EMTA, the erstwhile Emerging Market Traders Association, hosted an in-depth session today on the debt markets in developing countries, both sovereign and corporate. And it’s the corporate bonds which are by far the biggest worry: emerging-market corporate loans are now five times the size of the corporate bond market. And JP Morgan’s Joyce Chang came out with one of the scariest sets of datapoints I’ve come across in a while. Get this:

1. Total lending to emerging markets is now some $4.7 trillion.
2. 74% of that was lent by European banks.
3. Both Austria and Netherlands have lent more than 50% of their GDP to foreign developing nations.

It’s not just Latvia that’s in serious trouble: as Joyce said, a devaluation in Latvia could easily spill over to Bulgaria. At that point there are risks of 1997-8 all over again, only this time starting in Europe rather than Asia.

There was quite a lot of talk of how come the IMF and other multilateral institutions aren’t encouraging emerging-market countries in fiscal distress to reduce or attenuate their liabilities — there’s your answer right there. If emerging Europe started restructuring its debts, the pain in the EU would be enormous — and of course the G8 essentially controls the IMF and the multilaterals.

If the official sector is becoming friendlier to private-sector creditors, however, the big news today was the degree to which Lee Buchheit, the godfather of sovereign debt, has followed suit. Buchheit is an institution, both within Cleary Gottlieb, his law firm, and the sovereign-debt community more generally. He has represented dozens of sovereign debtors, and is known as the inventor of the exit consent — a tool by which countries can eviscerate the legal rights of minority bondholders. Up until very recently, he was considered by most private-sector bondholders to be the enemy; one of them described him to me once as an “evil genius”.

But Lee was singing a very different tune today, and unloaded with both barrels on his former client, Ecuador, and its president, Rafael Correa. Ecuador is a “rogue debtor”, he says, and its most recent default is pretty much the first time in 30 years that a country has defaulted without at least “a colorable claim to distress”.

Ecuador’s offer to its bondholders, said Buchheit, was “an extraordinary document unlike anything I’ve ever seen in this business”. Where most countries in distress at least pay lip service to the idea of wanting (just being unable) to pay, Ecuador repudiated its bonds outright, and said that it considered itself to have no legal or moral obligation to pay so much as a penny for them. That strategy was, no doubt, highly effective. But a large part of its success was due, said Buchheit, to the fact that the bondholders’ trustee — US Bancorp — “was bovinely passive” in the face of extraordinary provocation.

Buchheit did suggest that future sovereign bond issues will likely include clauses barring countries from defaulting and then buying back their distressed debt — not that such a clause would be remotely sufficient to stop a country like Ecuador which has little if any respect for international law. The bigger issue, said Buchheit, was those trustees. “What do you do to motivate the trustees to behave in an appropriate manner?” he asked, adding for good measure that “trustees are a species under the broader genus of invertebrates”.

One of the problems is that when trustees are chosen, they’re generally picked not on the basis of how hard they’re likely to fight for bondholders when push comes to shove, but rather on the basis of how cheap they are. But in general trustees are nearly always legally protected from bondholders, which means that if they take the easy and lazy way out and never kick up a fuss, they’re not going to be held liable for doing so. At the same time, of course, kicking up a fuss is an expensive and time-consuming thing to do. So there’s a lot of incentive to do nothing.

Buchheit was very worried about the consequences of Ecuador’s default. “Outliers tend to be infectious,” he said. “And once you establish a precedent, other countries and finance ministers will wonder why they should go through the tiresome business of negotiating with bondholders,” rather than just defaulting and buying back at pennies on the dollar.

Rafael Correa is no idiot. He has observed, said Buchheit, the tendency of the bond markets to forgive and forget much more quickly than bank lenders: “Financial markets today tend not to hold grudges the way that predecessor financial markets used to. So the traditional cost of a brutal restructuring is not one that they have to pay any more.”

And so, in the face of Correa’s provocation, Buchheit is speaking out. Most of his sovereign clients are keen to retain their access to the international capital markets; many of them are net creditors. So they no longer want their lawyer to stand up for sovereigns’ rights, so much as to repudiate actions by Ecuador which might well imperil their own ability to borrow money in future.

It’s truly a strange world, where distressed-debt investors like Hans Humes make nice noises about the IIF and formal restructuring mechanisms, while Lee Buchheit speaks out against “rogue debtors”. Might it be that out of this crisis is being forged a new consensus? I’m not holding my breath; these people almost never agree for long. But so many unthinkable things have happened already that nothing would shock me any more.

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.

Ecuador has closed out its bond exchange offer at the higher end of expectations, paying 35 cents on the dollar to investors who hold the 2012 and 2030 global bonds. That’s higher than the bonds have traded all year, and certainly higher than they have traded since Ecuador defaulted — which means that any vulture investors who bought the bonds in default will be able to lock in a decent profit for doing essentially no work at all.

What’s more, Ecuador has announced that anybody who put in an offer higher than 35 cents will be allowed to re-tender at the 35 cent level. This makes sense from Ecuador’s point of view, and gives people who tendered high the opportunity to re-think their strategy in the light of known events. It’s pretty clear that at this level a supermajority of the total bonds outstanding will end up being owned by Ecuador — which means that Ecuador will have the ability to strip a lot of creditor protections out of the instruments.

Ecuador has suffered no negative repercussions from its actions — quite the opposite. If the country needs any money in the next few years, it’ll be able to get it, from the Andean Development Bank or the Inter-American Development Bank or the World Bank or even the International Monetary Fund. None of them seem to particularly care that Ecuador defaulted on its global bonds, and emerging-market bondholders are so weak and fragmented these days that they hold very little sway any more within international financial institutions.

Indeed, given the short memory of emerging-market bondholders, I wouldn’t be surprised to see Ecuador regain its access to the international capital markets within a few years, thanks to the way in which it has managed to substantially reduce its (already pretty low) debt-to-GDP ratio. That could well be the thinking behind the decision to remain current on the 2015 global bonds, which were issued when current president Rafael Correa was finance minister. Look, he’s saying: we pay back the money that we borrow. We just don’t pay back debt which was originally borrowed decades ago and which was restructured twice in a manner designed to be as friendly as possible to private-sector creditors.

Looking at this from a systemic perspective, it’s pretty clear that in this instance the cost of default, to Ecuador, was negative. That’s dangerous: it radically increases the probability of tactical defaults from all manner of other countries, including Argentina, Venezuela, and various African states. And once a wave of sovereign defaults starts, it’s very difficult to stop, since the cost of default drops with each new event. Right now the risk of such a wave is surely near a multi-decade high.

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.

Matthew Turner points me to this rather interesting datapoint from the IMF’s International Financial Statistics for Ecuador. The country’s has had 845,000 ounces of gold for as far back as the statistics go — until January 2009, when they jumped to 1.76 million ounces, and then February 2009, when they rose further to 1.93 million ounces. That’s an increase of 1.085 million ounces (or about 37 tons of gold) in the space of two months — which at present prices is worth almost exactly $1 billion.

Curiously, the national valuation of the gold reserves hasn’t risen much — from $734.7 million in December to just $804.2 million in February. Which implies that the huge jump in gold reserves might just be some kind of data-input error. But on the other hand, it coincides exactly with Ecuador’s decision to default on its foreign debt. Might the Ecuadorean central bank be trying to convert attachable assets into something it can safely store at home? And if the country’s gold reserves have soared this year, why hasn’t Ecuador’s valuation of those reserves increased proportionally? It’s all most peculiar.

Update: The IMF says that indeed this is “a simple data mistake that is being corrected”.