We argue that those conditions are not consistent with the Modigliani-Miller framework. In particular, we suggest that when a sovereign debtor, such as the Philippines government, has interests that conflict with those of its creditors, it may choose to guarantee a portion of its debt, despite the fact that the issue of collateral is costly. We then discuss how it may be rational to retire this secured debt, as the Philippines is currently doing, when conditions improve. Sovereign risk and agency problem s One argument for the collateralization of loans is that the existence of collateral can influence the behavior of debtors. Under such circumstances, the agent may not be able to commit credibly to certain actions that are in the interest of the principal, even though making such a commitment might be in the agent's interest.
Agency problems are likely to arise in sovereign lending situations.
When foreign creditors have a claim on the proceeds of any investment that takes place in a nation, that nation has an incentive to invest less than it would without this debt obligation. The debt obligation itself can therefore distort the investment decisions of the debtor. Indeed, it was the desire to mitigate these investment distortions that originally motivated the Brady debt reduction. Secured debt does not face such an incentive problem, because creditors will earn the secured portion of debt regardless of the behavior of the debtor. Consequently, collateralization of the loan can mitigate the agency problems in international lending.