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Argentina's Default: Lessons Learned, What Happens Next

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For the second time in 13 years, Argentina has defaulted on its debt. Since the 2001 Argentine sovereign debt default, the country has experienced more than an aftermath of lawsuits and bond restructures, with the U.S. Supreme Court most recently siding with “holdout” hedge funds NML Capital and Aurelius Capital in a 7-1 ruling, ordering that Argentina pay the hedge funds full principal plus interest, amounting to a payment of $1.5 billion dollars. Until now, the entire saga has been nothing but dramatic, with Elliott Associates, the parent company of NML Capital, making attempts to impound Argentina’s national assets, including an Argentine warship and even the Presidential plane. Following the Supreme Court Ruling, a U.S. District Judge barred Argentina from paying interest to investors who own restructured bonds (who previously accepted 33 cents on the dollar from 2005 or 2010 restructurings) until it pays the hedge funds $1.5bn in compliance with the ruling. Since the parties failed to reach an agreement by July 30, the country entered a “technical” default on its restructured debt.

While this is all history now, what remains are the lessons to be learned and much interest in what happens next: a possible deal where third-party banks like J.P. Morgan and Citigroup buy the defaulted debt owned by the holdout investors.

Argentina's President Cristina Fernandez de Kirchner and Economy Minister Axel Kicillof look on during a ceremony at the Casa Rosada Presidential Palace (Photo Credit: Reuters)

Why Did Argentina Refuse To Pay The "Holdout" Investors?

Argentina has continually refused to pay the remaining “holdouts” (roughly 7% of bondholders who did not accept the terms of a 2005 or 2010 bond restructure that offered 33 cents on the dollar to creditors), citing that its central bank foreign reserves of $29 billion would be depleted by such a payment that could set precedent for further lawsuits and payments of other holdouts who hold approximately $15 billion in defaulted debt.

Argentina's Hypothetical Debt Obligations After Triggering Rights Upon Future Offer Clause (in $ billions)

Argentina also argues that its debt obligations would be compounded by a Rights Upon Future Offers (RUFO) clause in the 2005 and 2010 restructured bonds, which prohibits the country from voluntarily offering a better deal to the holdouts without also extending the same deal to restructured bondholders, which would be triggered by the $1.5bn payment to other creditors to NML Capital and Aurelius Capital. Violating the clause would trigger claims of potentially more than $120 billion. One standing issue is that the RUFO clause expires at the end of 2014. If Argentina were able to negotiate a delayed payment of the $1.5bn with NML and Aurelius for 2015, they could hypothetically avoid the additional debt obligations triggered by the RUFO clause.

 

Buenos Aires Graffiti Says "No to the payment of the debt" (Photo Credit: Marcos Brindicci/Reuters)

Lessons From The Past 13 Years Since the 2001 Argentine Default

This may just be the beginning for new Argentine economic woes, unless they begin to learn the lessons of dire economic consequences of defaults, better-informed sovereign debt underwriting, and honesty when it comes to reporting official economic statistics:

Lesson #1: Defaulting On Sovereign Debt Is Almost Always Associated With Significant Declines in GDP, Serious Currency Devaluation and High Rates of Inflation

To get a good sense of what the economic consequences are of a sovereign debt default, one needs to look no further than the Argentine experience from the last time it defaulted in 2001. GDP declined by -4.4% in 2001 and by -10.9% in 2002. Argentina’s GDP contracted -0.5% in the fourth quarter of 2013 and by -0.8% in the first quarter of 2014, which technically puts the Argentine economy in a recession already, which can only be exacerbated by the default.

                                            Argentina GDP Growth (Annual %)

Source: The World Bank

Drawing from the sovereign debt defaults of the past 20 years, the Argentine peso in 2001, the Russian ruble in 1998, and the Thai baht in 1997 all depict the same scenario: significant currency devaluation.

Not to mention, high rates of inflation are also associated with sovereign debt defaults. Aggressive increases in the money supply, especially from non-independent central banks, often accompany defaults with the goal of eroding the real value of outstanding nominally denominated debt or to radically improve a faltering economy after default. This is the mechanism often paving the way to high rates of inflation after a default. As Milton Friedman once said, “inflation is always and everywhere a monetary phenomenon” and that rings especially true after defaults. At the height of Argentina’s economic collapse in 2001, Argentina’s monthly inflation rate was as high as 10.4% in April 2002. Returning to such high inflation rates would not be very difficult as private estimates find that Argentina’s annual inflation rate is already currently in the 30-40% range.

Lesson #2: The Importance of A Collective Action Clause In A Sovereign Bond Indenture

The primary reason why the 2001 Argentina Debt default has lingered for such a long period to this very day comes down quite literally to the indenture written in the bond contract and what it was missing: a collective action clause. By definition, a collective action clause (CAC) allows a supermajority of bondholders to agree on a debt restructuring that is legally binding on all the holders of that issue. Such a clause enables a supermajority of bondholders to require "holdouts", like Paul Singer’s NML Capital who would rather sue for the entire principal plus interest, into accepting a restructuring offer of cents on the dollar such as the offer of 33 cents on the dollar made by Argentina’s government in 2010 that was accepted by 92% of the bondholders of the original 2001 issue. In this case, forgetting the collective action clause may be a $15 billion dollar mistake for Argentina, should the remaining holdouts successfully sue for 100% of principal plus interest, which they will likely do, following the new precedent.

Paul Singer, founder and CEO of hedge fund Elliott Management Corporation, at the 2012 SALT Conference (Photo Credit: Reuters)

Remember the European Sovereign Debt Crisis of 2010? The lessons learned in Greece with CACs and sovereign debt are very similar to those in Argentina. Going into the 2010 crisis, Greece did not have Collective Action Clauses built into their sovereign debt. The Greek government, with the support of the IMF and the ECB, in effect enforced a “retroactive” CAC with a 75% threshold so that with 85.8% of the bondholders approval (which excluded the approval of PIMCO’s Bill Gross), all Greek bondholders (including the few who disapproved) would receive 32 cents on the dollar (through a new bond offering). Effective January 2013, all newly issued European Bonds now have Collective Action Clauses.

Lesson #3: Inflating GDP Statistics Will Actually Trigger Further Interest Payouts

Argentina is famous for allegedly falsifying their macroeconomic data, a criticism that has come from many credible international sources including the International Monetary Fund. MIT professors Alberto Cavallo and Roberto Rigobon have demonstrated if you actually track inflation using price data from online sales websites and other marketplaces, your inflation number will differ greatly from the figure provided by the Argentine statistics office (INDEC). The MIT Billion Prices project sources an annual inflation number of roughly 40% as of July 2014 while the Argentine government is reporting an inflation figure in the area of 20%. Various sources claim including the IMF and The Economist that GDP numbers are also inflated.

Argentina Annualized Inflation (Official versus MIT Billion Prices Project)

(Photo Credit: PriceStats, State Street)

How this directly applies to Argentina’s debt situation is simple: the new restructured US dollar denominated bonds issued in 2005 and 2010 have interest payments that are linked to Argentina’s official GDP numbers. While inflating nominal GDP figures may create a favorable political appearance for the ruling party, it directly triggers interest payouts sooner than they actually should be made if the GDP numbers were accurate and consistent with the estimates of private economic consultants.

Argentina Annualized GDP Growth (Official versus Private)

(Photo Credit: The Economist)

What Happens Next?

ISDA Will Recognize This As A Credit Event

The International Swaps & Derivatives Association (ISDA), the leading derivatives trade group, has decided on the payout of credit default swaps (CDS), a separate product that acts as insurance and pays holders of the swaps if Argentina technically defaults on the bonds. ISDA has concluded that Argentina’s inability to settle interest claims this past Wednesday does constitute "a failure to pay credit event" and will trigger a payout for credit default swap buyers. The ISDA committee will now hold an auction to settle the outstanding CDS transactions. The same body made an affirmative decision on credit default swaps insuring Greek sovereign bonds, which paid out in 2012.

Argentina Annual Probability of Default from 5 Year Credit Default Swaps

(Photo Credit: Deutsche Bank Research)

Accelerated Bond Payments Not A Major Concern For Now

As Argentina is now in technical default, its bondholders now have the ability to ask for immediate repayment of interest plus the full principal, a process known as “acceleration”. Since roughly 25% of bondholders witnessed a skipped interest payment, they are entitled to accelerate payments. In addition, the remaining 75% of other bondholders (without a skipped interest payment) through a “cross-default” provision may be able to ask for accelerated payments as well.

Mark Weidemaier, an associate professor of law at the University of North Carolina School of Law, in a Wall Street Journal interview expressed his skepticism that restructured bond investors will demand accelerated payments, “the question is whether Argentina views a short-term default as a worse option than cutting a deal now and risking litigation under the RUFO clause...As long as you think a country is able and willing to pay you, and it’s all contingent on getting this deal done”. The Argentine government is also

Possible Bank Deal To Circumvent The RUFO Clause

Many believe that Argentina’s debt woes will potentially be short-lived and that the default may be "temporary" one as a possible deal is being negotiated where third-party banks like J.P. Morgan and Citigroup buy the $1.5bn in defaulted debt owned by Elliott Associates and Aurelius Capital, the “holdout” hedge fund investors.

Argentina would not participate in such a settlement with the hedge funds because doing so would trigger the Rights Upon Future Offers (RUFO) clause, requiring the country to give the same terms for the 93 percent of investors who accepted 33 cents on the dollar that went along with the country’s debt restructurings in 2005 and 2010. Essentially, the bank deal is a third-party solution to circumvent the RUFO clause (that would trigger an approximately $120bn payout), but still pay Elliott Associates and Aurelius Capital their full principal plus interest amounting to $1.5bn dollars.

The expectation of a bank deal is keeping restructured bond prices at 90 cents on the dollar from following further from a closing price of 96 cents on Wednesday, the day the country entered into technical default. Nonetheless, the Argentine Merval stock index fell 8.4% on the official news of default. While the latest Argentine debt crisis may optimistically find a speedy fix so the country may begin paying interest to restructured bondholders, international credit markets will not forget a 21st century default like this one.