By Nate Raymond and Daniel Bases

NEW YORK,(Reuters) - Argentina faced tough questions on Wednesday from a U.S. appeals court over its stance toward a group of dissident bondholders, a legal showdown that has sparked fears the country could have its second massive debt default in 11 years.

The 2nd U.S. Circuit Court of Appeals in New York heard more than two hours of arguments as it weighs whether to reverse an order that the Argentine government pay $1.3 billion to the so-called holdouts, led by Elliott Management affiliate NML Capital Ltd and Aurelius Capital Management.

The court's decision could have wide impact on global debt markets.

Circuit Judge Reena Raggi, one of the three judges on the panel, peppered Argentina's lawyers with questions.

The court's role is to enforce contracts, "not to rewrite them," she said, adding it "hardly seems appropriate for a court not to enforce one of its orders because a party will breach another of its obligations."

The arguments came 11 years after Argentina defaulted on about $100 billion in sovereign debt. About 92 percent of its bonds were restructured in 2005 and 2010, giving holders 25 cents to 29 cents on the dollar. But bondholders who did not participate in those debt swaps have sought full repayment.

If ordered to pay the small group of holdout creditors, there are fears that Argentina could default again on $24 billion in previously restructured debt.

A lawyer for Argentina stood by the position of its government, led by President Cristina Fernandez, that the holdouts should not be paid in full, and that the country could end up ignoring a court order requiring payment.

"We would not voluntarily obey such an order," Jonathan Blackman, a lawyer for Argentina, told a three-judge panel.

He nonetheless said the country is open to a solution that is "workable and doesn't create a terrible confrontation."

Raggi, who dominated the questioning, responded that Argentina was trying to dictate what the court should order.

The holdouts investors have long argued that they are simply attempting to hold Argentina to its obligations and that the government has plenty of reserves to compensate them.

There is "no question" the country has the capacity to pay, Ted Olson, a lawyer for NML, told the court.

"This is a lawful obligation of Argentina," he said.

ARGENTINA OFFICIALS IN ATTENDANCE

As a sign of the importance of the case, Argentine Vice President Amado Boudou, Economy Minister Hernan Lorenzino and several other high-level Argentine officials attended the hearing.

Lorenzino, at times slumped in his chair surrounded by Argentina's lawyers and at others resting his chin in his hands as he listened intently to the arguments, made no statement as he was whisked from the courtroom to a waiting vehicle, surrounded by security.

"When you have good arguments, when you have faith in those arguments and you're accompanied by different parties who say the same as you do, you have faith that common sense will end up prevailing," Lorenzino later told Argentine television.

The arguments drew a large crowd as roughly 100 lawyers, analysts and journalists waited for over three hours for a chance to watch the hearing from inside the court.

Two rooms were provided for a spillover audience and a private service streamed the arguments via webcast.

Argentina's local debt market had closed before the hearing began, with bonds closing up 0.2 percent on average in light, jittery trade.

In a sign of investors' growing concerns about a possible default on Argentina's debt, the cost to insure its restructured sovereign debt rose more than 65 basis points late Wednesday to 2,162 basis points, or more than $2.1 million annually for five years for every $10 million of debt held in a portfolio, according to data provider Markit.

EARLIER ORDERS

In February 2012, U.S. District Judge Thomas Griesa in Manhattan ruled that Argentina had violated its contractual obligation to treat all creditors equally. That meant the country would have to pay the holdouts if it also wished to pay bondholders who agreed to two giant debt swaps.

In October, the 2nd Circuit largely upheld Griesa's ruling on equal treatment for bondholders. On Wednesday, the three-judge panel said it would not revisit that ruling.

Argentina had sought a rehearing by the panel or all of the judges of the 2nd Circuit. The fate of its request for a full-court review remains unclear.

The arguments on Wednesday centered on a subsequent order by Griesa last November that the next time Argentina made an interest payment to the exchange bondholders, it would have to pay $1.3 billion owed to the holdouts into a court escrow account.

The appeals court is also examining treatment of Bank of New York Mellon, which acts as trustee to the exchange bondholders, and the impact from the ruling's injunction on other third parties.

James Martin, a lawyer for BNY Mellon, said the court's injunction against it violated its rights, since the bank was not a party to the case.

"It fundamentally violates the Constitution," Martin said.

David Boies, a lawyer for a group of bondholders who participated in the restructurings, told the court his clients had been held "hostage," and that their participation in the debt exchanges "should not count against them."

"We care that if there is going to be an injunction, that binds us in terms of what we're going to receive, that it will be equitable," he said.

The case is NML Capital Ltd et al v. Argentina, 2nd U.S. Circuit Court of Appeals, No. 12-105.

(Additional reporting by Jonathan Stempel, Martha Graybow, Rodrigo Campos, Hilary Burke and Helen Popper)

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