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.

I’ve lost count of how many times I’ve recommended James Macdonald’s excellent book A Free Nation Deep in Debt: The Financial Roots of Democracy to people interested in the connections between democracy, development, and debt capital markets. So I’m very chuffed that Macdonald has popped up in the comments on this blog to talk about the historical precedents behind Ecuador’s decision to repudiate some of its old debts, while staying current on certain of its newer debts.

His comment is, naturally, worth quoting in full:

One of the interesting features of this default is the revival of the idea of different treatments accorded to different types of debt. There is a long history of such practice. The main purpose has always been to gain the short-term cost benefits of default without incurring the lont-term penalty of reduced access to the credit markets.

In this case, the regime treats its own debts as legitimate while treating those of its predecessors as illegitimate (or at least less legitimate). Eighteenth- century France used a different technique: treating previously defaulted debts as immune to further write-downs, while more recent debts were viewed as fair targets for default because their interest rates were, not surprisingly, considerably higher and could therefore be deemed usurious.

After the Napoleonic War, France finally became a reliable borrower, and one of the main demonstrations of this was honoring the Napoleonic debts in spite of the temptation to repudiate them. It was argued at the time that this was not merely a matter of good faith, but rather an unavoidable price for access to the credit markets on favorable terms as enjoyed by Great Britain.

To my mind, this remains a valid argument. Historically, default almost always had a negative short-term cost - it certainly did so on for France before 1815. The regime always had access to new loans after each bankruptcy; but its access to credit was limited by its previous track record. Attempting to justify its actions by differentiating between types of debt did not fool creditors. They may have continued to lend, but always at rates that factored in the risk of default, and in amounts considerably lower than they were willing to lend to Great Britain.

Just because Ecuador currently experiences a short-term gain will not turn it into a good credit risk. Only paying debts regardless of short-term incentives to default will remove it from the vicious cycle of borrowing and default which has mired Ecuadorean (and Latin American) history since liberation from Spain.

Madonald is right, of course, but it’s also worth noting that “the idea of different treatments accorded to different types of debt” is not something old which is being rediscovered — in many ways it never went away. The international community, including established debtor nations like France and the UK, even enshrined it in the concept of “preferred creditor status” — the idea that the IMF and the World Bank should always be senior to bondholders. And the Brady plan was basically a plan to turn sovereign loans into sovereign bonds on the grounds that while lots of countries had defaulted on their bank loans, none had defaulted on their global bonds, and as a result global bonds were considered safer or more senior than bank loans.

Anna Gelpern has written extensively about this issue: the big difference between sovereigns and corporates is basically that sovereigns are constructively ambiguous about which debts they consider senior to which other debts. “Sovereign immunity,” she writes, “empowers a government to choose the order of repayment among its creditors based on political imperatives, financing needs, reputational concerns or any other considerations”. The answer to this problem is not the idea that all governments should always pay all their debts in full — after all, sovereign credit risk has always existed and will always exist. Instead, a more formal system of transparent and enforceable seniority could make debt markets more efficient and debt restructurings less ugly.

For the time being, however, if and when there’s another wave of sovereign defaults, it’ll be largely up to each individual country which debts they choose to default on. Will it be foreign-currency debts, like Argentina, or domestic-currency debts, like Russia? Will it be bonds, or loans, or both? What will they do with trade finance and other vital short-term credit lines? And where will the multilaterals stand? No one ever knows, until the default actually happens.

Update: Yet more from Macdonald in the comments.

According to Ecuador’s finance minister — and there’s no reason not to believe her — there’s been “excellent” take-up of her offer to buy back Ecuador’s 2012 and 2030 bonds at somewhere in the neighborhood of 30 cents on the dollar. As Reuters’s Maria Eugenia Tello notes,

Most holders of defaulted debt have so far failed to create a united front against Ecuador to seek repayment via courts.

This is in contrast to what happened the last time the Ecuador defaulted, in September 1998. Back then, Ecuador made the announcement in the middle of the annual meetings of the IMF in Washington, and substantially all of Ecuador’s bondholders were in the same place at the same time. It didn’t take long for them to organize meetings and reject Ecuador’s offer to pay some bonds in full while in other cases using the bonds’ own built-in collateral to keep current.

Why do bondholders seem to have lost cohesion over the past decade? At the time, I thought that the experience of Ecuador’s 1998 default was going to be the event which catalyzed bondholders to come together as a much more unified bloc — and indeed the Emerging Market Creditors Association was formed as a direct result of the way that the Ecuador default was handled.

But EMCA fell apart, nothing really took its place, and a major global financial and economic crisis kinda took the wind out of bondholders’ sails. At this point, most of them have neither the energy nor the time horizon nor the levels of capital needed to rally and fight — Ecuador’s timing, you could say, is perfect in that regard.

What’s more, any holdout strategy is fraught with risk:

Many market watchers on Wall Street say Ecuador has a key advantage because Correa had already bought back most of the debt when the country started to threaten a default and dragged down market prices in late 2008. Ecuador has not confirmed or denied past buybacks.

The point here is that if and when Ecuador controls a supermajority of the bonds — which it certainly will by the time the exchange is over, if it doesn’t already — it can start modifying a lot of the covenants in them, making a court fight that much more difficult. Most hold-out or “vulture” creditors tend to dislike litigating bonds in any event, preferring loans instead, which tend to have stronger covenants.

So if there are any hold-outs, their best hope will be that they’re in a tiny minority, and Ecuador just does what it did last time, and pays them off in full because it’s easier and cheaper than fighting them in the courts. But the hold-outs would probably need to amount to less than 4% of the amount issued before Ecuador went down that route.

Will there be 96% takeup of this offer, including bonds Ecuador already owns? It’s possible, but I suspect that there will be enough too-high bids, in the 40-cent-and-over range, to stop that from happening. In which case Ecuador’s holdouts will find themselves in much the same position as Argentina’s. Which is to say, an unhappy position indeed.

Thomas Pindelski  asks:

Given that CA now has the lowest credit rating of all the states, does that make the high rates CA is offering in recent auctions something to avoid, owing to the risk of default, or something to cherish on the lines of ‘too big to fail’.

This is something which came up in conversation today, unsurprisingly, in the wake of my talk to the regional bond dealers. One of them came up to me and indignantly told me that he’d been a muni bond dealer for 38 years, and that of course he knew all about credit risk, as had his forebears before him. To which the natural response is: well, if you’re pricing California debt at these levels, then you must reckon that there’s a pretty substantial probability of default.

The more interesting response was, basically, “my moral hazard trumps your moral hazard”. In other words, it’s true that because California has insured itself against default, there’s moral hazard there: whenever anybody is insured against anything, the likelihood of that thing happening goes up. But at the same time, there’s a bigger moral hazard at play: the federal government will never let California default, it’s too big to fail. And so when push comes to shove, California will get a federal bailout before it defaults on its bondholders.

I suspect, however, that the moral hazard seniority works the other way around: the fact that California’s bondholders are insured means that it’s not too big to fail, and that in fact a payment default by the state would have very little in the way of in-state systemic consequences. (I have no idea what it might do to the monolines, but if they can’t cope with a single credit defaulting, they really shouldn’t be in the business they’re in.) The federal government might step in to mediate the negotiations between the monolines and the state, but it’s not even obvious why it would want to do that.

The more powerful argument why California won’t default is that a payment default is illegal under state law: California’s simply not allowed to default on its bonds. But what are the monolines going to do, sue? If California defaults on say a $1 billion payment which the monolines have to pay, then California owes the monolines $1 billion. If the monolines sue the state and win, then California owes the monolines $1 billion. It’s not clear that they’ve advanced very far. Could they start attaching state assets? I doubt it, somehow.

My hope is that the monolines would get their money back reasonably quickly — the unintended consequences of a default would force California’s dysfunctional legislature to wake up to the pettiness of its actions, and serious fiscal policies might finally be able to be passed. But I can’t say that outcome is particularly probable: the California legislature has shown no signs of being grown-up in the past, or even of moving in that direction.

And indeed the really nasty unintended consequences of a Californian default might well be felt outside the state, with the closing down of the municipal bond market nationally. Once California defaults, it’s hard to see any other state raising private general-obligation funds at any kind of interest rate it would consider acceptable.

Which brings us back to the moral-hazard play: maybe the Feds would bail out California, not for California’s sake, but rather for the sake of the municipal bond markets as a whole. But it’s hard to see where they would get the money, or how Congress would ever approve such an appropriation.

Still, Treasury surely has some kind of traction here — maybe it can tell California that it won’t get any stimulus-bill funding if it’s in default on its obligations. Might that do the trick?