Lessons from Ecuador’s bond default

By Felix Salmon
May 29, 2009

EMTA, formerly the Emerging Markets Traders Association, had an interesting panel on the Ecuador default today. It was a bit lopsided: no one on the debtor side — and EMTA invited the country’s own representatives, as well as its lawyers and bankers, and even the US Treasury — would agree to attend. As such, it was really a panel of private-sector participants, and felt much like a wake: it was clear that with the success of Ecuador’s exchange offer, the country has won and the private sector has lost.

In the long term, of course, Ecuador might not have benefitted all that much from its antics: Erich Arispe, of Fitch Ratings, pointed out that the country is paying out much more in cash payments for its bonds than it would have had to pay over the next couple of years in coupon payments. On top of that, Ecuador is racking up lots of new debt to multilateral institutions like the Andean Development Fund and the Inter-American Development Bank, so even its fiscal position isn’t really improving.

But in the short term, Ecuador has elegantly managed to buy back a very large chunk of its debt at just 35 cents on the dollar. Old Ecuador hand Hans Humes, of Greylock Capital, summed up how spectacularly successful the Ecuador strategy was, calling it “one of the most elegant restructurings that I’ve seen”.

In hindsight, the deal could hardly have been done any better. First and most important was the matter of timing: as all the panelists agreed, there’s no way that Ecuador could have pulled this stunt in 2006 or even the first half of 2007. But the country was playing the long game: president Rafael Correa was elected president, on a platform which included debt repudiation, in January 2007; Ecuador’s clear intention to default on its debt earned it a pretty much immediate CCC rating from Fitch. Yet the default didn’t happen until December 2008, almost two full years after Correa’s election.

The wait turned out to be the best thing that Ecuador could have done, because in the interim the global debt markets were plunged into turmoil. And Correa didn’t pull the trigger until he could see the whites of his opponents eyes: he announced that he was defaulting on the 2012 global bonds at exactly the time that three huge hedge funds, which held Ecuador’s debt, were being forced by their prime brokers to liquidate their holdings. As a result, the selling pressure on Ecuadorean bonds sent them tumbling from the 70s to the 20s almost overnight.

They would have fallen further, into the waiting arms of a small army of hungry vulture funds eager to get back into the distressed-debt game after many years essentially being priced out of it. But then Ecuador pulled its next smart stunt: it used Banco del Pacifico, a large Ecuadorean bank, to start buying bonds at levels above 20 cents on the dollar. That was just high enough that the vultures didn’t want to amass a large position, and ensured that any future restructuring would face little organized opposition just because Ecuador’s bondholders were so fragmented.

Ecuador’s next clever step was to pay cash for its defaulted bonds, rather than trying to do a bond exchange. That meant that it didn’t need to go through a laborious SEC registration process, during which the legality of the Banco Pacifico stunt would surely have been questioned. And its final clever step was not to put forward a take-it-or-leave-it offer, as Argentina did, which would allow bondholders to agitate for a mass “no” vote. Instead, they just asked bondholders to name their price.

Of course that’s what the bondholders did. None of them wanted to be left as holdouts, given the ease with which Ecuador could change the covenants on the bonds, and also the fact that they hadn’t even managed to accelerate the 2030 global bonds by the time the default happened.

Joe Kogan of Barclays Capital said that bondholders’ inability to accelerate the 30s doesn’t just show a collective action problem. “It demonstrates that people weren’t really willing to hold on to the bonds, and that the original investors who had these bonds were trying to get rid of them,” he said: no one, in the present environment, had any appetite at all for litigation which could drag out for years.

No one expected Ecuador to pull this particular rabbit out of the hat. The country has a reputation for utter incompetence when it comes to fiscal matters, and a few months ago it fired its highly-respected and long-standing legal counsel, Cleary Gottlieb. Somehow, however, this exchange offer was probably the most successful and least fraught debt restructuring in the history of Latin American sovereign defaults.

The multilaterals played their part, by condoning Ecuador’s actions and basically taking its side, despite the fact that the country had no fiscal need to default. And Argentina, weirdly, helped too: holdouts there have got very little to show for their litigation to date, and indeed Argentina was found in contempt of court in New York this week for basically ignoring a judge’s orders to keep certain funds in the US. It was a legal victory for bondholders, but won’t help them get any richer.

And of course it also helped that Ecuador was so small. Even with the bonds at par, they accounted for only about 0.5% of the emerging-market index, which means that at this year’s prices Ecuador constituted about one quarter of one percent of a diversified EM portfolio. You could fight them, but when your portfolio is down 20% for other reasons, what’s the point.

Kogan was sanguine on the question of whether Ecuador’s default would spill over into other emerging-market sovereigns. Most countries with bonds outstanding have some kind of access to the bond market, he pointed out; Ecuador hasn’t been able to issue debt in years, so losing access was no big deal for Ecuador, as it would be for most other countries. Ecuador also isn’t going to suffer as much in terms of economic costs as other countries might — its corporations aren’t going to lose bond-market access either (because they never had access) and it’s not going to suffer a bout of hyperinflation, because it’s dollarized. And although the last Ecuadorean president to default did immediately get kicked out of office, this one was re-elected comfortably, so there aren’t the kind of political costs that you’d expect in other countries. The only real new costs to Ecuador might come in a few years, if holdouts manage to attach Ecuador’s oil exports in one way or another — but given the success of the exchange offer, there probably won’t be any holdouts, or Ecuador could continue to pay them their coupons, just as it’s continuing to pay the coupons on its old Brady bonds which weren’t tendered into the 2000 exchange.

Hans Humes, however, was more worried about Ecuador setting a precedent. “As much as we can say this is an outlier, any country which runs into trouble has a great blueprint now of how to do it,” he said. The last time Ecuador defaulted, it was reasonably constructive, at least in hindsight: it hired Cleary Gottlieb, a big financial-markets law firm, it entered into dialogue with creditors including the Dart family, and it was criticized in some quarters for paying too much to bondholders rather than too little. No one can accuse it of that this time around.

“The world has changed,” said Humes — we’re now living in a world where not only Ecuador can default, but Iceland can default as well. And that’s a world where defaults by small emerging-market countries simply don’t have the systemic consequences that everybody thought they might have. I even heard Humes say something I never thought I’d hear a died-in-the-wool buy-sider like him say: “Maybe,” he said, the solution to “go back to Anne Krueger’s model”

He was referring to SDRM, the attempt by then IMF first deputy managing director Anne Krueger to create a sovereign bankruptcy court. Not a single private-sector player thought this was a good idea, as far as I could tell, and certainly no one on the buy side had any time for the idea. But now, it’s clearly better than nothing — and nothing is what bondholders are ending up with these days. “The official sector’s already beaten us,” said Humes. If you’re going to capitulate to Ecuador, then capitulating to the IMF is easy in comparison.

17 comments

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“Kogan was sanguine on the question of whether Ecuador’s default would spill over into other emerging-market sovereigns.”

I’m glad to hear that he’s sanguine about the question, because the answer isn’t going to provide him with nearly so much grounds for insouciance.

Who on God’s earth doesn’t believe that people would rather not repay loans at full value, or not at all? Especially when they don’t like the original terms? Was Hans Humes the only person there who’d met actual human beings?

“president Rafael Correa was elected president, on a platform which included debt repudiation”

That’s like running on a platform for shipping toxic waste to another country.

I think they got lucky because of the market conditions and the fact that they are so small also helped them to pull it off. Other countries who try to follow their blue print may not be as successful.

Good for Ecuador. For years corrupt politicians in Ecuador have been fighting for Wall Street’s interests. It was time that someone finally looked after Ecuador’s own interests.

Ecuador Bond holders have already made their money in interest payments. The reason they agreed to Ecuador’s terms is because they realize they’re not losing much at all.

You won’t find the real cost to Ecuador in these terms; the dead generally don’t get more dead. The cost here is an opportunity cost — Ecuador has just put more nails in its coffin, when it should be removing them. Having little or no access to the bond market is tragic politically, socially and economically, as much for Ecuador as for every other modern country.

Posted by maynardGkeynes | Report as abusive

The international reserves of Ecuador have fallen from 6,5 billon in sep08 to 2,9 billon in may09. The external public debt including Central Bank debt with the Latin-American Reserves Fund (FLAR) has increase in the last year in near $ 500 million. The possibility to finance the high public spending with multilaterals is very low because those sources have exhausted. Unemployment is soaring consequently violence and insecurity in streets is at all times high. According to ECLA (Economic Commission for Latin-American) Ecuador growth will be negative for 3 consecutive years (2008-10) the only one in the region. There are other poor economic indicators like trade balance and inflation. If somebody wants to label Ecuador bond buy back as a “success” at least we have to take a look to this indicators.

Posted by Francisco | Report as abusive

Francisco, every country in the world has seen its revenues shrink, credit tighten and debt increase. If there is any difference with Ecaudor it because they have been particularly hard hit by the fall in oil. Also, they used some of the money to buy a lot of their debt at fire sale prices (genius). As Salmon says, Ecuador still has plenty of places to go for credit and hard currency. And just because some Commission predicts Ecuador will falter in the coming years does not make it true. ECLA has underestimated growth in leftist countries like Venezuela and Argentina pretty systematically the last few years.

av2t: It’s easy to blame the international crisis as a scapegoat of a wrong economic management. In Ecuador public expenditure increased from 28% in 2007 to 41% of GDP in 2008. It’s a basic economic principle that in a revenue crisis you have to adjust and use your savings to make a soft landing. Well Ecuador did exactly the opposite. The fall in reserves is basically due to the failure of the government to reduce expenditure. Take the case of Chile and the ability of Finance Minister Andres Velasco to manage the crisis. Cooper Stabilization Fund has been used so effectively this year defending (without populism) the most vulnerable social sectors. If you don’t believe in “some Commission” data projections (ECLA), you may check data of “some Bank” or “some Fund” (WB, IMF). You mention “plenty of sources” of finance: IMF and WB denied financing unless there is serious change in the economic approach which is very unlikely. IDB is project tied finance, not liquidity to finance current public expending. Ecuador already used its operational capacity in the Latin American Reserves Fund. Perhaps you are thinking in Venezuela, or Iran: whishful thinking. Just to mention, Iran offered $300 million financing in oil pipes! I almost forget there is another source of financing: leaving dollarization…

Posted by Francisco | Report as abusive

i actually wasn’t suggesting we do Krueger’s SDRM idea the way she threw it out – i don’t think i’d like the idea of a multilateral agency of any kind being the judge in a contract dispute between a sovereign and private creditors. i do think you could tweak the idea and set some sort of arbitration process in the jurisdiction that bonds are issued. given the current conditions, i don’t see that happening.

Posted by hans humes | Report as abusive

Francisco,
Ecuador’s political uncertainty required government investing since the private sector is holding out of the country. It’s a question of who should invest first. In the Ecuador it’s clearly the state. Saving oil money was politically impossible, otherwise Correa would be out. The reserves are in better position than in Gutierrez’s period. Dollarization won’t come down at this level. Clearly the default process was genious.

Juan:
You and others consider that “the default process was genius”. In Spanish we have a two words for this sort of genius is VIVEZA CRIOLLA (check your google). Unfortunately these “vivezas” sooner or later must be paid. Ecuador’s default is based in a shortsighted view and on time it will hit back Ecuador. In relation to the international reserves, remember that in Gutierrez period (2004) oil revenues were 5.7% of GDP in 2008 16.4%. Obviously there was a huge difference in oil price.

Posted by Francisco | Report as abusive

Francisco,

“Viveza criolla” better describes the last bond restructuring done in Ecuador, where Ecuador overpaid bondholders. I don’t agree with many of Corrrea’s policies, and agree that he did not save money for harder times, but you’ve to admit that this bond restructuring was done well, and is very innovative. How much it will hurt or benefit Ecuador in the long term remains to be seen, but we’ve finally got someone in power with vision and execution.

Posted by Fernando Rivera | Report as abusive

Fernando: I agree with you. Time will tell if the buy back was a genius or a big blunder, if the so called 21st socialism (21st populism?) worked for the people and if the actual president had “vision and execution” or was just another messianic leader fooling people and seeking to perpetuate in power at any cost.

Posted by Francisco | Report as abusive

Juan facts do not change with Francisco’s data about oil revenues as percentage of GDP…and oil revenues are increasing again. I think that only somebody that irrationally thinks that every single decision made by Correa is wrong may not see this buy back as a smart move.

Posted by J | Report as abusive

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