Felix Salmon

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?