1. to the budget, despite the country’s economic meltdown.

1.       Was President
Kirchner’s decision to repudiate a large portion of the nation’s foreign –
currency public debt the right decision for Argentina?


In December 2001, after four years of deepening recession
and mounting social unrest, Argentina’s
government collapsed and ceased all debt payments. Argentina had failed to pay before,
but this time it registered the largest sovereign default in history.  Argentina had to restructure over $100
billion owed to domestic and foreign bondholders, including $10 billion held by
U.S. investors.  A final offer made in
June 2004 amounted to a 75% reduction in the net present value of this debt,
making it the largest proposed write-down in the history of sovereign restructurings.
Argentina made a reasoned case that its debt was simply too big to repay, and
combined with its lack of progress on structural economic reforms, there was
also reason to believe the economy may have trouble achieving levels of
prolonged growth in output and revenue needed to achieve sustainability without
a huge writedown in its debt.  In the late 1990s, its deficits weren’t
particularly large, and its debt burden wasn’t particularly heavy.  In
1998, the debt burden came to only 38% of GDP, interest payments on the foreign
portion totalled only 29% of exports, and the deficit came to only 1.2% of
GDP.  Yet investors hammered the country, rolling over the debt at
ever-high interest rates.  Rising interest expenses derailed the budget, leading
to bigger deficits and even higher interest expenses. As people increasingly
began to believe that the peso would be devalued, nobody with dollars wanted to
give them up and nobody without them wanted to accept pesos in payment. 
As a result, a modern 21st-Century economy fell back to barter.  When
President Duhalde finally gave up the fight in January 2002, the peso plunged
by two-thirds, and default became inevitable. Duhalde and Kirchner then fought
to bring order to the budget, despite the country’s economic
meltdown. Kirchner increased export and corporate income taxes that took
revenue up to 23% in 2003 and 26% in 2004. This resulted to large and growing
budget surpluses.  Kirchner did everything “right” , and made its
creditors a fair offer contingent on decent Argentine growth in the
future.  When the creditors stalled, he showed strong intransigence.

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2.     Did Argentina
emerge stronger or weaker as a result of the debt repudiation?

Argentina’s political, social and economic structures
began to recover after the largest sovereign default in history. President
Kirchner did successfully consolidate and stabilize the political and social
systems while real gross domestic product growth in Argentina, after a short
term plunge, expanded that year by almost 9 percent, and real wages rose over
pre-default levels (see charts). Helped by growth, taxes on booming commodity
exports and debt default, the government was rolling in money: it achieved a
primary surplus of 4% of GDP that year, well over the target agreed with the IMF. Encouragingly, political consolidation and social stabilization were
becoming entrenched and would contribute to continued strong economic growth
over the next two years. Poverty, inequality and unemployment rate dropped
dramatically, while the consumer confidence doubled-up following the decline in
inflation (see charts). This was an enormous
achievement for a country that was gripped by unprecedented political and
social instability between 1999 and 2002, when the cumulative contraction of gross
domestic product approached 20 percent. The president’s hard-nosed tactics did generally pay off. Though starved
of credit and operating largely on cash, the economy was still benefiting from
the devaluation of 2002. Investment, mainly by smaller firms, was back to where
it had been in the 1990s. The Merval equity index boomed, the industrial
production grew substantially, and the number of companies filing for
bankruptcy fell. At around 75% of GDP, Argentina’s
debt ratio remained higher than the 52% then carried by its neighbour Brazil. But the
interest burden on Argentina’s
debts was now much lighter (a coupon of 2-5% in the first 10 years, compared
with 10% in Brazil)
and the maturities much longer than the market would normally accept. Standard
& Poor’s, had said it would upgrade Argentina to B- after a successful
debt swap. Although the Kirchner experiment was successful, the consequences of
his actions were far-reaching.  Argentina
faced legal judgments over the repudiated debt in every money market capital in
the world, preventing the government from borrowing outside Argentina.  Furthermore, foreign direct investment fell
sharply compared to other Latin American countries; and the need to finance
government operations through domestic lending forced the government to inflate
the Argentine peso.



3.   What are the best
options for addressing the challenge of sovereign debt restructurings at the
international level? Can they be implemented in the current international


Sovereign defaults are time consuming and costly to
resolve. The default by Argentina
took four years from initial default to exchange offer, and still lingers as
creditors explore legal options. Reasons for delay vary from case to case, but
the most important remain the same: a) creditors, especially smaller ones, have
an incentive to hold-out from the restructuring, when being able to disrupt a
country’s effort to service new debts, and b) each creditor has the incentive
to delay his own negotiations in order to avoid costs, and free ride on other
creditors’ negotiations. In order to respond to these problems, various
instruments have been implemented. One of these, the collective action clauses,
which would allow an approved assembly of bondholders to restructure sovereign
debt, have been widely discussed but not yet universally adopted, because of
signalling, legislation and voting problems. Another instrument is the SDRM,
which while unifying creditors into one negotiating entity, it simultaneously
protects the debtor from legal action for a short period of time. However, this
proposal leaves unclear several crucial details that need further examination.
Finally the last resort for both the creditors and debtors is the imposition of
an ultimatum, or the acceptance of the status quo, an approach which can result
in increases to costs for all parties. In short, the details of designing a
voluntary approach to debt workouts are complex. It will be a challenge to
enshrine clauses in sovereign debt that are detailed enough to create an
orderly debt workout, yet attractive enough for creditors and debtors to agree
to introduce them.



 1)   Why did Citigroup initiate a conversion of
its preferred equity to common equity?

The 2007 crisis triggered a deep re-examination of the way bank health
is measured in the U.S.
financial system. Bankers and regulators generally preferred to use what is
known as “Tier 1” ratio of a bank’s capital adequacy. It takes into
account equity other than common stock. By Tier 1 measurements, most big banks,
including Citigroup, appeared healthy. Citigroup’s Tier 1 ratio was 11.8%, well
above the level needed to be classified as well-capitalized. Nevertheless, there
were two catalysts for the initiation of talks with the government about a
possible conversion of Citigroup’s preferred equity to common. First,
Citigroup’s shares fell to historic lows. That didn’t pose a direct threat to
the company’s stability, but it spooked customers into pulling their business, and
could push the bank toward a dangerous downward spiral. Second, bank regulators
were about to start performing their battery of stress tests at the nation’s
largest banks as part of the Obama administration’s industry-bailout plan. As
part of those tests, the Federal Reserve was expected to dwell on the TCE
measurement as a gauge of bank health. Most banks’ TCE ratios were indicating
severe weakness. Until then, TCE – essentially a gauge of what common
shareholders would get if an institution were dissolved – has been one of the
less prominent ways to measure a bank’s vigor. TCE has also been among the most
conservative measures of financial health. However, Citigroup’s TCE ratio stood
at about 1.5% of assets at Dec. 31 2009, well below the 3% level that investors
regard as safe. The discussed conversion would improve investors’ perceptions
of the company’s balance sheet, and would limit the observers’ questions about
Citigroup’s solvency.

2)   How
significant is the dilution expected to be?

Citi had 5.45 billion common shares outstanding. It was offering to
convert up to $27.5 billion of preferred shares held by “private” investors
other than the U.S. government (like the government of Singapore and Prince
Alwaleed) into common shares, at a conversion price of $3.25. That would create
another 8.46 billion shares. For every dollar that is converted, the U.S. government
would also convert one dollar of its preferred stock, up to $25 billion; that
is the $25 billion from the first round of recapitalization back in October of
2008. That would create another 7.69 billion shares. So if everyone converts as
much as possible, there will be 21.60 billion shares outstanding, of which the
U.S. government would own 7.69, for an ownership stake of 36% (from a starting
7%) . The other private investors would own 39%, and current shareholders would
own 25%.

3)   If you were a Citigroup equity holder, would you approve of this

      Because of the newly perceived need for TCE, the
bailout plan under discussion is to convert some of the preferred stock into
common stock. Citi wouldn’t actually get any new cash from the government, but
it would be relieved of some of the dividend payments (currently close to $3
billion per year), and of the obligation to buy back the shares in five years.
This would be a real benefit to the bank’s bottom line, and hence to the common
shareholders. The conversion would significantly increase the banks’ solvency
and stability, two important factors for long term profitability. Expected
gains would increase, and so the common stock holders would benefit from a rise
in stock prices. At the same time, though, Citi would issue new common shares
to the government, diluting the existing common shareholders (meaning that they
now own a smaller percentage of the bank than before). Bottom line, it’s all
about the anticipation of further government intervention from the common share
holder. If no more intervention and dilution is expected, the amount by which
the shareholders in aggregate are better off should balance the amount of
dilution to the existing shareholders, making the exchange a profitable stake.




4)   If you were a preferred holder, would you approve of this conversion?

Citi was trying to
persuade some investors holding preferred shares to convert some of those
stakes into common stock. However there is a clear rationale for a possible
refusal of private holders to convert – they could suffer vast losses. For
example, called ‘perpetual convertibles’, GIC’s preferred shares represented a
beneficial stake of 5.3 per cent if converted, and also offered an annual
coupon of 7 per cent. But a conversion into common equity would cut off that
income stream, so the deal must offer more benefits : the GIC return should be
equal or above the coupon. In addition, if GIC converts its preferred shares
into common stock, alongside the US government, this will lead to an
enormous dilution of the sovereign fund’s stake, while keeping in mind a
possible Citi nationalization ; but this could be their only option. If GIC
does not convert, and the situation worsens, even the 7 per cent annual coupon
may vanish as well. The final conversion price of $3,25 is a profitable term,
giving better chances to a favorable reaction from the private holders. It all
comes down to the private holders anticipation of the company’s future, and
their profits as common share holders.


5)   Evaluate the pricing of Citigroup’s preferred shares relative to its
common stock. Is there an opportunity here? If so, what are the tricks?

As the government’s
term sheet proposed the conversion of Citi preferred stock into common at a price
of $3.25, a huge number of accounts thought there was a significant arbitrage
to be held there. Here’s how the Citi arbitrage play would work. Citi said they
would offer to exchange all preferred shares to common stock at $3.25 per
share, giving the preferred around 7.7 share of common stock. The common,
however, was trading far below $3.25–all the way down to $1.50. 
Basically, Citi was asking preferred holders to pay $3.25 for shares that you
could buy in the open market for just $1.50. There were around 81 million
preferred shares, originally sold for $25. But Citi’s troubles led investors to
sell those off so steeply that they were then trading between $5 and $7.50 . If
you get 7.7 shares of common worth $1.50 a share, each share of preferred is
worth $11.55. To put it differently, if you bought a share of preferred for
$7.50, you could flip them for common worth $11.55. When investors—especially
hedge funds—got their mind around this, they started buying up the preferred
shares, sending the price higher. The trade could be
boxed by shorting 7.7 shares of common for every share of preferred purchased,
thereby “securing” a roughly 50% return. This (probably among other
things) explains the persistent drop in Citi
common over the day as hedge funds were locking in what they thought was a
certain premium. But there was a catch. The government never promised
that the average investor would be able to convert their preferred to common at
the same ratio as everyone else. And there was an immediate concern that when
investors realized this, Citi’s shares would rally amid a massive short


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