1. Was PresidentKirchner’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 recessionand mounting social unrest, Argentina’sgovernment 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 $100billion owed to domestic and foreign bondholders, including $10 billion held byU.S. investors. A final offer made inJune 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, andcombined with its lack of progress on structural economic reforms, there wasalso reason to believe the economy may have trouble achieving levels ofprolonged growth in output and revenue needed to achieve sustainability withouta huge writedown in its debt.
In the late 1990s, its deficits weren’tparticularly large, and its debt burden wasn’t particularly heavy. In1998, the debt burden came to only 38% of GDP, interest payments on the foreignportion totalled only 29% of exports, and the deficit came to only 1.2% ofGDP.
Yet investors hammered the country, rolling over the debt atever-high interest rates. Rising interest expenses derailed the budget, leadingto bigger deficits and even higher interest expenses. As people increasinglybegan to believe that the peso would be devalued, nobody with dollars wanted togive them up and nobody without them wanted to accept pesos in payment.
As a result, a modern 21st-Century economy fell back to barter. WhenPresident Duhalde finally gave up the fight in January 2002, the peso plungedby two-thirds, and default became inevitable. Duhalde and Kirchner then foughtto bring order to the budget, despite the country’s economicmeltdown. Kirchner increased export and corporate income taxes that tookrevenue up to 23% in 2003 and 26% in 2004. This resulted to large and growingbudget surpluses. Kirchner did everything “right” , and made itscreditors a fair offer contingent on decent Argentine growth in thefuture. When the creditors stalled, he showed strong intransigence. 2.
Did Argentinaemerge stronger or weaker as a result of the debt repudiation?Argentina’s political, social and economic structuresbegan to recover after the largest sovereign default in history. PresidentKirchner did successfully consolidate and stabilize the political and socialsystems while real gross domestic product growth in Argentina, after a shortterm plunge, expanded that year by almost 9 percent, and real wages rose overpre-default levels (see charts). Helped by growth, taxes on booming commodityexports and debt default, the government was rolling in money: it achieved aprimary surplus of 4% of GDP that year, well over the target agreed with the IMF. Encouragingly, political consolidation and social stabilization werebecoming entrenched and would contribute to continued strong economic growthover the next two years. Poverty, inequality and unemployment rate droppeddramatically, while the consumer confidence doubled-up following the decline ininflation (see charts). This was an enormousachievement for a country that was gripped by unprecedented political andsocial instability between 1999 and 2002, when the cumulative contraction of grossdomestic product approached 20 percent.
The president’s hard-nosed tactics did generally pay off. Though starvedof credit and operating largely on cash, the economy was still benefiting fromthe devaluation of 2002. Investment, mainly by smaller firms, was back to whereit had been in the 1990s. The Merval equity index boomed, the industrialproduction grew substantially, and the number of companies filing forbankruptcy fell.
At around 75% of GDP, Argentina’sdebt ratio remained higher than the 52% then carried by its neighbour Brazil. But theinterest burden on Argentina’sdebts was now much lighter (a coupon of 2-5% in the first 10 years, comparedwith 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 successfuldebt swap. Although the Kirchner experiment was successful, the consequences ofhis actions were far-reaching. Argentinafaced legal judgments over the repudiated debt in every money market capital inthe world, preventing the government from borrowing outside Argentina. Furthermore, foreign direct investment fellsharply compared to other Latin American countries; and the need to financegovernment operations through domestic lending forced the government to inflatethe Argentine peso.
3. What are the bestoptions for addressing the challenge of sovereign debt restructurings at theinternational level? Can they be implemented in the current internationalcontext? Sovereign defaults are time consuming and costly toresolve. The default by Argentinatook four years from initial default to exchange offer, and still lingers ascreditors explore legal options.
Reasons for delay vary from case to case, butthe most important remain the same: a) creditors, especially smaller ones, havean incentive to hold-out from the restructuring, when being able to disrupt acountry’s effort to service new debts, and b) each creditor has the incentiveto delay his own negotiations in order to avoid costs, and free ride on othercreditors’ negotiations. In order to respond to these problems, variousinstruments have been implemented. One of these, the collective action clauses,which would allow an approved assembly of bondholders to restructure sovereigndebt, have been widely discussed but not yet universally adopted, because ofsignalling, legislation and voting problems. Another instrument is the SDRM,which while unifying creditors into one negotiating entity, it simultaneouslyprotects the debtor from legal action for a short period of time. However, thisproposal leaves unclear several crucial details that need further examination.Finally the last resort for both the creditors and debtors is the imposition ofan ultimatum, or the acceptance of the status quo, an approach which can resultin increases to costs for all parties.
In short, the details of designing avoluntary approach to debt workouts are complex. It will be a challenge toenshrine clauses in sovereign debt that are detailed enough to create anorderly debt workout, yet attractive enough for creditors and debtors to agreeto introduce them. 1) Why did Citigroup initiate a conversion ofits preferred equity to common equity?The 2007 crisis triggered a deep re-examination of the way bank healthis measured in the U.S.
financial system. Bankers and regulators generally preferred to use what isknown as “Tier 1” ratio of a bank’s capital adequacy. It takes intoaccount equity other than common stock. By Tier 1 measurements, most big banks,including Citigroup, appeared healthy. Citigroup’s Tier 1 ratio was 11.
8%, wellabove the level needed to be classified as well-capitalized. Nevertheless, therewere two catalysts for the initiation of talks with the government about apossible conversion of Citigroup’s preferred equity to common. First,Citigroup’s shares fell to historic lows. That didn’t pose a direct threat tothe company’s stability, but it spooked customers into pulling their business, andcould push the bank toward a dangerous downward spiral. Second, bank regulatorswere about to start performing their battery of stress tests at the nation’slargest banks as part of the Obama administration’s industry-bailout plan.
Aspart of those tests, the Federal Reserve was expected to dwell on the TCEmeasurement as a gauge of bank health. Most banks’ TCE ratios were indicatingsevere weakness. Until then, TCE – essentially a gauge of what commonshareholders would get if an institution were dissolved – has been one of theless prominent ways to measure a bank’s vigor. TCE has also been among the mostconservative measures of financial health. However, Citigroup’s TCE ratio stoodat about 1.
5% of assets at Dec. 31 2009, well below the 3% level that investorsregard as safe. The discussed conversion would improve investors’ perceptionsof the company’s balance sheet, and would limit the observers’ questions aboutCitigroup’s solvency.2) Howsignificant is the dilution expected to be?Citi had 5.45 billion common shares outstanding. It was offering toconvert up to $27.
5 billion of preferred shares held by “private” investorsother than the U.S. government (like the government of Singapore and PrinceAlwaleed) into common shares, at a conversion price of $3.25. That would createanother 8.46 billion shares. For every dollar that is converted, the U.S.
governmentwould also convert one dollar of its preferred stock, up to $25 billion; thatis the $25 billion from the first round of recapitalization back in October of2008. That would create another 7.69 billion shares. So if everyone converts asmuch as possible, there will be 21.60 billion shares outstanding, of which theU.S. government would own 7.69, for an ownership stake of 36% (from a starting7%) .
The other private investors would own 39%, and current shareholders wouldown 25%.3) If you were a Citigroup equity holder, would you approve of thisconversion? Because of the newly perceived need for TCE, thebailout plan under discussion is to convert some of the preferred stock intocommon stock. Citi wouldn’t actually get any new cash from the government, butit would be relieved of some of the dividend payments (currently close to $3billion 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 commonshareholders.
The conversion would significantly increase the banks’ solvencyand stability, two important factors for long term profitability. Expectedgains would increase, and so the common stock holders would benefit from a risein stock prices. At the same time, though, Citi would issue new common sharesto the government, diluting the existing common shareholders (meaning that theynow own a smaller percentage of the bank than before). Bottom line, it’s allabout the anticipation of further government intervention from the common shareholder. If no more intervention and dilution is expected, the amount by whichthe shareholders in aggregate are better off should balance the amount ofdilution 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 topersuade some investors holding preferred shares to convert some of thosestakes into common stock.
However there is a clear rationale for a possiblerefusal of private holders to convert – they could suffer vast losses. Forexample, called ‘perpetual convertibles’, GIC’s preferred shares represented abeneficial stake of 5.3 per cent if converted, and also offered an annualcoupon of 7 per cent. But a conversion into common equity would cut off thatincome stream, so the deal must offer more benefits : the GIC return should beequal or above the coupon.
In addition, if GIC converts its preferred sharesinto common stock, alongside the US government, this will lead to anenormous dilution of the sovereign fund’s stake, while keeping in mind apossible Citi nationalization ; but this could be their only option. If GICdoes not convert, and the situation worsens, even the 7 per cent annual couponmay 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 allcomes down to the private holders anticipation of the company’s future, andtheir profits as common share holders. 5) Evaluate the pricing of Citigroup’s preferred shares relative to itscommon stock. Is there an opportunity here? If so, what are the tricks?As the government’sterm sheet proposed the conversion of Citi preferred stock into common at a priceof $3.25, a huge number of accounts thought there was a significant arbitrageto be held there. Here’s how the Citi arbitrage play would work.
Citi said theywould offer to exchange all preferred shares to common stock at $3.25 pershare, 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 youcould buy in the open market for just $1.50. There were around 81 millionpreferred shares, originally sold for $25. But Citi’s troubles led investors tosell those off so steeply that they were then trading between $5 and $7.50 .
Ifyou get 7.7 shares of common worth $1.50 a share, each share of preferred isworth $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—especiallyhedge funds—got their mind around this, they started buying up the preferredshares, sending the price higher. The trade could beboxed by shorting 7.7 shares of common for every share of preferred purchased,thereby “securing” a roughly 50% return. This (probably among otherthings) explains the persistent drop in Citicommon over the day as hedge funds were locking in what they thought was acertain premium. But there was a catch.
The government never promisedthat the average investor would be able to convert their preferred to common atthe same ratio as everyone else. And there was an immediate concern that wheninvestors realized this, Citi’s shares would rally amid a massive shortsqueeze.