Ecuador Approches Default

Here we go again.

A brief history: as soon as he was elected, back in 2006, Ecuadorean president Rafael Correa started making entirely-predictable noises about defaulting on his country's bonds. (He'd said he'd do just that throughout his presidential campaign.) For much of December 2006 and January 2007, speculation about an Ecuadorean default was rampant -- and there was even an announcement that the country was going to miss a coupon payment that February. But the coupon payment was made (prompting the classic headline "Ecuador's on-time bond payment confuses economists"), and later developments indicated that the whole thing was a way for Ecuador to manipulate the bond and CDS markets as secondary-market prices plunged to around 70 cents on the dollar.

Well, if you thought 70 cents was a low price to pay for an Ecuadorean bond, just look what's happening now. The benchmark 2012 bond was trading at par as recently as September 8; now it's down to 14 cents on the dollar, thanks to yet another game involving missed coupon payments and talk of grace periods. Otto Rock, who came up with the wonderful image below, is convinced Ecuador's not going to default, and not only because Venezuela has written hundreds of millions of dollars of credit protection on Ecuador, and it's not a good idea for a Latin leftist government to piss off Hugo Chavez so enormously over a piddling $30 million coupon it can easily afford.

On the other hand, the market is clearly pricing in a default of almost unprecedented severity: I don't think that even Cuba's bonds are trading at these kind of levels, and they haven't made a coupon payment since Batista was in power. The official EMBI spread on Ecuador's bonds, if you're interested, is 4,457bp over Treasuries -- which makes it a much riskier bet than the likes of Pakistan (2,073bp) or Argentina (1,834bp).

One of the big differences between now and 2007 is that at least back then Ecuador had lawyers -- and very good ones, at that, led by the doyen of sovereign-debt negotiators, Cleary Gottlieb's Lee Buchheit. Unfortunately, Cleary was fired by Ecuador earlier this year, in a fit of recriminations over the country's last bond restructuring, in 2000. If Ecuador really does default this time round, it will be almost impossible to find any lawyers or bankers both willing and qualified to embark upon the extraordinarily complicated, expensive, and time-consuming process of trying to restructure the debt. Instead, Ecuador's creditors will rush to attach the country's assets -- something which will be made much easier by Ecuador's lack of legal representation and by the fact that its currency is the US dollar.

In fact, I'm quite sure that vulture funds like Elliott Associates have been buying up as many Ecuadorean bonds as they can lay their hands on in the past couple of days. They're experts at buying up debt for pennies on the dollar and then using aggressive court tactics to try to get paid back in full -- and I'm sure they can hardly believe their luck that (a) the debt is so cheap; (b) Ecuador will put up no real legal opposition; and (c) nearly all the country's financial assets reside, ultimately, in the US, which is also the jurisdiction under which the bonds were issued.

All of which means that we're probably in for a messy time. If Ecuadorean finance minister Elsa Viteri really thinks she can hold constructive "talks with bondholders", she's going to be in for a rude awakening: since Ecuador is clearly capable of making the bond payment, those bondholders are going to have no sympathy whatsoever for the country's real or imagined economic plight. Remember that the bonds in question have already been restructured twice -- once in the Brady Plan, and once in 2000. There's also a good chance that many of the bondholders have bought credit protection on their positions, and would at this point love an event of default which got them paid out in full.

The degree to which the Correa administration understands all this is very unclear. Defaulting on the bonds makes no economic sense at all: it would save very little money (about $400 million a year) while costing billions in terms of foregone multilateral loans, trade credit lines, and attached foreign assets. The problem, of course, is that there's only one person with the ability to tell Correa to get a grip -- and that's Hugo Chavez. When Chavez is bondholders' best hope, you know things are pretty desperate.

Update: One comment and one email tell me that contra Bloomberg's reporting, the bond price never fell as far as 14 cents. It seems the low point was 21 cents, which makes more intuitive sense to me.