Recently, the Sensex and Nifty went through some wild gyrations after Standard and Poor’s Ratings Services declared Argentina a debt defaulter. The country had failed to pay $539 million in interest due to its creditors, not because it couldn’t afford to pay them, but because a US court order barred Argentina from settling these dues unless it coughed up the $1.3 billion it owed to the so-called ‘vulture funds’.
What is it?A vulture fund is a private equity or hedge fund that buys up bonds issued by companies, countries or individuals in deep financial trouble at beaten down market prices. They then try to make big gains by suing the debtor for a much larger sum than they originally paid for buying the bonds. That makes it clear how vulture funds got their name; they ‘prey’ on companies and issuers who are in distress because they’ve taken on too much debt.
In the case of Argentina, after the country defaulted on its debt of close to $100 billion in the 2001 crisis, many vulture funds swooped in to pick up the country’s bonds from the secondary markets for a song. These were mainly US hedge funds spearheaded by billionaire Paul Singer’s NML Capital.
The country’s financial situation only worsened and, unable to make interest payments, it asked lenders to take a ‘haircut’, that is, waive their dues and settle for part payment.
While Argentina managed to restructure more than 90 per cent of its debt between 2005 and 2010, a few vulture funds held out and refused to take a haircut. They sued Argentina in a US court demanding full payment for their bonds. The court upheld their demand and asked Argentina to pay the vulture funds in full.
Why is it important?The global financial system has seen quite a few nations either defaulting on debt or tottering on the brink after the credit crisis. Thanks to vulture funds, Argentina has been declared in default a good five years after the crisis, for the second time in 13 years.
While vulture funds make up a small portion of the country’s total creditors, the US court order has put Argentina between a rock and a hard place. Unless they pay the vulture funds, they will be unable to pay others, thus continuing to default.
While talks are on between Argentina and the US to find a compromise, the risk for Argentina may nevertheless escalate, if other bondholders were to wake up and sue as well. Argentina may find it difficult to raise money on the international debt markets due to a steep premium on its borrowing costs.
Why should I care?Yes, India isn’t the same as Argentina, but try telling that to foreign investors who lump all emerging markets under a huge risky asset class. Debt troubles in any developing nation usually cause global investors to peg up the ‘risk premium’ they assign to all emerging market investments. Events like Argentina’s default make investors nervous and trigger outflows from emerging economies. Foreign investors pulled out close to $820 million from Indian debt markets last week, and the rupee tumbled to as low as 61.7, as if in sympathy with Argentina.
BottomlineVulture funds may seem evil, but they do put the fear of god into defaulters. Given the problems that Indian banks face with large corporate defaulters, maybe what we need are a few vulture funds to balance the scales.
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