Vulture funds come under sovereign fire

By Robin Wigglesworth

Vultures, parasites, pirates and loan sharks. Investors that snap up the debts of countries in financial distress in an attempt to profit from an eventual restructuring are often maligned by their supposed prey.

Such a strategy is more kindly described as “holding out”. Holdouts are typically – but not always – hedge funds that buy defaulted government debts on the cheap and refuse to join in a restructuring, “holding out” for a better deal. Sometimes they sue for the full amount.

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The strategy can be phenomenally profitable, but it is also risky and difficult. Critics say holdouts make it harder for stricken countries to restructure their debts.

Argentina’s recent legal defeats at the hands of Elliott Management, a hedge fund that has made suing governments a calling card, have exacerbated those concerns. But do holdouts really sabotage sovereign restructurings?

Not much, argues a recent report by Moody’s. After studying 34 bond restructurings over the past decade and a half, the rating agency has concluded that fears that holdouts undermine smooth sovereign restructurings are “exaggerated”.

The finding is unsurprising. Essentially, holdouts are free-riders that want restructurings to go ahead, so that paying them in full is merely an annoyance, part of the routine cost of sovereign debt workouts.

If too many creditors hold out, restructurings fail and no one gets paid. Indeed, most bondholders are banks and asset managers that tend to sign up to restructurings, almost irrespective of how harsh the terms.

There are downsides for holdouts. Those that agree to a restructuring might get a “haircut”, but get liquid, tradeable bonds in return. Holdouts may be repaid in full, but often only at the maturity of the original bond – which could be years away. Meanwhile, their securities are exceptionally illiquid.

For the countries involved, it is often easier to pay off holdouts. Although it is extremely difficult to collect on legal judgments against governments, holdouts can create legal headaches that most want to avoid.

“Worries over holdouts are usually overdone,” says Charles Blitzer, a former official at the International Monetary Fund that worked on several government debt workouts. “Bond restructurings have generally concluded quickly and with overwhelming participation by creditors. If there are any holdouts, they rarely rock the boat.”

For example, when Greece restructured almost €200bn of bonds last year, investors with roughly €6.4bn of Greek bonds decided to hold out. They were overwhelmingly concentrated in harder-to-restructure international law bonds, so Athens has so far elected to repay all holdouts in full.

Nonetheless, there are growing concerns that Argentina’s case may shift the incentives in favour of holding out, and upset the run of relatively smooth restructurings.

Elliott has successfully argued that an obscure bond clause called pari passu that promises equal treatment of creditors prevents Argentina from paying its restructured bondholders but not Elliott. An appeals court is expected to confirm the judgment soon.

This could prove pivotal for future restructurings, by handing holdouts a precedent. If countries do not pay them, holdouts can in theory hold payments to restructured bondholders “hostage”. But by potentially emboldening more creditors to hold out, it may make future restructurings harder to complete.

“Before you could credibly threaten to not pay holdouts, but this case makes that much more difficult,” says one European official who has studied holdouts. “If this goes through it will be a hugely powerful instrument.”

Elliott, Moody’s and others argue that “collective action clauses” – which allow a majority of bondholders to force an agreement on all – mean that the Argentine case will have little or no fallout, however.

These clauses have become more common and are now embedded in almost all international bonds. Local law bonds can be retroactively fitted with CACs, as Greece did with its domestic debts.

Still, CACs are no panacea. Although bondholders have tended to overwhelmingly vote in favour of restructurings, the Argentine precedent could make creditors more inclined to hold out.

Moreover, CACs are usually individual to each bond. Determined hedge funds can to snap up a blocking stake, typically 25 per cent, to prevent a restructuring of that specific security – a tactic holdouts used with many of Greece’s international bonds.

Although still uncommon, litigation is on the rise. Three German academics – Julian Schumacher, Christoph Trebesch and Henrik Enderlein – have counted only 108 creditor lawsuits between 1976 and 2010, but more than half of those have been filed since 2000.

The German study also found that the lawsuits are increasingly being filed by hedge funds rather than banks and traditional asset managers. They typically sue for longer, and for bigger amounts. Many experts fear the Argentine precedent could embolden them further, upsetting the restructuring apple cart.

http://www.ft.com/intl/cms/s/0/41a633ae-ab3d-11e2-8c63-00144feabdc0.html#axzz2RNkxlTd8