Click here for Part 1: An overview of the Argentine Debt Crises.
Click here for Part 3: A discussion of Kyle Basss bullish view on Argentina and my own thoughts as well.
In order to understand this debt crises, it is important to understand the history of bankruptcy law, which I present as follows:
As a definition, Bankruptcy is the legal status of someone who is unable to repay his debts. We shall refer to such people as bankrupts or the bankrupt. For most of recorded history, someone who was bankrupt was considered a criminal and a pariah. Bankruptcy laws such as they existed were designed to punish the bankrupt while at the same time recovering as much as possible for the creditor. In ancient Greece, for example, the bankrupt became an indentured servant to his creditor.
In various places and times throughout the world punishment for bankruptcy included various forms of servitude or prison. The more modern approach to bankruptcy began in England in 1705. Under this act the Lord Chancellor was allowed to release jailed bankrupts after 14 days once a disclosure of all assets was made and there started to be some recognition that bankruptcy law ought to be used to protect the debtor as well as the creditor.
Allowing bankrupts to start their own proceedings began in 1825 if their creditors agreed, and by 1849 Voluntary bankruptcy was introduced in England.
Bankruptcy law under the Articles of Confederation and early United States also was designed to protect creditors. After the United States was formed bankruptcy law was left primarily to the states and debtors prisons in many states existed until the mid 1800s.
The Federal Government passed the Bankruptcy act of 1898 and established the modern version of debtor-creditor relations and also permitted companies voluntary relief from creditors.
There have been numerous major overhauls of bankruptcy laws since.
Modern Bankruptcy laws are designed to accomplish three things:
- To solve a collective action problem among creditors.
- To enhance or maintaing the ongoing value of a firm in distress.
- To provide an individual with a fresh start in his finances.
Lets examine the reasoning and justification for each one:
1. If an individual debtor is overburdened by debt to multiple creditors there is a collective action problem. Lets look at an example:
John is a carpenter by trade. He owns a Van worth $2,500 and has $2,500 worth of necessary tools. He makes $3,000 per month. He overextended himself on debt and owes 5 different credit card companies $5,000 each. Without bankruptcy law each credit card company is in a race to see who can file and prosecute a civil case against John and then race to take his assets to satisfy the debt. This results in extensive costs for all 5 credit card companies with one of them recovering $5,000 and the rest recovering zero.
It is in the interests of ALL parties if this doesnt happen. By racing to take away Johns van and his tools, the total amount recovered will be LESS for the creditors than if John is able to declare bankruptcy. (Now, bankruptcy law is complex and there is a difference between a restructuring and a liquidation but I am just illustrating a point here). By allowing John to keep his van and tools a bankruptcy court might order that John be allowed to repay his debts over a period of five years, allowing all of the companies to be paid in full. This is a win-win for all parties involved.
2. This same concept can be applied to a company in distress. For simplicitys sake lets imagine a company that earns 10 million dollars per year. It has operating expenses of 9 million dollars per year and thus an operating income of 1 million dollar per year. That is, the company opening every day and producing its products is creating gain to the shareholders and creditors of 1 million dollars per year. However, the company has an interest expense of 2 million dollars per year and can no longer make its payments. Lets assume in this case that the company has $500,000 of assets and owes $20 million to two different creditors.
In the absence of bankruptcy protection for the company, creditors will race to seize the $500,000 of assets. The company will close down, and the employees will lose their jobs. However, as the company operations are profitable it makes more sense if the company is given bankruptcy protection and is allowed to continue to operate while a deal is worked out between the owners and the creditors under the bankruptcy system. There are many possibilities of how this might be worked out. . Most likely in the case that I described the company would be turned over to the creditors. It would continue to operate and combined the creditors would both come out ahead compared to one of them seizing the $500,000 of assets.
3. The third major justification for modern bankruptcy law is to provide a fresh start for a bankrupt individual. There are really two motives for this. The humanitarian motive is really just a second-chance motivation. That is, much of society believes that people should be given second chances and not be burdened by an un-repayable debt for the rest of their lives. The second motive is economic. A man facing crushing debt who cannot ever keep another penny that he earns will simply never work again and become a burden on his family, friends, and/or the government.
Why Is This Relevant to Argentina?
Lets say we have a company in the US that typically is profitable and has promise for the future but is going through a slump and cant pay its debts. We will call it Jones Manufacturing. It negotiates with its creditors and 93% of them agree to take new bonds worth only 30% of the previous ones. However, 7% of the bondholders refuse this agreement and attempt to seize the companies assets. What would happen? Again, bankruptcy law is complex but the short answer is that Jones would filed for Bankruptcy and with 93% of the existing bondholders agreeing to the restructuring the bankruptcy judge would be able to force the existing 7% into the same deal.
Simply put: Argentina doesnt have this option. There is no international bankruptcy court.
Hence, the issues that we discussed above come into play. Creditors are racing each other to try to take Argentinian assets around the world. By having to hide these assets and keep assets in Argentina ALL creditors are being impacted as it impairs Argentinas ability to operate in the world economy and thus be in as strong of a position as possible to repay its debts.
Why isnt there an international bankruptcy court? First of all, international law itself is a tricky concept, and one that I intend to discuss in a later post, but countries have shown that they can work together under a variety of economic treaties and there is no reason why an international bankruptcy court could be created. There have been calls for this before. In fact, the IMF has been charged with the task of coming up with an international bankruptcy framework before. The Economist Joseph Stiglitz has been calling for one as well. The opposition to one comes mainly along the familiar lines:
1. The contract is clear. Argentina agreed to pay its debts in full. Ryan McMaken of the Mises Economics Blog makes this argument:
Basically, the contract with the creditors is crystal clear. It does not allow for the Argentine state to weasel out of paying some creditors by striking new deals with some other creditors. It’s as simple as that.
Interestingly, he then goes on to say:
Now, I agree with Chris Westley that the Argentine government should just honestly announce that it has no plans to pay anyone back, and to make a clean default. That was a risk the creditors took. Indeed, while Stiglitz and Gusman claim that Griesa’s decision prevents a “fresh start” the only true “fresh start” here for the taxpayers of Argentina is a default.
Anything else is a twisting of a very simple legal contract to favor a relatively-powerful government over the interests of private investors. Argentina wants to get out of paying its debts either way, but if it honestly defaults, there will be a downside to its credit rating. On the other hand, if it can game the legal system so that it can avoid making good on its debts while still not legally be in default, then that’s so much better. And, of course, that’s what Stiglitz et al want. Endless spending with no consequences, ever.
This argument makes no sense to me. Argentina is trying to behave as if an international bankruptcy court exists. That is, Argentina is trying to do the right thing. It successfully negotiated with its creditors. Under any bankruptcy court if 93% of creditors agree to something, the court would force the other 7% into agreement.
Now, unlike Stiglitz, I agree with McMaken that Judge Griesas ruling was correct. Griesa is not a bankruptcy judge and the case was not a bankruptcy case. It was not Griesas place to act as if it was, and it is not his place to impose international bankruptcy policy on the world.
It is worth noting that Argentina is not voluntarily in default. Argentina wants to pay its creditors who agreed to an exchange. In response to Griesas ruling, Argentina is moving again to do what it can to pay its creditors. The holdouts have the option of joining the exchange creditors.
Why McMaken would encourage Argentina not to try to pay its creditors is beyond me, but I suspect that it is a failing to understand the underlying principles and reasons for bankruptcy law, and how bankruptcy law is beneficial to all parties involved.
With the litigation by the holdouts against Argentina and the exchange holders we see precisely the theoretical problem as outlined earlier above creditors working against each other to the detriment of all parties.
It is important to note that Elliot is not a vulture or evil. Elliot is simply pursuing its own economic self interest. While many deride Elliot for that, I dont. I simply point out that this is precisely why international bankruptcy law is desperately needed.
The other arguments against an international bankruptcy court are really just arguments against bankruptcy law itself. The most common argument against an international bankruptcy court is that It will make it harder for sovereigns to issue debt. However, bankruptcy laws in the United States have certainly not decreased the degree to which lenders are willing to lend. Over the last 20 years lending of all sorts has skyrocketed even as bankruptcy filings have increased.
Other arguments are just the same familiar arguments against bankruptcy in general. Namely, that the bankrupt are deadbeats who shouldnt be given a break, etc.
The last 100 years of bankruptcy law demonstrate however that bankruptcy laws improve outcomes for both debtors and creditors.
In the face of this crises we have George Soros and Kyle Bass buying Argentine debt. Lets take a look at that in part 3.