Vulture Funds: As Bad As They Sound?

The Backstory of Vulture Funds: How swapping bad debt saved banks — and nations

That, in slightly different words, is what one of the many people I talked to for my article on vulture funds argued. And there's some logic in that, because in a sense, what vulture funds do isn't particularly innovative. The funds buy up unpaid sovereign debt at discount prices. Why are they sold so cheap? Because loans no one pays aren't worth very much at all in practice, and the creditors stuck with them need to get them off their balance sheets.

Collection agencies work, in a way, on the same principle: If you don't pay your cell phone bill for three months, your service gets cut — but your debt is still on your cell company's books. Making something off of your bill is better than making nothing, and since you've made clear you're not going to pay it, the provider sells it, for much less than you owe, to a collections agency. The agency makes a profit by getting you to pay them as much of that full sum you owe as they can persuade you to pay.

Here's where my reporting outlines vulture funds as different. They're not necessarily interested in harassing a country into paying them. And besides, if a sovereign nation hasn't paid back the first creditor, what sensible investor would think it would pay back the second one?

So vultures don't buy debts cheaply on the chance that the debtor will pay up. They buy them with the intention of turning that debt into something attractive, and real — a slice of a local business that might make some tangible cash.

Now, that's not what everyone thinks. Anti-vulture fund groups say that vultures buy the debt with the full intention to sue the pants off poor countries, essentially making a profit on the backs of the global poor. After a lot of work on this issue, that line seems disingenuous to me. And that's not just because I've talked, off the record, to vulture investors who have explained what they wanted to invest in, how those investments went awry, and how they ended up in court (details I've been able to corroborate elsewhere, without having to take a source's word for it).

That's because the finance world — and the development world — was head-over-heels for vulture investment in the 1980s and '90s. They just didn't call it that: They called it "debt swaps."

Debt swaps start the same way: Buy an unpaid debt for cheap — $1000 debt, say, for just $100. That's ten cents on the dollar. Instead of acting like a collection agency, the debt swapper acts like an investor. He takes that $1,000 note — debts are called "notes," and if it's your debt, you owe the full face value of a note, no matter what someone paid for it — to a government and says, "You owe me $1,000. But instead of paying me, why don't you give a preferential exchange rate and turn that into $1,100 in local cash. Then I'll invest it in a local business, which will grow your economy."

This is a fairly new strategy — in fact, there wasn't a market for sovereign debt at all until 1983, and accounting practices and U.S. federal regulation kept American participation low for another four years — but the innovation quickly took off. By 1988, more than $7 billion of debt was swapped for investment. Bank of America, Chase Manhattan, and American Express jumped into the field. Like slicing up and rebundling mortgages — and because of similar deregulation — swapping debt became the financial elixir of its era. After just a decade of deregulated trades, the sovereign debt market was worth $5 trillion.

Investors loved it, and countries liked it, too. Many economists attribute some of the recovery of Latin America — in particular in Chile — to the magic of debt swaps.

Vulture fund investors will tell you all of this to illustrate the utility of the strategy they use. Some will also say that if you can't sell debts on the secondary market, then the primary market will shrivel up — in other words, that reselling a debt to someone who knows how to make money off of it helps alleviate the risk of lending to someone in the first place. Hardliners will tell you that a country that takes out a loan should be responsible enough to pay it back.

But there's another version of that story that doesn't often get told: It's about irresponsible lending. The countries many vulture investors have targeted are not only poor; they're also corrupt. When you loan millions of dollars to a Congolese dictator famous for drinking expensive pink champagne, you probably shouldn't be surprised if you don't get paid back.

But here's the kicker: Even irresponsible lending is a story older than vulture funds. Africa's debt crisis of the 1990s wasn't the first time the world realized unsustainable debt threatens economic stability everywhere. It was actually the Latin American debt crisis of the 1970s that first exposed how vulnerable even rich countries are to poor countries' "irresponsible" spending. By 1982, Third World debt amounted to 113 percent of the assets of America's nine largest banks. Had only half of those debtors defaulted, it would have left America's six largest banks bankrupt.

What happened instead? The financial industry invented the debt swaps described above. By the mid-1990s, the aid industry was using debt swaps to finance all kinds of development projects. In fact, UNICEF swapped millions of dollars, turning the national debt of some countries where it worked into investment in its own work there. The Nature Conservancy helped pioneer turning debt into local conservation projects.

But the strategy became less popular when the investors became private.