FRBSF Economic Letter
96-24; August 23, 1996
One of the major barriers to resolving the Latin American debt crisis
of the 1980s was the "collective action" difficulties among
creditors--that is, the difficulty of getting the lenders to take actions
that would benefit them as members of the group but that might not be
in their individual interest. In the case of sovereign lending, for example,
where enforceable legal mechanisms are absent, collective action difficulties
arise for two reasons. First, because creditors differ markedly in their
characteristics and incentives, they have problems negotiating as a group
with their debtors. Second, in "free-riding" situations, where
individual creditors can benefit from the efforts of others, they are
likely to undertake less effort than would be optimal for the group as
a whole.
Recent changes in the composition of foreign borrowing indicate that
foreign debt claimants are likely to become more widespread and diverse.
Figure 1 shows that developing
countries in Latin America and East Asia have seen a rapid increase in
the share of foreign borrowing through public and private issues of bonds--from
5 percent in 1986 to 32 percent in 1994; in contrast, the share financed
through commercial bank lending has exhibited a slow, but secular decline--falling
from a recent high of 44 percent in 1987 to a low of 28 percent in 1993.
Since bondholders are both less concentrated and more heterogeneous than
banks, their increasing share of disbursements enhances the potential
for collective action difficulties in the future.
This Economic Letter examines the role of collective action
difficulties in foreign lending disputes. It first reviews the experience
of banks during the Latin American debt crisis of the 1980s. It then discusses
the mechanisms that did prove successful in resolving collective action
difficulties among these creditors, arguing that lending disputes were
better resolved through agreements flexible enough to accommodate creditor
heterogeneity. Finally, it reviews the covenants contained in public and
private international bonds which are designed to facilitate the resolution
of potential future foreign lending crises.
The Baker Plan, first implemented in 1986, illustrates the nature of
the difficulty banks have experienced in coordinating their lending efforts.
The Baker Plan was designed to address the debt problems that arose in
15 developing nations after Mexico suspended its external debt payments
in 1982. The general belief underlying the Baker Plan was that the payments
difficulties of these countries reflected their "illiquidity"
rather than insolvency; that is, they appeared to have the resources and
growth prospects necessary to service their debt obligations in the long
run, but they were experiencing temporary problems in maintaining their
current payments.
Therefore, the Baker Plan called for commercial banks and international
financial institutions to extend loans to these 15 countries over a three-year
period. Commercial banks were called on to extend approximately $7 billion
annually (roughly 2.5 percent of their total exposure) for a total disbursement
of approximately $20 billion, and the IMF and the World Bank were called
on to provide between $20 and $25 billion. The logic behind this call
for additional lending was that if the debtor countries could receive
adequate financing to allow them to maintain their debt payments through
a temporary difficult period, they would be more likely to meet all of
their debt obligations over time.
In studies of the efficacy of the Baker Plan, estimates of the magnitude
of the disbursements commercial banks actually made over the period differ;
however, most do agree that they fell far short of their goals. For example,
Husain (1989) estimates that the highly indebted countries received only
$4 billion in net new long-term financing. Moreover, he found that if
payments on private non-guaranteed debt are taken into account, commercial
banks actually received more in repayments than they extended in new money.
If one believes that highly indebted nations in fact faced liquidity
problems, then the shortfall in new disbursements to them could be described
as a problem in collective action across bank creditors. While it was
generally perceived that it was in the interest of creditors as a group
to lend more in the short run to enhance their total discounted stream
of payments, individually each bank had the incentive to "free-ride"
on the efforts of other creditors by not extending the amount required
under the Baker Plan. This explains why the level of new money extended
to the highly indebted nations under the Baker Plan may have been below
the optimum.
The Brady Plan, which began in 1989, allowed creditors to convert their
existing debt claims into a variety or "menu" of new claims.
The plan involved two rounds. In the first round, creditors bargained
with debtors over the terms of these new claims. Loosely interpreted,
the options contained different mixes of "exit" and "new
money" options. The exit options were designed for creditors who
wanted to reduce their exposure to a debtor country. These options allowed
creditors to reduce their exposure to debtor nations, albeit at a discount.
The new money options reflected the belief that those creditors who chose
not to exit would experience a capital gain from the transaction, since
the nominal outstanding debt obligation of the debtor would be reduced,
and with it the probability of future default. These options allowed creditors
to retain their exposure, but required additional credit extension designed
to "tax" the expected capital gains. The instruments included
in the Brady deals differed in other aspects as well. The principal of
many instruments was collateralized, as were "rolling interest guarantees,"
which guaranteed payment for fixed short periods. The first round negotiations
thus involved the determination of the effective magnitude of discount
on the exit options together with the amount of new lending called for
under the new money options.
In the second round, creditors converted their existing claims into
their choice among the "menu" of options agreed upon in the
first round. The penalties for creditors failing to comply with the terms
of the deal were never made explicit. Nevertheless, compliance was not
an important problem under the Brady Plan. Banks wishing to cease their
foreign lending activities tended to choose the exit option under the
auspices of the deal.
The Brady Plan therefore achieved better results than the Baker Plan
since it was designed to incorporate creditor heterogeneity. Creditors
faced a variety of options into which they could convert their claims.
By offering a "menu" of options, the Brady Plan permitted credit
restructurings to be tailored to the heterogeneous preferences of creditors.
The terms achieved under these deals indicate that debtors used the menu
approach to reduce the cost of debt reduction (see Diwan and Spiegel 1994).
The experiences of the Baker and Brady deals illustrate the importance
of allowing creditors to negotiate with debtors and make decisions among
themselves as a group. The intransigence of a relatively small number
of creditors whose incentives diverged from those of the larger group
could preclude the closing of a globally desirable deal. In the Baker
Plan, the uniform call for new lending was unacceptable to some creditors,
who extended less than their allocation of new funds. Although the Brady
Plan offered more flexibility, it still left some creditors dissatisfied
with the outcomes. In the Brazilian Brady deal, for example, a number
of lawsuits have been filed by creditors unhappy with its terms.
Because bond holders represent an even less concentrated and more heterogeneous
group than commercial banks, collective action difficulties among bondholders
are likely to be even more prevalent. One response is the inclusion of
contractual provisions which could help to facilitate the resolution of
a liquidity crisis. The Group of Ten reports that these provisions, which
are already included in many syndicated loan agreements, are also being
included in some bond contracts [Group of Ten (1996), pg. 14].
These provisions fall loosely into one of three categories: First, there
are provision that allow for the collective representation of bondholders
in the event of a liquidity crisis. These provisions~typically designate
the rules under which bondholder representatives are selected. However,
in practice international bond issues rarely delegate extensive power
to such representatives. Typically, they designate an agent who can call
meetings and issue notices, but who is not mandated to make significant
decisions on behalf of individual bondholders. Second, there are "qualified
majority voting clauses," which allow for changes in a bond contract
to be made without the unanimous consent of the bond holders. These clauses
are designed to preclude a small group of minority creditors from preventing
the resolution of a liquidity crisis. Third, there are "comparable
treatment" and sharing provisions, which discourage individual creditors
from taking individual actions with or against the debtor. These provisions
are designed to maintain contractual seniority among debtholders. For
example, they preclude the debtor from negotiating a deal with an individual
creditor which dilutes the value of a second creditor's claim.
In practice, there are limitations to the effectiveness of all types
of contractual provisions. Since the international bond issues rarely
delegate extensive power to an agent, the ability of delegates to facilitate
desirable outcomes may be limited. Bond prices indicate that the market
does not believe that majority voting clauses have a large impact on voting
outcomes among bondholders. For example, English bonds which include qualified
majority voting clauses are not priced very differently by the market
from bonds without such clauses. The effectiveness of sharing clauses
in international bond issues in facilitating the resolution of financial
crises is also likely to be limited. For example, a country's foreign
bonds are issued by both public and private agents and at different points
in time. The myriad classes of bonds that can be issued leaves the identification
of the relative seniority of claims unclear. Bondholders of these disparate
claims are likely to question any decision concerning relative seniority
among classes of issues. Consequently, these clauses are only likely to
be effective across holders of an individual bond issue.
Since the strength of contractual provisions in alleviating collective
action problems is limited, it is unclear how useful these provisions
will be in addressing future international liquidity crises. Nevertheless,
the movement to bond finance in international borrowing does not necessarily
threaten the stability of the financial system. Indeed, there are a number
of reasons to consider this change in the composition of lending desirable.
If debtors are moving from financing through commercial banks to financing
through bonds, it must be the case that this form of financing is available
on better terms. This implies that the market is relatively unconcerned
about the increase in collective action difficulties associated with bond
finance. Moreover, creditor countries may find it desirable that bonds
have no explicit government distortions analogous to fixed-premium deposit
insurance.
However, the increased diffusion of creditors, which makes it more difficult
to address liquidity crises once they arise, makes the avoidance of these
crises even more imperative. The Group of Ten report offers a number of
recommendations. These include a renewed emphasis on enhancing the circulation
of information necessary to establish accurately and clearly the creditworthiness
of sovereign debtors, and a call for greater surveillance by the international
financial institutions.
Mark Spiegel
Senior Economist
Diwan, Ishac, and Mark M. Spiegel. 1995. "Are Buybacks Back?: Menu-Driven
Debt-Reduction Schemes with Heterogeneous Creditors." Journal
of Monetary Economics 34, pp. 279-293.
Group of Ten. 1996. "The Resolution of Sovereign Liquidity Crises:
A Report to the Ministers and Governors Prepared under the Auspices of
the Deputies." BIS, Basle, and IMF, Washington, D.C. May.
Husain, Ishrat. 1989. "Recent Experience with the Debt Strategy."
Finance and Development 26, pp. 12-15.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to
Research Department
Federal Reserve Bank of San Francisco
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