneth Pollack, a senior fellow at the Center for Middle East Policy at the Brookings Institution.

But the match seemed destined to be short-lived. Just a few days after the Islamic State conquered Mosul, its fighters were involved in a shootout with ex-Baathists near Kirkuk that left 17 dead, the New York Times reported. Then, in early July, ISIS fighters were spotted driving around Mosul and abducting retired Iraqi generals, taking them from their homes draped in the Islamist black and white flag, and putting them into the backs of SUVs with tinted windows, according to Reuters. The generals' families and local residents said that ISIS took away as many as 60 ex-officers and Baathists whom they deemed opposed to their ultimate goal of establishing an Islamist caliphate and erasing Iraq's current borders.

More recently, the ideological fissures in the alliance have become pronounced. In late July, JRTN put out a statement condemning sectarianism and the persecution of religious minorities, including Christians and Yazidis, who would ultimately run for their lives from ISIS marauders in Sinjar, prompting President Barack Obama to launch airstrikes to stop a possible genocide. While the JRTN statement didn't signal out its Islamic State allies -- they never do -- analysts said it showed that the Baathists and former ruling elites are distancing themselves from the terrorist group and are indirectly condemning its tactics. "It's very roundabout, but it's clear what they're talking about," said Daveed Gartenstein-Ross, a senior fellow with the Foundation for Defense of Democracies.

Both sides must know that their marriage of convenience is now heading for a divorce. "Baathists want the ouster of Maliki, to regain some of the stature and political participation that they've been denied since the fall of Saddam Hussein. And that's a very different goal from setting up a caliphate," Tayler said. "Many Baathists see ISIS as puritanical terrorists, and one can understand why. And ISIS certainly sees the Baathists as smoking, drinking ne'er do wells.... I think the Baathists are starting to get it that this potentially is a gross miscalculation" to think the two sides could work together, Tayler said.

"It's unequivocally a good thing" if the two sides have a falling out, said Daniel Byman, the director of research and a senior fellow in the Center for Middle East Policy at the Brookings Institution. An even better outcome, he said, would be for a new Iraqi government to bring less fanatical Sunnis -- which the Baathists arguably represent -- into a new government.

But that won't be easy, because JRTN includes more than just technocrats and erstwhile generals. The group also is composed of Sunni nationalists, who fought a bloody campaign against U.S. forces, and tribal militias. "JRTN is a nasty group of people," Pollack said, and includes elements so violent and sectarian that U.S. military commanders dubbed them "the irreconcilables," during the 2007 American-led surge.

The good news is that whatever deal JRTN thought it could make with its terrorist muscle, it appears to be going south. "It absolutely has not held," Gartenstein-Ross said of the tenuous alliance. "They had mutual interests. But JRTN has completely underestimated how dangerous ISIS is."

The group's tactics are so brutal that it was expelled from al Qaeda and split off from opposition fighters in Syria, who wanted to focus their efforts on overthrowing strongman Bashar al-Assad, not creating a new Muslim state. The question now is how JRTN would separate from the Islamic State without igniting an all-out war, which it could it very well lose. "ISIS is stronger than JRTN overall," Gartenstein-Ross said.

But there's a rift now that the United States could exploit. It would almost certainly require making some political alliances with ex-Hussein loyalists. Yet that may be the least bad option, and the one that could keep the United States from drifting deeper into a new war in Iraq. "It's great news if Baathists and other Sunni elites disentangle themselves from a repugnant alliance," Tayler said. "It's great news not just politically, but in stopping the scourge of ISIS taking over vast portions of Iraq and terrorizing the population."

Salah Malkawi / Getty Images News