Argentina cannot turn its back on negotiations with holdout creditors after defaulting on its sovereign debt, a U.S. judge instructed on Friday, just as the country's failure to service a June interest payment was declared a "credit event."

In a stern tone, U.S. District Judge Thomas Griesa in New York slammed the decision by Latin America's third biggest economy to defy his order that it pay in full holdout investors suing it and instead default on $29 billion in debt.

As Griesa was speaking, a 15-member committee facilitated by the International Swaps and Derivatives Association (ISDA) voted unanimously to call the missed coupon payment a "credit event." The move triggers a payout process for holders of insurance on Argentine debt, which analysts estimate could amount to roughly $1 billion.

Griesa said, "Nothing that has happened this week has removed the necessity of working out a settlement." He chided Argentina for making public statements he characterized as misleading.

"The debts weren't extinguished. There's no bankruptcy, no insovency proceedings," Griesa said. "The debts are still there."

The veteran judge has been at the center of Argentina's drawn-out fight against the New York hedge funds suing it for full payment on bonds they bought on the cheap following the country's record 2002 default on $100 billion in debt.

Argentine bond prices slightly extended earlier losses after Griesa's comments.

In other markets, the blue-chip Merval stock index <.MERV> pared earlier losses to trade down just 0.6 percent from Thursday's close at 8,150.91. The peso currency traded fractionally weaker on the black market at 12.700 per U.S. dollar.

Griesa told both sides to continue working with mediator Daniel Pollack, a lawyer one senior Argentine government minister had dubbed "incompetent" a day earlier.

Argentina's lead lawyer told the judge the Buenos Aires government had no confidence in Pollack after he released a statement after negotiations broke down saying the case had become "highly politicized."

"The Republic of Argentina believes ... it was harmful and prejudiced to the republic and the impact on the market," lawyer Jonathan Blackman said in an exchange that prompted Griesa to tell the hearing that everyone should "cool down" about ideas of mistrust.

RISK OF ACCELERATION

The Argentine government maintains it has not defaulted because it made a required interest payment to a bank intermediary on one of its bonds. But Griesa blocked that deposit in June, saying it violated his ruling that Argentina settle its dispute with holdout investors first.

As a result, holders of exchanged Argentine bonds did not receive the interest coupon payment by a July 30 deadline.

On Friday, the ISDA-facilitated Determinations Committee declared that a "failure to pay" event had happened. It will now hold an auction to settle outstanding credit default swap (CDS) transactions.

CDS reaction was muted as market participants waited for ISDA's auction process to start and investment accounts remained hesitant to take positions.

"The amounts are not very large. We estimate the amount of CDS outstanding for Argentina at about $1 billion; it's not something that’s going to systemically affect financial markets," said Jorge Mariscal, emerging markets chief investment officer at UBS Wealth Management.

Before Friday's hearing, Argentina's government had said it expected nothing favorable to come from Griesa. It has previously called the federal judge an "agent" of the New York hedge funds.

Argentina had argued it needed to await the Dec. 31 expiration of a legal clause barring it from paying under better terms to the holdouts than those accepted by restructured debt holders before changing its negotiating terms, said Ander Faergemann, senior emerging debt fund manager at PineBridge Investments in London.Argentina's latest debt crisis is a far cry from the mayhem that surrounded its default in 2002, when the economy collapsed around a broke government and millions of Argentines lost their jobs. This time the government is solvent.

Asked how painful the default would be to the shrinking economy, Rune Hejrskov at Jyske Invest said: "It really depends if it's a 'default lite' (quick settlement) or a hard default. Either way, there will be a toll on the macro backdrop."

Fund managers have generally said that the market so far has priced in an agreement within the next six months.

However, some have said the risk that bondholders would accelerate their demands on the principal value and accrued interest would grow if expectations of a deal waned.

"I would not be surprised, if this drags on longer, which would complicate the picture," UBS's Mariscal said when asked if there would be an acceleration.

(By Joseph Ax, Nicholas Brown and Richard Lough; Additional reporting by Walter Bianchi in Buenos Aires and Carolyn Cohn, Andrew Winterbottom and Davide Scigliuzzo in London; Writing by Richard Lough; Editing by W Simon and Jonathan Oatis)