The End of Sovereign Bonds without Collective Action Clauses

Dialogue with the Alter Ego on US Court ruling in favor bond holders who opposed the Argentina debt restructuring of 2005 and 2010

Question by Alter Ego of Noah denkt™ (AE): This week’s ruling by a US Court in favor of bond holders of Argentinian debt issued in 1994 who refused to accept subsequent debt restructuring arrangements after Argentina’s default in 2001 rocks the entire financial system. It effectively puts into question all traditional debt restructuring arrangements in case of a sovereign default where no collective action clause was originally included in the bond contract. Some observers are quite annoyed about that ruling. (See for instance, Prof. Costas Lapavitsas in the France24 Debate). What does Noah denkt™ make of the pertinent Court ruling and its effects on the financial system?

Answer by Noah denkt™ (Nd): Well, the court’s decision obviously takes the original bond contract at face value and doesn’t allow Argentina to renege on the written promises it first made to its creditors. (See. www.gpo.gov/fdsys/pkg/USCOURTS-ca2-12-00105/pdf/USCOURTS-ca2-12-00105-1.pdf) In other words, this is a ruling about contract law and not about the stability of the financial system. To some extent that strangely echoes a view that once was prevalent in the financial markets which is that sovereign debt is the safest of all investments since countries don’t go broke. Of course, we know now more than ever that this rule of thumb is no longer true. Hence sovereign debt is no longer the safe investment tool that it used to be.

AE: Noah denkt™ is not worried then that this fundamentalist ruling against Argentina might affect the stability of the financial system?

Nd: Not really, since it will become standard procedure now to introduce Collective Action Clauses in all future bond contracts which, in case of default, will allow to overrule a minority opposition to a debt restructuring that has been accepted by a majority of bond holders.

AE: But there is still abundance of old, all-out bond contracts around. If a default should happen there it will be impossible now to negotiate a reasonable way out of a national default mess.

Nd: Well, it is certainly not going to get easier after this ruling. We need to take into account though that Argentina has been particularly unsophisticated in its handling of both, the court case and the minority opposition demands. A more engaging and cooperative approach from the Argentinian government might have eased off some of the severity that it is now being confronted with. Future defaults without Collective Action Clauses may therefore have some wiggle room left that isn’t apparent in the Argentinian case. If the worst still comes to pass though one would have to hope that large creditors who are willing to compromise with a debt restructuring will find a way to make the minority opposition acquiesce to the deal. After all, they, the large bond holders that is, have a lot to lose too.

AE: So you are saying that in unprotected sovereign defaults of the future the majority bond holders have to lean even more heavily on the minority bond holders to get their cooperation with a certain debt restructuring plan?

Nd: We can’t think of any other way for these traditional bond default cases where the contracts were domiciled under US jurisdiction.

AE: Hopefully, you are right. Must we not recognize though that the bond market will change even with the introduction of Collective Action Clauses? Will there not be a surge in interest rates once bond buyers have to contractually accept that they won’t get their original claims fully honored in case of a default?

Nd: Theoretically, yes. At the same time though, there was probably some vague and subconscious premonition already built into the valuations that you might not get all your money back in case of a sovereign default. So, in practice, the Collective Action Clauses will probably not change the interest rate levels.

AE: Okay. – Well, we cannot conclude this particular dialogue without asking you about the 1600% profit margin which the “vulture funds” hope to gain from being stubbornly opposed to any Argentina debt restructuring. Does it appear reasonable and ethically sound to Noah denkt™ to pursue such a “vulture” strategy? After all, we have to bear in mind that these belligerent funds weren’t among the original creditors of Argentina but instead purchased said bonds in the secondary market at a 300% discount?

Nd: Well, Mr. Singer of Elliot Management and others certainly had a lot of guts to hold out and go to these extreme lengths to make their money.

AE: So you view their approach as ethically acceptable?

Nd: They have exploited a loophole in the bond contract law and they deserve credit for doing so. After all, they help all of us now to close that loophole and make the system better and cleaner.

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