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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
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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