The Corporation of Foreign Bondholders

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This group eventually became the CFR as it is known today... --CSR

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The Corporation of Foreign Bondholders
Prepared by Paolo Mauro and Yishay Yafeh

Authorized for distribution by Eduardo Borensztein

May 2003
Abstract
The

This paper analyzes the Corporation of Foreign Bondholders (CFB), an association of British
investors holding bonds issued by foreign governments. The CFB played a key role during
the heyday of international bond finance, 1870–1913, and in the aftermath of the defaults of
the 1930s. It fostered coordination among creditors, especially in cases of default, arranging
successfully for many important debt restructurings, though failing persistently in a few
cases. While a revamped creditor association might once again help facilitate creditor
coordination, the relative appeal of defection over coordination is greater today than it was in
the past. The CFB may have had an easier time than any comparable body would have today.

Introduction................................................................................................................... 3
II. The Need for Creditor Coordination, 1870–1913 Versus Today ................................. 6
III. Effectiveness: Successes and Failures ......................................................................... 9
IV. The Corporation of Foreign Bondholders: Mode of Operation ...................................13
A. The CFB's Objectives—Provision of Information and Creditor Coordination...13
B. The CFB's Institutional History, Organization, and Officers' Incentives ...........13
C. Coordination Among British Creditors................................................................15
D. Mechanisms for Reaching Consensus Within the CFB.......................................16
E. Internal Disagreements and Coordination Among Holders of Different Bonds..17
F. Forceful Coordination Among Creditors .............................................................18
G. Coordination with Bondholders in Other Countries ............................................18
H. Relationship with the British Government ..........................................................20
I. When Negotiations Between the CFB and Borrowing Government Failed ........21
J. The Nature of Settlements ...................................................................................23
V. Assessment, Implications, and Open Questions ...........................................................25


References.............................................................................................................................27
Figure 1. Loans in Default, 1877–1913 ..............................................................................10

"During the autumn of last year, a Conference of jurists and public men of various
countries was held [...], having for one of its objects a discussion of the possibility
of international agreements upon the principles of law which should determine the
liability of Sovereign States and foreign subjects in their relations to one another.
As a preliminary condition to the application of the moral force which is, after all,
the sole ultimate sanction in such cases, there can be no question as to the advantage
that would result from such an agreement."

(Corporation of Foreign Bondholders, Annual Report, 1874, London, p. 73.
The Conference referred to was the Congress of International Law held in Geneva
in 1873 and attended by Isidor Gerstenberg, Chairman of the Council of the CFB).

I. INTRODUCTION

Improved creditor coordination in cases of sovereign default is a key objective of some
proposals for reforming the international financial architecture, notably those related to a
sovereign debt restructuring mechanism, more widespread use of collective action clauses, and
a voluntary code of conduct for creditors and sovereign debtors.2 In today's era of bond finance,
creditor coordination is difficult—probably even more so than it was in the 1970s and 1980s,
when the bulk of flows to emerging markets took the form of syndicated bank loans. Bondholders
are more numerous, anonymous, and difficult to coordinate than are banks. Thus,
potential lessons for improved creditor coordination today may be sought by going further back
into the past and examining the experience of the most recent previous era of global financial
integration and bond finance, namely 1870–1913.

The present paper focuses on the detailed workings of the Corporation of Foreign
Bondholders (CFB), an institution formally set up in 1868 by private investors to help them
coordinate their actions in cases of international default. The CFB, a London-based association
of British investors holding foreign securities, was active and extremely influential between the
late 1860s (when international lending attained a very large scale) and the early 1950s (the time
of the last restructurings of international defaults that had taken place in the early 1930s).3 The
CFB is thus of particular interest today, having operated during the first era of bond finance for
emerging markets—when many countries ranging from the large (Argentina, Brazil, China,
Japan, Russia, Turkey, ...) to the small (Antigua, Guatemala, Liberia, ...) issued bonds in
London (Mauro, Sussman, and Yafeh, 2000, Table 1). That era bears many similarities to the
current environment: indeed, it is only during the 1990s that bonds returned to be as sizable a
vehicle of finance for emerging markets, and that global financial integration again reached the
high levels experienced before World War I (Obstfeld and Taylor, 1998).4

Economists (Eichengreen and Portes, 2000; and Portes, 2000), lawyers (Macmillan,
1995b), and investment bankers (Buchanan, 2001) have pointed to the potential relevance of
institutions such as the CFB in today's environment.5 A few key bondholders have already
taken tentative steps in the direction of recreating a bondholders' association: the Emerging
Markets Creditors Association (EMCA) was established in 2000, although it has thus far
focused on issues of international financial architecture rather than playing an explicit role in
country-specific cases.6

Could a revamped creditor association similar to the CFB provide a "private sector
alternative," or at least a complement, to proposed reforms such as the introduction of collective
action clauses or a sovereign debt restructuring mechanism? In what respects was the CFB
successful in the past, and how successful would it be in the current environment? Which
present-day problems are likely to be resolved through an association of this type? To address
these questions, the present paper seeks to explore key similarities and differences in this
context between today and 1870–1913, and to provide the most detailed and comprehensive
description to date of the CFB's mode of operation.

Much has been written on the first era of international financial integration, 1870–1913,
when Britain and other European countries lent vast amounts of capital to the emerging markets
of the day (see, for example, Bordo and Eichengreen, 2002; Mauro, Sussman, and Yafeh, 2002;
and Obstfeld and Taylor, 1998). Fishlow (1985) and Lindert and Morton (1989) provide
excellent overviews of that era with a focus on international defaults. The CFB's importance in
that context is well recognized, but its detailed workings remain relatively underexplored. Feis
(1930), Borchard (1951), and Wynne (1951) provide early and fascinating treatments. More
recent, and closely related to the present paper, are a study by Kelly (1998), who discusses
sovereign defaults and international trade in 1870–1913, and an impressive series of studies by
Eichengreen and Portes (1986, 1988, 1989a, 1989b and 2000), who discuss sovereign debt,
defaults, and workouts in the interwar period (with some reference to earlier cases and the
1980s), and analyze the CFB in substantial detail. In particular, Eichengreen and Portes assess
the CFB's effectiveness using two approaches. First, they compare the ex post returns on
holdings of foreign bonds obtained by British bondholders to those obtained by American
bondholders, who lacked a permanent organization to pursue their interests until the Foreign
Bondholders Protective Council was created in 1933 (Eichengreen and Portes, 1989a). Second,
they compare the typical delays between default, reorganization, and return to market access,
before and after the establishment of the CFB (Eichengreen and Portes, 2000). Finally, Wright
(2000) argues that the CFB's main role was to enforce collective behavior among creditors by
disseminating information of members who "defected" and lent money to a defaulting country
while it was embargoed; he presents a game-theoretic model that analyzes this function of the
CFB.

Our analysis is mostly based on our own independent reading of the original sources
(especially the Annual Reports of the CFB), but our interpretation is heavily influenced by what
we have learned from previous studies on this topic. Our intended objective is not only to add
important unearthed details to previous analyses of the CFB's mode of operation but also to
provide a single reference point to what is known about the CFB, which had previously been
scattered around a number of different studies.
Our evaluation of the CFB and the potential lessons from its experience proceeds as
follows. We first review the key differences between the international financial environment
of 1870–1913 and that of today (Section II), and then analyze the CFB's success record
(Section III) and mode of operation (Section IV). Our main conclusions (Section V) may be
summarized as follows. A revamped creditor association today might somewhat facilitate
coordination among creditors, especially as it relates to coordination among holders of different
bonds issued by the same country. At the same time, for today's bondholders, the appeal of
"defection" rather than cooperation with other creditors seems to be greater than it was in the
past. Indeed, much of the original rationale for creditor associations seems to have disappeared,
notably the need for creditors to coordinate in taking over collateral and tax revenues in
defaulting countries. Moreover, a revamped creditor association may not be able to tackle
challenges that existed to a far lesser extent in the past, such as avoiding lawsuits on the part of
individual creditors.

http://www.ksri.org/bbs/files/research02/wp03107.pdf

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HAMLET WITHOUT THE PRINCE OF DENMARK: RELATIONSHIP BANKING AND CONDITIONALITY LENDING IN THE LONDON MARKET FOR FOREIGN GOVERNMENT DEBT, 1815–1913

Marc Flandreau

The Graduate Institute, Geneva
Juan Flores

University of Geneva

Abstract

This paper offers a theory of conditionality lending in 19th century international capital markets. We argue that
ownership of reputation signals by prestigious banks rendered them able and willing to monitor government
borrowing. Monitoring was a source of rent, and it led bankers to support countries facing liquidity crises in a
manner similar to modern descriptions of "relationship" lending to corporate clients by "parent" banks.
Prestigious bankers' ability to implement conditionality loans and monitor countries' financial policies also
enabled them to deal with solvency. We find that, compared with prestigious bankers, bondholders' committees
had neither the tools nor the prestige required for effectively dealing with defaulters. Hence such committees
were far less important than previous research has claimed.

This paper develops an analysis of conditionality lending during the long era of London-based ―globalized‖ foreign government debt markets that ended at the start of World War I. The argument we make is that the concepts and insights from modern relationship banking theory provide powerful tools for understanding how international capital markets could exact ―structural adjustment‖ from borrowing governments. In a nutshell, this occurred because of market structure. A few prestigious intermediaries owned the ability to ―certify‖ a borrowing government, which enabled them to influence the terms of market access. The intermediaries thus had a measure of monopoly power over borrowers and used it to obtain adjustments that increased the likelihood of repayment. Conditionality lending was an investment in the prestigious bankers' own brand. This explains why prestigious banks were both able and willing to manage their clients' liquidity crises.

The starting point of this new view is earlier research by Flandreau and Flores (2009) providing analytical insights on, and empirical evidence of, the role of capital, prestige, and market share as collaterals in the foreign government bond markets that developed in London in the early 1820s. Here we seek to expand the range of the argument both analytically and historically. First, we argue that ―rules of the game‖ similar to those that operated in the early 1820s were also in force in subsequent periods and, in fact, apply to the entire Pax Britannica era (1815–1913). Second, we show how the signaling role (emphasized in our previous research) was combined with control. Third, we show how focus on control does provide a theoretical clarification of the logic of conditionality lending to 19th-century foreign governments.

An important aspect of our theory (if not the main one) is that it departs from conventional thinking in recent historical research on sovereign debt. The dominant mode of thinking has been to emphasize three alternative modes of governing sovereign debt: bondholder activism, high-quality domestic institutions, and imperial influence. In this paper, we abstract from the role of imperial influence, whose invocation amounts to assuming the problem away. External imperial control means that sovereign debt is not sovereign at all, explaining why the debts of colonies have been generally and rightly perceived as less risky by investors.1 We also abstract from domestic institutions and the North–Weingast veto-point theme, since this is simply another approach to assuming the problem away. There are many real-world examples of when ―desirable‖ institutions were not present and yet lending occurred. When, say, Argentina or (as Nathaniel de Rothschild put it) ―the Khan of Khiva, or ... any of those States were borrowing, they were likely to default and did.2 In such cases, markets had to deal with the resulting mess. We therefore investigate the situation of countries for which neither imperial control nor appropriate domestic institutions (whatever may be meant by that) were available.

Previous research has suggested that the ―solution‖ to these problems would have been the emergence of bondholders' committees (such as the British Corporation of Foreign Bondholders of 1868) to coordinate creditors' activism and perhaps increase the odds of sovereign repayment.3 To the casual observer it seems that bondholders' committees were the only available mechanism to deal with default, so their operation attracted considerable research interest; a few equations later down the road, authors grew accustomed to seeing these committees as the engine of successful sovereign debt in the 19th century. However, focusing on bondholders while ignoring the rest of the cast is analogous to putting on Hamlet without the Prince of Denmark. In the global financial game, the lead is played by the international banker. Bondholders set the drama into action by seeking revenge (thus playing the Ghost's role in Hamlet), but the instrument of revenge (the Prince) was the banker.

The language of corporate finance theory provides a natural way to think of bankers and how their actions differed from those of bondholders' committees: to distinguish creditors' committees from international bankers, one may liken their respective roles to ―direct‖ monitoring by shareholders and ―delegated‖ monitoring by a parent bank. These alternative institutions perform in different ways, address different informational problems, and are therefore optimal in different settings. It is often emphasized that bank monitoring becomes optimal when control through shareholder assemblies fails. Shareholder assemblies can fail when they prove unable to acquire relevant information from the agent (borrower) or because coercion is impossible owing to such collective action problems as inability to coordinate and free-riding. In such instances (and if some additional conditions are met), delegated monitoring through a bank may be the superior arrangement.4

In order for underwriting banks to play a role in our tale, there must have been some aspects to their organization that ensured value would be created by their intervention. On this account, our previous joint research establishes that, in the early 19th century, certain underwriters could add value because of their reputation or prestige. Prestige enabled bankers to own a large market share and would have been lost had they cheated investors. This finding addresses the contracting ―externality‖ that prior research had argued is a key weakness of international debt and bondholders' collective action. Thus, monitoring by reputable banks rested on imperfect competition. In other words, even before the bondholders could organize themselves as a cartel, a mechanism for concentrating lending authority existed ―naturally‖ in the underwriting market. We shall argue that there are reasons to believe this natural monopoly or oligopoly probably outweighed what bondholders could do, given the latter's tendency to free-ride. Moreover, although bondholders' committees may have carried sticks (they could, in principle, prevent countries from borrowing in the market to which they were affiliated), they had no carrots; because they were not in the lending business, they could not, for instance, rescue a borrower facing an illiquidity crisis.

In contrast, prestigious underwriters did have such power. While entirely neglected in the recent macroeconomic literature, this theme has been popular with some previous business historians who previously suggested that prestige did play a role in foreign debt underwriting (See, for example, Hidy (1949) on Barings, Gille (1965, 1967) on Rothschilds, and Suzuki (1994) on Japanese government finance). In this paper, we seek to systematize these earlier intuitions by providing a rigorous framework to handle them. In particular, rather than focusing on specific banking houses or borrowers, we characterize the general landscape in which borrowers and banking houses interacted. Moreover, we articulate a theory to explain why prestige played a role in crisis lending. We argue that prestige and market power earned some bankers an informational rent on country-specific knowledge and put them in a convenient position to deal with payment crises. They could decide whether a given country was experiencing a liquidity or solvency crisis and then address it. We suggest prestige gave rise to a type of bargaining between lenders and borrowing governments that is similar to that described in ―relationship banking‖ models. These models study the reasons for the emergence of repeated interactions between banks and corporate borrowers (as in today's Japanese system of main banks or in the German system of universal banks). The traditional argument for relationship banking is that banks have comparative advantages in corporate monitoring. An important theoretical insight is the role of liquidity provision. The main bank is expected to provide support to its clients in difficult times because of (among other things) greater signalling power. A corollary is that the bank acts not only through signaling but also through control. The main bank can deliver value by enforcing proper policies and creating incentives for organizational reform when needed. Of course, the resulting policies need not be conducive to growth or development; they need only protect the underwriter's reputation for successful monitoring. This may explain why some earlier historians have used the language of imperialism to describe the relation between banking houses and borrowers.

It is unclear why the international banker has been omitted from the picture in recent years. One reason may involve a theoretical prejudice—namely, the popularity of the free-riding argument. Researchers have generally doubted that underwriting banks would ever be able to manage their conflicts of interest. An explicit statement to that effect is given by Eichengreen and Portes: ―bondholders recognized ... that the issuing house was likely to be torn apart between the interests of two sets of customers: bondholders and foreign borrowers. ... Given the potential for conflict of interest, most readjustments were therefore negotiated not by issuing houses but by independent committees (1986, p. 621). These remarks ostensibly apply to the interwar order, but they have 19th- century roots. For instance, The Economist wrote in 1897 about the powerful influence of issuing houses ―who find it practically impossible to do fresh business with the debtors while the default lasts, and who are therefore, naturally anxious that some sort of settlement should be arrived at, more especially as settlements of the kind ... are frequently followed by new loans.

Another explanation for the general neglect of the underwriting banks' role may be the historical context in which the recent literature originated. Research on the history of international debt was sparked by the 1980s international debt crisis. At that time, it was clear that large U.S. banks had failed to monitor the risks of their own portfolio of commercial loans. This fact cast doubt on the capacity of intermediaries to screen (let alone to signal). Finally, it must be said that much of the action relevant to our argument occurred in places that cannot be easily observed (given the ―radar‖ targets of recent economic historians). Indeed, by providing support to illiquid governments, bankers helped prevent problems from reaching the market. Cases that became known tended to be, by construction, the most desperate ones: those in which bankers were less interested and for which the last-resort effort was left to bondholders. We do not say that these were unexciting or irrelevant cases, nor that the recent interest in bondholders' committees (and in how they acted) is entirely misplaced. But we do argue that a good deal of filtering occurred upstream, so that a focus on bondholders suffers from selection bias. We therefore doubt that such a focus is an adequate starting point for studying the global financial architecture of the period 1815–1913.

In this paper, we will study why and how prestigious underwriters (here, Rothschilds and Barings) found themselves helping out investors. We will argue that they did it in different ways an that there was product differentiation within prestige. Rothschilds specialized in the safest financial instruments and did a lot of monitoring and crisis lending in order to avoid default. Barings, on the other hand, engaged in riskier deals (witness the Barings crisis!). They were involved, post-default, in debt restructuring and/or credit restoration operations. In other words, they acted as a collection agency for other bankers' deals: coming to the rescue of borrowers' honor (after borrowing countries had failed), which they sought to restore in order to shine their own shield.
In summary, this perspective implies a nearly complete reversal of recent research trends. It has been argued elsewhere that bondholders created value by creating missing institutions of collective action to control market access (in essence, taking a stake in the underwriting process); however, we shall argue that prestigious underwriters created value by handling the enforcement of delinquent debts and relying on a market power that was already there (in essence, exercising the kind of market access control that has been traditionally associated with bondholders).

(CHART ON PAGE 38 is a must see...--CSR)

Figure 3. Countercyclical Prestige: Rothschilds' Market Shares during Booms and Busts (units: market share in %)

http://graduateinstitute.ch/webdav/site ... 8-2010.pdf