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10 Int'l Fin. L. Rev. 10 (1991)
Moral Hazards and Other Delights

handle is hein.journals/intfinr10 and id is 162 raw text is: 0 Moral hazards and other delights The development of a secondary market in LDC debt may lead sovereign borrowers into temptation. By Lee C Buchheit of Cleary Gottlieb Steen & Hamilton, New York A distressingly large part of the author's life has been spent in the pursuit of situations that can fairly be described as involving an element of moral hazard, Thus, when he first heard that sovereign borrowers suffered from similar temptations, he experienced a profound sense of camaraderie. He was later to learn, however, that the moral hazards to which sovereign borrowers are said to be attracted are far different from those which afflict the weaker specimens of legal counsel to sovereign borrowers. Incidentally, they are also far less entertaining. Childish temptations In the sovereign debt context, the phrase 'moral hazard' describes any situation that rewards, or could be seen as rewarding, the sovereign borrower for its financial misbe- haviour. The nature of these per- ceived hazards has changed signifi- cantly over the eight years of the sovereign debt crisis. During the early years (1982-85), a sovereign debt renegotiation in- volved primarily the deferral of principal maturities, the syndication of the occasional new money loan and the linking of both activities to an IMF-endorsed economic stabi- lisation programme for the debtor country. An implicit premise of these restructuring techniques was that sovereign borrowers suffered from irresistible temptations to run amok in their economic and financial affairs if given even the smallest opportunity. As the banks saw things, these temptations threatened to reverse all of the benefits which the debt restructuring was supposed to bestow on the sovereign borrower (chief among which, in the banks' eyes, was an orderly and early return to normal debt service capacity). The creditors therefore adjudged it pru- dent not to permit much latitude in which the borrower's presumed self-destructive impulses could oper- ate. Restructuring 'windows' (ie the periods during which the maturing principal of old loans was subject to rescheduling) were kept short; new money was made available only in instalments and only upon the satisfaction of conditions applicable to each instalment; convenants and events of default in the restructuring documentation were extremely rigorous in comparison with pre- crisis loan agreements; and every aspect of the commercial bank restructuring/new money package was inextricably linked to an IMF stand-by or extended fund arrange- ment and a concurrent restructuring of Paris Club debt. Proposals for relaxing these proce- dures were said to invite the moral hazard that a borrower might enjoy the benefits of its creditors' conces- sions without subjecting its domestic economy to the discipline necessary to prevent a recurrence of the circumstances which gave rise to the need for such concessions in the first place. For their part, the sovereign borrowers argued that this 'short- leash' approach to debt restructuring only perpetuated the appearance that the country was lurching for- ward from crisis to crisis; an appearance that could be very costly in terms of discouraging voluntary investment flows, the return of flight capital and so forth. As a result of their obsessive concern about moral hazards, the borrowers' said, the banks were effectively preventing sovereign debtors from being able to show any long or even medium term financial stability, thus prolonging the very crisis which the creditors were attempting to cure. In retrospect, the moral hazards that so worried creditors and creditor governments during the 1982-85 period were really of the most innocent and childlike variety. Voluntary misbehaviour by a sovereign borrower gained nothing in the way of additional concessions from creditors during this period and it only aggravated the economic misery back home. The real tempta- tions toward fiscal misbehaviour were political in origin. The exist- ence of restrictive conditions in commercial bank restructuring agreements was rarely sufficient by itself to cause a sovereign to resist these temptations if it were other- wise disposed to succumb. Nor was the prospect of a return to the warm sunshine of creditor approval ever thought an adequate inducement on its own to bring wayward sovereign borrowers back into line. Starting in the mid-1980s, however, something happened in the sovereign debt business that would in time give a new and much more sinister meaning to the phrase moral hazard - banks started selling their sovereign loans at a discount from face value. Secondary market seductions The secondary market in LDC debt began its life during the 1983-85 period in a very tentative way. Transactions were infrequent. Dis- counts were small. Sellers were hesitant and often secretive about their intention to sell. By the end of the decade, however, the size of the market was measured in the billions of dollars of debt traded. Selling pressure and other factors produced steep discounts on the credits of many countries. Some participant banks even boasted openly of their International Financial Law Review April 1991

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