If last months carnival of anti-globalization protestors outside the annual meeting of the International Monetary Fund (IMF) in Washington amounted to a noisy bonfire of discontent, what went on inside at the meeting was more like a blast furnace. Hundreds of investors told the IMF off with a focused fury that made street protestors seem like clownish entertainment.
What is the burning issue? Sovereign debt restructuring. The IMF, along with the U.S. Treasury, is pushing for a program to allow sovereign nations-the kind that come to the IMF for bailout packages again and again-to walk away from debts by declaring bankruptcy, like an insolvent corporation.
Its not that there arent good intentions. But bankers, investors and analysts say the proposals are seriously flawed and unlikely to be resolved without a reduction of their rights.
Investors say that, by making it easier for governments to default, the new plan will make American investors bond portfolios riskier, while not easing the risk of bailouts, either. If the measure goes through, they say, it would hurt millions of Americans who invest in bond mutual funds, either individually, through 401(k)s or in pension plans.
As stocks plunge, those funds are growing. U.S. investors now have $18.8 billion parked in bond funds, according to Lipper, Inc., a mutual fund tracker in New York. That includes $3.66 billion in emerging market bond funds that invest in countries where defaults are most likely.
"Its a bad idea," said David DeRosa, a Yale professor, and president of DeRosa Research & Associates, an investment firm in New Canaan, Conn., who got an earful of the sentiment at the IMF investor meetings himself. "People are very angry. I dont know any trader of securities who thinks the restructuring issue is a good idea," he said.
The plan, which the IMF calls a "sovereign debt restructuring mechanism" (SDRM), has been in the works for about two years, and its managing director, Anne Krueger, has made a forceful case for it. Kruegers idea is to encourage governments to recognize early on that they cannot pay their debts and then enter a sovereign bankruptcy process that will make resolving unpaid debt issues go more smoothly than currently. With a trend toward more defaults, on paper this might look like a good idea.
But what it would amount to is either a new international court to settle disputes, or modifications to new or existing bond contracts.
Possibly cowed by the baleful response from investors, the IMF is now saying the process is evolving, and a more developed draft proposal is likely to be on the table at the IMFs next meeting in April. "Were too far from conclusion," said IMF spokesman Francisco Baker. "Were just getting the ball rolling."
But some investors think the IMF still cant hear them. They say a world bankruptcy court or a modification of bond contracts poses serious risks for bond portfolios.
For one thing, they dont like the idea of moving jurisdiction from U.S. courts in New York (which now usually oversee legal disputes involving foreign-government bonds) to somewhere else.
"Savers buy such bonds because they trust the debtor, but even more because they trust the U.S. laws," said Ottavio Lavaggi, an Italian investor who manages his own bond portfolio. "Now the IMF wants to change all those contracts, not only future contracts, but all those issued in the last 20 years, and say: If the debtor fails to pay, what happens will be decided by an international court, appointed by bureaucrats and politicians, and they will decide the case according to the wishes that some (other) government might have in the future."
Moodys Investors Service, Inc, in a September study called "Proposed Frameworks for Sovereign Debt Restructuring" saw potential problems, too.
The international credit-rating agency warned that the sovereign restructuring would probably be an incentive for more bailouts as states find bankruptcy an easier option for resolving their debt problems.
A defaulting government might be hauled in to court to restructure, but a court cant do much if that government does not follow its demands. Unlike a corporation, which can be forced to sell assets or fire its CEO, a sovereign state cannot be forced to do such things without the threat, or actual use, of military force.
For corporations, "a bankruptcy procedure is an administrative process, a good faith effort to allow a bankrupt to come out of bankruptcy, and start over," said Farisa Zarin, who led the Moodys team on the study. In a typical corporate bankruptcy, "there needs to be a reasonable plan, with a judges approval. And if a bankruptcy proceeding doesnt produce a plan, creditors can divvy claims on a priority basis," she said.
"But there is no comparison to a sovereign situation. At the end of the day, a sovereign is a sovereign, and creditors cannot divvy up a country," she said. That reduces the leverage bondholders can exert over states that fail to pay their debt or adhere to their restructuring plan.
And what would the creation of a world bankruptcy court mean for bondholders? It will lower the value of their bonds, she says.
"Its making owning bonds more risky, because the likelihood of getting paid is riskier," Zarin said.
As an alternative to a world bankruptcy court for deadbeat governments, U.S. Deputy Treasury Secretary John Taylor has advocated adding clauses, or new rules, to bond contracts that would enable creditors to sue a nation for payment, but only if a certain majority of bondholders agree on the lawsuit. An individual investor would no longer have the right to hold out for full payment and sue by himself.
This would create problems because it could require altering the contracts for existing bonds, which would lower their value by making them riskier.
"Debt is a contract," said Robert Konigsberger, principal of Gramercy Advisors in Connecticut, a hedge fund that represented bondholders during Ecuadors bond default in 1999. "If Brazil owes $1 million, it is a contract. How can they try to impose a new system when they have an existing system? Its contracts the IMF is trying to change."
Treasury spokesman Tony Fratto says the U.S. is seeking new collective action clauses only on new bond contracts, to prevent lone-holdout investors from halting possible bankruptcy settlements during the debt restructuring process. "The idea is to work out a lot of stuff before bonds are issued. We favor putting the language right into the bond contract," he said.
But Lavaggi thinks a collective action clause, which means legal action can be taken only if a majority of bondholders want it, would give all the voting power to large holders of debt over smaller investors. "The bottom line is the U.S. government would strip individual investors of their legal rights dating back to 1934, to favor big banks and international bureaucracies," he said.
While Mexico, which needed an IMF bailout to pay off its bonds in the 1990s, argued against collective action clauses because they would raise the cost of borrowing, Fratto said that the Treasury Department believes that an orderly default procedure written into bond contracts before they are issued would create a more predictable scenario for debt defaults, which in turn would lower risk.
"There have been some countries that have rightly expressed concern about what the cost would be of including collective action clauses in new bond covenants. Its a legitimate issue, because we dont want countries to pay more for clauses. We want to lower cost of borrowing, not increase it. A more stable environment will contribute to that," he says.
But Konigsberger disagrees. "It wont solve the problem of why these countries default," he said.
The drive for a world bankruptcy court, or a new type of bond contract, he said, is not about promoting sound economic policies in Third World governments. It is about positioning the IMF for the next round of national defaults. "The IMF is out of money, and out of ideas," Konigsberger said. "Their model has failed."
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