08-01-14

Another Default for Argentina

A blog post is too short a forum to fully explain the last decade of debt reshuffling in Argentina, but we hope that this post can serve as a suitable jumping-off point for those delving more deeply into the situation. With a limited number of words, we will attempt to describe the historical context of Argentina's debt situation, and how they came to 'default' yet again this past week.

In December of 2001, after two unsuccessful bailouts from the IMF, Argentina defaulted on slightly less than $100 billion in outstanding debt - the largest sovereign default in history up to that point (Greece would pass them in 2012). A total of $81.8 billion in debt was owed to private creditors, with $6.3 billion to the Paris Club (an informal group of nations who act in common to negotiate debt relief for developing nations) and $9.5 billion to the IMF. Though negotiations began in 2002, it wouldn't be until January of 2005 that an agreement was reached. In an unprecedented approach to dealing with default, Argentina set aside the IMF and Paris Club debts, and instead began working on a settlement with private creditors directly. By January of 2005 the $81.8 billion in debt now had accrued $20.8 billion in past-due interest payments, but the nation still managed to exchange $62.3 billion (of the $81.8) for $35.2 billion in new debt. The remaining private debt (about $19.5 billion) was not tendered, and this group would form the first core of "holdouts". The $19.5 billion as well as the debts to the Paris Club and IMF (along with past due interest on all debt) were left to be resolved later.

In 2006 Argentina paid back the IMF $9.5 billion in full, avoiding any future international pressure to comply with IMF restructuring guidelines. In June of 2010, it created a second bond exchange program targeting the initial holdout group, and was able to exchange another $12.4 billion in debt. At that time the IMF provided a breakdown of the exchange, noting that the majority of those forming this second holdout group with $6 billion in debt were hedge funds (see table below).

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Approximately 94% of debt holders had now accepted restructured terms across the 2005 and 2010 exchanges. By the end of 2010, Argentina owed $11.2 billion to holdouts (principal and past due interest) and the remaining debt of $6.3 billion to the Paris Club.

Four years later Argentina would reach an agreement with the Paris Club to repay its debt (now $9.7 billion with interest, penalties and other fees) over five years in tranches. It made payment on the first tranche this past Monday

Where does this leave private creditors? In 2012 Southern District of New York Judge Thomas Griesa ruled that Argentina could not make interest payments on its restructured bonds without also paying the holdouts the full value of their bonds. This interpretation of the 'pari passu' clause within the debt agreements (which requires that all debt holders be treated equally) was challenged by Argentina. His decision was upheld later that year by the 2nd Circuit, which agreed that since the bonds listed New York as their jurisdiction, Argentina could not rely on sovereign immunity to avoid the SDNY ruling. Since that ruling, Argentina has been struggling with what to do next.

When it makes a payment to the bond's trustee Bank of New York (to distribute to investors), the money cannot be distributed without violating the judicial order. However, paying out additional money to make whole the holdout investors would trigger 'rights upon future offer' clauses in the restructured debt, requiring them to extend the same terms to those who voluntarily took the restructuring in 2005 or 2010. 

After a lengthy back and forth, including multiple trips to circuit court and appeals to the U.S. Supreme court, things came to a head on June 16 this year, when the Supreme Court once again refused to hear Argentina's appeal, and issued a ruling allowing bondholders to subpoena banks in order to trace the nation's assets abroad for recovery. Despite Argentina's refusal to comply, the original ruling became final for Bank of New York, preventing Argentina from making interest payments that June. Due to a 30-day grace period, Argentina did not actually default until this week on July 30th, and were immediately downgraded on Thursday to selective default by S&P. Argentina has made it clear that the money to pay restructured debt holders was posted to Bank of New York. 

Judge Griesa's ruling has not been popular on the world stage, with the IMF noting that it gives too much power to a handful of creditors in disrupting restructurings, and the U.S. government has stated that the ruling is "impermissibly broad" and undermines U.S. relations with the rest of the world. According to the Depository Trust & Clearing Corp. there are $20.7 billion in credit default swaps (CDS) outstanding on Argentine debt which must now be resolved. 

In brief, credit default swaps show the price on an annual basis for insuring against default by the referenced entity. So, a five year senior CDS on Argentina would show the annual cost of insuring against default on senior Argentine debt for the next five years. This cost is commonly shown in basis points, or one hundredth of one percent. A basis point quote of 1,000 should be read as a cost of 10% of the notional value per year (for more information on CDS, please see our White Paper on the subject). The chart below shows the five-year senior CDS rate for Argentina, depicting a declining cost over the course of 2014, with a large spike in June 2014 corresponding to the Supreme Court decision, a reversal, and then another climb leading up to the point of default. Interestingly, the spread declined on July 31st, the day after the default. 

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Bond prices followed a similar path, but climbed the day after the default from a yield of 8.8% to 9.7%, still well below the mid-June highs of around 12%. Markets seem to be digesting Argentina's uncertain path forward.

The most active litigants have been two U.S. hedge funds; NML Capital Fund (a part of Elliot Management Corp.) and Aurelius Capital Management. NML has even gone so far as to have an Argentine naval vessel seized at port in Ghana as a means to recover on the $1 billion in debt that it is owed. NML will certainly continue to push forward in seeking a full recovery on its position.

Forcing a broader default on the restructured debt may negatively impact a number of U.S. open-end mutual funds. According to data from Morningstar, funds managed by industry giants like Fidelity, Vanguard and Putnam have exposure to Argentina ranging from 1-2%. Van Eck Global's Unconstrained Emerging Markets Bond Fund (EMBAX) has the highest listed exposure at 5.68%.

The struggle to reach a negotiated settlement has grown more contentious, and seems to have reached a boiling point with no resolution in sight. In a sign of the times, the hashtag #Griefault has been trending on twitter, a nod to investor awareness of the role Judge Griesa's decision played in forcing Argentina into another default slightly more than a decade after its first (still unresolved) default.  

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