Tag Archives: default

It Takes More than Two to Tango: Cry, But Not for Argentina, nor for the Holdouts

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U.S. federal courts have ruled that Argentina is prohibited from making payments to fulfill 2005 and 2010 agreements with its creditors to restructure its debt, so long as it is not also paying a few creditors that have all along been holdouts from those agreements.  The judgment is likely to stick, because the judge (Thomas Griesa, in New York) told American banks on June 27 that it would be illegal for them to transfer Argentina’s payments to the 92 per cent of creditors who agreed to be restructured and because the US Supreme Court in June declined to review the lower court rulings.

It is hard to cry for Argentina or for its President, Cristina Fernández de Kirchner. Nevertheless the ruling in favor of the holdouts is bad news for the international financial system.  It sets back the evolution of the international debt restructuring regime.

Why is it so hard to feel sympathy for a developing country that can’t pay its debts?  In the first place, Argentina in 2001 had unilaterally defaulted on the entire $100 billion debt, rather than the usual effort to negotiate new terms with the creditors.  Thus when it finally got around to negotiating a settlement with the 92% majority of bondholders four years later, it could almost dictate the terms: a 70% “haircut” or loss.

In the intervening decade, the Kirchners have gone out of their way to pursue a variety of innovatively bad economic policies, reversing a preceding decade of good policies.  Ms. Fernandez has seriously impaired the independence of the central bank and the statistical agency, forcing the adoption of CPI statistics that understate the inflation rate, so systematically that most people no longer use them.  She has broken contracts and nationalized foreign-owned companies.  When prices for Argentina’s leading agricultural export commodities, reached very high levels on global markets —  a golden opportunity for the country to boost growth of output and foreign exchange earnings (chronically insufficient)  – she imposed heavy tariffs and quotas on soy, wheat and beef exports, thereby preventing producers from taking advantage.

On the other hand, some might counter that the holdout hedge funds who brought the suit to Judge Griesa are not that sympathetic either. Many of them are called “vulture funds” because they are not the original creditors but rather investors who came along later, buying the debt at deep discount, hoping to profit subsequently through court decisions.

But all this is beside the point. (And these investors shouldn’t let the name bother them so much; after all vultures have their own ecological niche.  When Alexander Hamilton, the first U.S. Treasury Secretary, redeemed the debts of the 13 colonies at full face value, he was well aware that some speculators who bought at deep discount would profit.) The problem with the Argentine debt case has little to do with moral failings of either the plaintiffs or the defendants.  Instead the problem is the precedent for resolution of international debt crises.

The popular reaction to the recent rulings, even among those less familiar with the sad history, is anti-Argentina. After all, the judge is just enforcing the legal contract embodied in the original bonds, isn’t he?   As President Calvin Coolidge supposedly said, about American loans to the WWI allies, “They hired the money, didn’t they?”

If only the world were so simple. If only a simple legal regime of consistently enforcing the explicit terms of all loan contracts, by making the debtor pay, were sufficiently practical to be worth pursuing.  But (even leaving aside jubilee-style forgiveness by “bleeding-heart social workers”) capitalists figured out many years ago that the financial system requires procedures for rewriting the terms of debt contracts under extreme circumstances.    The British Joint Stock Companies Act of 1857, for example, established the principle of limited liability for corporations.  Debt bondage and debtors prison have also been illegal since the 19th century, regardless what the debt contract might say.  Individuals can declare bankruptcy.  So can corporations, of course.   (And if the prophetic Keynes had been able to persuade Americans like Calvin Coolidge to recognize reality and forgive unrepayable debts of European governments, the history of the interwar period might have been different.)

Corporate bankruptcy law works relatively well at the national level.  There will always be times when it is impossible for a debtor to pay — and admittedly other times, hard to distinguish, when the debtor merely claims that it can’t pay.  A poor legal system is one that keeps otherwise-viable factories shuttered while assets are frittered away in expensive legal wrangling, and everyone is left worse off.   A good legal system is one that: (i) allows employment and production to continue – in those cases where the economic activity is still viable (in re-organized form]; (ii) divides up the remaining assets in an orderly and generally accepted way (even if some creditors oppose the “cramdown”), and (iii) makes these determinations as efficiently and speedily as possible and with the minimum of moral hazard (by imposing costs on managers, lenders, shareholders, and – if necessary – bondholders, so as to avoid encouraging future carelessness).

No such debtors’ court or body of law exists at the international level.  Some think that this long-standing lacuna is the primary difficulty with the international debt system.  Ambitious proposals to solve it over the years, such as a Sovereign Debt Restructuring Mechanism (SDRM) which might be housed at the IMF, have always run into political roadblocks.

But incremental steps had been slowly moving the system in the right direction since the 1980s.   In the international debt crisis that began in 1982, IMF country adjustment programs went hand in hand with “bailing in” creditor banks through “voluntary” coordinated loan rollovers.  Eventually it was recognized that a  debt overhang was inhibiting investment and growth in Latin America, to the detriment of both debtor and creditor;  after 1989, Brady-Plan write-downs alleviated the debt overhang.   Subsequent programs to deal with emerging market crises featured an analogous combination of country adjustment and “Private Sector Involvement” [such as agreement by lenders to stretch out maturities].  Voluntary debt exchange offers worked, roughly speaking, with investors accepting haircuts.

After Argentina’s unilateral default in 2001, many borrowers and lenders saw more clearly the need to allow explicitly for less drastic alternatives ahead of time and so incorporated more “Collective Action Clauses” when writing their lending contracts.  CACs are provisions that are voluntarily agreed to by all participants ahead of time to facilitate restructuring.  They make it possible, if the borrower subsequently runs into trouble, to restructure debt when a substantial majority of creditors wishes to do so, even if a few hold-outs do not.  The minority is then bound by the majority decision. The incremental steps had created a loose sort of system of debt restructuring.  It still had many deficiencies.  Restructuring often was too late and too little to restore debt sustainability.  But it worked, more or less.  (The IMF has continued to work on ways to make its biggest rescue programs conditional not just on country reforms but also in some cases on private sector involvement, in the form of reprofiling or, when necessary, reduction of debt.)

The real danger of the court ruling in the case of the Argentine hold-outs is that, in a parochial instinct to enforce a written contract, it will undermine the possibility of negotiated re-structuring of unsustainable debt burdens in future crises, because free-riding holdouts may be able to prevent it.   Contrary to the saying, it takes more than two to tango.   It is not enough for the debtor and 92 per cent of creditors to reach an agreement, if holdouts and a New York judge can block it.

The court delivered a peculiar interpretation of the pari passu (equal treatment) clause that is standard in many sovereign debt contracts.  It interpreted pari passu to mean that creditors who had not agreed to the debt exchange were to be paid 100% of the original claim at the expense of the creditors that had accepted the new bonds. Moreover, the court gave the holdouts a very powerful weapon to enforce their claims by holding settlement and clearing institutions in the US and even in Europe responsible for routing any payments of Argentina.

Financial markets may find a way around the precedent of the court ruling in future contracts.   Likely responses to the problem include a shift toward writing contracts outside the United States, greater use of CACs, and elaboration of the pari passu clause.   But some warn of extra-territorial reach by the US court.  Some even think the decision could inadvertently interfere with CACs, though there is probably a fix for this. 

Other recent developments have also worked to reverse the progress in the global resolution regime, as inadequate as it already had been.  Europe’s handling of the crisis that began with Greece in 2010 was too slow, too optimistic, too reluctant initially to restructure bond-holders, and too enamored of fiscal austerity.  The mistakes eventually encompassed even such specific no-nos as a consideration in the Cyprus case of haircutting small bank depositors.

Time will run out for the Land of the Tango by the end of July.  Perhaps the result of the court decision will be that, unable to pay all its debts, Argentina will be forced instead to default on all its debts.  More likely, in the end it will manage to come to some accommodation that hold-outs find more attractive than the deal accepted by the other creditors.  Regardless, the outcome will undermine voluntary debt workout agreements in the future.  This is bound to make debtors and creditors alike worse off.

This column appears also at VoxEU, July 22, 2014.  A condensed version appeared at Project Syndicate; Comments can be posted there.

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Will Financial Markets Crash Before October 17, or After?

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October 4 is the first Friday of the month, the day when the Bureau of Labor Statistics routinely reports the jobs numbers for the preceding month.   Is the havoc created by our current political deadlock over fiscal policy showing up as job losses?   We have no way of knowing.  On October 1 the BLS closed for business, like many other “non-essential” parts of the government.  There will be no more employment numbers until the shutdown ends.

Last week, Wall Street economic analysts responded to the usual surveys as to what they thought the upcoming employment numbers would be.   (These surveys are what the media refers to each month when they tell you that employment rose or fell “more than economists expected.”)    The median forecast in last week’s  Bloomberg survey, for example, was a prediction that the BLS would report that “Payrolls increased by 175,000,” the biggest gain in four months.   But there was no word on how many of the respondents recognized that there would in fact probably be no number at all on October 4, because the Labor Department would have been closed by the government shutdown.

It seems to me that this minor blind-spot is symbolic of a failure of Wall Street to focus adequately, until now, on the long-impending government shutdown and still-impending October 17 deadline for raising the national debt ceiling.   One reason for the lack of concern up until this point is that observers are jaded; they feel they have seen this movie before (with fiscal cliffs, sequesters, shutdowns, and ceilings); that it is “only politics;” and that Washington always averts catastrophe at the last minute. Well, maybe not this time. 

Another reason is that the financial markets all summer long were busy over-reacting to developments regarding the Federal Reserve.   The stock market reached a high two weeks ago on the information, which was considered news, that monetary policy was not going to be tightened imminently after all.   Now the fixation is passing from monetary policy to fiscal policy. Not a moment too soon.

Both sides in Washington are firmly dug in, and don’t plan to back down.  If the politicians don’t get their act together  and the debt ceiling is really not raised, the results will be very bad indeed.   I actually mean “if the Republicans don’t get their act together.”  I think President Obama is fully credible when he says he will not let one faction in one party in one house of congress, in one branch of the government, threaten to blow us all  up if they don’t get their way on the Affordable Care Act.

The US has never defaulted on its obligations before.  Some continue to imagine that the government could stay within the debt ceiling but meet its obligations out of incoming tax revenue.  This is wrong.  Even if there were enough tax revenue to service the treasury debt for awhile, there would not be anywhere near enough to meet all the other legal obligations that the federal government has already incurred under the congressionally passed budget.  If the government doesn’t pay Staples the money that is owed for office supplies that it bought last month, that is a legal default just as much as if it fails to service its bonds.  

Perhaps, given the desperation of the situation when the time comes, President Obama could try one of the gimmicks that have been proposed, such as minting the trillion dollar coin or taking the position that the debt ceiling violates the constitution or other laws.   These are not attractive options because they would probably provoke a constitutional crisis.   So let’s assume that he doesn’t take them.

It seems to me that this then leaves two possible outcomes: either the financial markets fall before October 17 and the Republicans respond by backing down or the financial markets fall after October 17 and the Republicans respond by backing down.   Precedents for financial markets forcing such a reversal include the delayed congressional passage of the unpopular TARP legislation in the fall of 2008 and the delayed passage of an unpopular IMF quota increase 10 years earlier.   (In the last debt ceiling showdown, in August 2011, default was avoided at the last minute;  but the stock market fell sharply anyway, when S&P for the first time ever downgraded US debt from AAA.)

After a remark by Obama about the markets yesterday, some accused him of “scare tactics,” of fanning Wall Street fears for political advantage.  The reality is almost the reverse:  if Obama thinks like a pure politician, he will let the Republican Party complete the process of committing suicide (suicide by means of binge tea partying).  The way to do this would be to wait until October 17 and let the Republicans take the blame not just for a decline in the stock market or for the inconvenience to anyone who has to deal with the government during the shutdown, but – if there is no resolution in time to raise the debt ceiling – to take the blame for the likely result: a second global financial crisis and global recession.   

But that would be a very high price to pay for political advantage.  Even if the Republicans cave in within a few days after October 17, so as to avert the global recession, by then the creditworthiness of US Treasury debt will have been irreparably harmed.  My guess is that Obama thinks it would be much better for the country if the markets were to tank and the Republicans to back down before October 17 rather than after, even though the Tea Party would then live to fight another day.

[I discussed these matters this morning on BBC radio, “US Shutdown Risk to Global Economy,” and Fox Business News, “Who Will Listen to the President’s Warning to Wall Street?” Varney & Co..  One of the Fox team claimed that the stock market has usually gone up in government shutdowns.  It turned out that her statistic referred to the subsequent month;  in other words the market goes up when the shutdown is ended.  In fact it typically goes down during shutdowns, by 2 ½ % in the case of those lasting 10 days or more. It looks to me that this exchange was excluded from the segment posted on the Fox website.] 

Comments can be posted at the site of the Project Syndicate blog version of this post.

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Black Swans of August

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       Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacation in the belief that world affairs were quiet.   Examples of geopolitical jolts that came in August include the outbreak of World War I, the Nazi-Soviet pact of 1939 and the Berlin Wall in 1961.  Subsequent examples of economic and other surprises in August have included the Nixon shock of 1971 (when the American president enacted wage-price controls, took the dollar off gold, and imposed trade controls), 1982 eruption in Mexico of the international debt crisis, Iraq’s invasion of Kuwait in 1990, the 1991 Soviet coup, 1992 crisis in the European Exchange Rate Mechanism, Hurricane Katrina in 2005, and US subprime mortgage crisis of 2007.   Many of these shocks constituted events that had previously not even appeared on most radar screens. They were considered unthinkable. 

The phrase “black swans” has come to be used to mean a very unlikely event of this sort.  Managers of Long Term Capital Management in 1998 or of most major banks in 2008 have suggested that they could not be expected to have allowed for a financial collapse such as the one that followed the default of Russia or the one that followed the bursting of the US housing bubble, because it was a “7-standard deviation event,” that is, an event of inconceivably tiny probability…in the realm of the probability that two major meteors hit the earth at the same time.   This is nonsense.  If the statistical model says the probability of a financial crisis is that low, it is the model that is wrong.  This is like the case when “hundred-year floods” turn up every few years.

A bit more enlightened are people who talk about Knightian uncertainty or “unknown unknowns.” Ignorance with humility is better than ignorance without it.    A still better interpretation is that statistical distributions have “fat tails,” in technical terms.  But it would be nice to get beyond the Jurassic Park lesson (“don’t be surprised if things go wrong”), to be able to say intelligent things about what causes tail events. 

       What does “black swan” really mean?   In my view, it should refer to an event that is considered virtually impossible by those whose frame of reference is limited in time span and geographical area, but that is well within the probability distribution for those whose data set includes other countries besides their own and other decades or centuries. 

      Consider five examples of mistakes made by those whose memory did not extend beyond a few years or decades of personal experience in a small number of countries.

1. “All swans are white.”  The origin of the black swan metaphor was the belief that all swans were white, a conclusion that might have been reached by a 19th century Englishman based on a lifetime of personal observation and David Hume’s principle of induction.   But ornithologists already knew that there in fact existed black swans in Australia, having discovered them in 1697.  A 19th-century Englishman encountering a black swan for the first time might have considered it an event of unthinkably low probability, even though the relevant information to the contrary had already been available in ornithology books.  It seems a waste of an excellent metaphor to use the term just to mean a highly unexpected event.  A better use of “black swan” would be to mean an event that would not have been quite so unexpected ex ante if forecasters had cast their data net over a broader set of countries and a longer time perspective.

 2. “Terrorists don’t blow up big office buildings.”   Before September 11, 2001, some terrorist experts warned that foreign terrorists might try to blow up tall American office buildings.   These warnings were not taken seriously by those in power at the time.   Many Americans did not know the history of terrorist events taking place in other countries and in other decades.  

 3. “Housing prices don’t fall.” Many Americans up to 2006 based their behavior on the assumption that nominal housing prices, even if they slowed down, would not fall.   After all, “they never had before,” which meant that they had not fallen in living memory in the United States.   They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940s.  Needless to say, many a decision would have been made very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline in prices.

 4. “Volatilities are low.”   During the years 2004-06, financial markets perceived market risk as very low.  This was most nakedly visible in the implicit volatilities in options prices such as the VIX.  But it was also manifest in junk bond spreads, sovereign spreads, and many other financial prices.  One of the reasons for this historic mis-pricing of risk is that traders were plugging into their Black-Scholes formulas estimates of variances that went back only a few years, or at most a few decades (the period of the late “Great Moderation”).  They should have gone back much farther – or better yet, formed judgments based on a more comprehensive assessment of what risks might lie in wait for the world economy.

 5. “Big banks don’t fail.”   “Governments of advanced countries don’t default.”   “European governments don’t default.”  Enough saidGreece‘s debt troubles, in particular, should not have caught anyone by surprise, least of all northern Europeans.   The perception was that euro countries were fundamentally different from emerging markets, that like Germany they were free of default risk.  Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. But even when the Greek crisis erupted, leaders in Brussels and Frankfurt seemed to view it as a black swan, instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, the Mexican crisis of 1994, and many others in history, including among European countries.

      My next blog post will list some of the shocks that, even though low-probability, have high enough probability that they should be treated as thinkable rather than unthinkable, they would have great consequences, and they therefore warrant some advance preparation.

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