Sovereign bond restructuring: The buy side starts to bite back

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In a world where sovereign bondholders are disparate and disunited they are hard pressed to get a good deal if a defaulting sovereign and its bank advisers devise a unilateral exchange offer or other restructuring. With the often bitter experience of three such restructurings behind them, bondholders are getting together to protect their position.

Sovereign bonds have been successfully restructured by three countries to date.

Pakistan, Ecuador and Ukraine launched market-based operations, persuading holders of bonds these countries said they could not service to accept new bonds with longer maturities and lower returns.

The choice for investors was either to get nothing if the countries defaulted, or accept the new bonds on less favourable terms.

So far, these bond exchanges have satisfied the troubled countries, the international financial institutions, and the banks.

Only one group remains unsatisfied: the bondholders. Now they are getting organized and fighting back. From now on countries and banks are likely to have to do more than pay lip service to bondholders' and creditors' rights if they are to keep bringing successful exchange offers to market. And the debate now rages over whether it is possible to draft a broadly acceptable code of conduct for such debt negotiations, or whether each case must be resolved differently.

The system of sovereign bond restructuring as it stands was not designed with creditors' rights in mind. In fact it wasn't designed at all: it just happened in an ad-hoc kind of way after the Paris Club set the ball rolling by forcing Pakistan to bail in its private-sector creditors. No-one's plan was followed, even approximately; no-one foresaw how the process would end.

Although there are no widely agreed principles for such debt work-outs, bondholders have become alarmed that, in the midst of these minor crises, precedents have been set that might dictate a future pattern for restructurings that is inimical to their interests.

So they have set up the Emerging Markets Creditors Association (EMCA).

EMCA holds some high-value trump cards. Bondholders, after all, hold almost all privately held sovereign debt and provide substantially all of the new balance-of-payments flows to emerging-market sovereigns.

Furthermore, all of the official sector's best-laid plans for the future of emerging markets will come to naught if bond financing dries up.

"You can't develop a policy on rescheduling unless you take a view on private-sector flows," says Michael Chamberlin, executive director of the Emerging Markets Traders Association. "Every time you do something, you ought to think about whether you want to encourage those flows, or whether you want to discourage them. The government has to catalyze the private sector to do whatever policy it wants to implement."

The problem is that there is no compelling research about the likely effects of different methods of sovereign bond restructuring on net flows, so the fall-back position is simply to revert to talking one's book. And there's no sign that such research is forthcoming, despite the IMF, in its latest paper on the subject, calling it "clearly a priority area for further research".

It's certainly new territory. Until November 1999, no country in living memory had attempted to alter the payments profile on its international bonds. That was when Pakistan, at the behest of the Paris Club of bilateral sovereign creditors, and over loud objections from emerging-market investors, launched its bond restructuring.

The Paris Club had always had a principle of comparability of treatment. This said that private-sector obligations should be treated no better than public-sector obligations. It just hadn't ever applied that principle to bonds before. "That was like breaking an egg," recalls Timothy Geithner, who at the time was under secretary for international affairs at the US Treasury. "It changed precedent. It changed a whole set of assumptions."

Pakistan was followed by Ukraine and Ecuador. All of the countries restructured their bonds by means of exchange offers, with bondholders voluntarily swapping their old bonds for new ones with a better chance of being paid.

Now, after the bond swaps, the debate rages on the next step. What is interesting about the debate is where the fault lines lie. The private sector and the official sector, in many instances, are not that far apart.

Terence Checki at the Federal Reserve Bank of New York, for instance, has views so close to those of Ernest Stern of JP Morgan that they jointly wrote a paper on the subject.

Yet the large bulge-bracket banks often have a fault-line running right through them, as some of the biggest disagreements take place within the private sector, between the buy side and the sell side.

Many of the biggest investors in emerging-market debt, such as JP Morgan Investment Management and Morgan Stanley Asset Management, are owned by the same companies that underwrite the bonds they are investing in. The Chinese walls between them divide not only profit centres but also whole philosophies.

The leading example of this is Abigail McKenna, a fund manager at Morgan Stanley Asset Management, who has taken the lead in rallying fellow institutional investors to form EMCA. McKenna is just as quick to criticize JP Morgan and Salomon Smith Barney for their handling of the Ecuador exchange offer as she is to criticize the Paris Club for its tenacity in clinging to an undefined and undefinable comparability principle.

"The reality is that the interest of the sell side doesn't always coexist with the interest of the buy side," says EMCA co-founder and Pimco fund manager Mohammed El-Erian. "The sell side was advising Ecuador on a unilateral proposal. They were paid by Ecuador for that.

You can't expect them to represent the interests of the buy side. There are many instances where the incentives are not aligned."

The formation of EMCA was something the official sector and the sell side neither foresaw nor particularly wanted. What will happen if EMCA has its way and bondholders have a much larger role in future sovereign debt restructurings than they have had so far?

The official sector is worried that bondholders will take an even larger slice of what is necessarily a finite pie, and the sell side is worried that if deals are negotiated directly between sovereigns and creditors, it will have a much reduced role in the process.

Both sides routinely raise the spectre of interminable multi-year debt negotiations, like those seen in the 1980s, as reason never again to go down that road: imagine increasing the scope of those negotiations, which lasted for ever with dozens of banks involved, to include thousands of bondholders.

There were other good reasons to ignore bondholders before September 1999. The general consensus was that they couldn't and wouldn't have much of a voice in restructurings. Any given bond typically has thousands of different bondholders worldwide, many of whom wish to remain anonymous, and none of whom particularly wants to reveal the size of a position. Also, most sovereign bonds are issued under New York law, which requires the unanimous agreement of bondholders to change the payments profile on the bond. That raised the spectre of a single Belgian dentist holding out against billions of dollars' worth of bondholders, and scuppering any attempt at negotiations.

Even when the bonds were issued under English law, and included collective action clauses that allowed a super-majority of bondholders to agree to a restructuring, sovereign debtors were generally advised not to attempt formal negotiations with bondholders. Pakistan, for instance, had collective action clauses in its bonds, but rather than attempting to renegotiate their terms, it issued the same sort of unilateral exchange offer that it would have done had the clause not been there.

The reason was that it didn't want to call a bondholder meeting, fearing that such a meeting could make it much easier for bondholders to get together to oppose a deal.

By that point - November 1999 - bondholders had, for the first time, proved that they had teeth. And they had done so in the most dramatic way possible, by rejecting Ecuador's attempts to stay current on its obligations. Instead, they accelerated the country's Brady bonds, making the full principal due and payable immediately.

Unfortunate timing

In hindsight, it was probably unfortunate for Ecuador that the timing of its decision to be the first to default on a sovereign bond coincided with the annual meetings of the IMF/World Bank in Washington, when the greatest number of sovereign bondholders is gathered in one place. Ecuador had already missed the coupon payments on its discount and PDI Brady bonds, raising the dander of many bondholders, who complained loudly that the country had done so at the request of the IMF.

"I think the IMF intervened in Ecuador," says one high-profile former US Treasury official who was not directly involved in the talks. "My guess is the IMF and the Treasury both took the view Ecuador should default." (The IMF denies advising Ecuador one way or the other.)

Ecuador was still within the 30-day grace period on the bonds when the IMF/World Bank meetings were being held. At the last possible minute, at 10 pm on a Sunday night, Ecuador announced how it intended to stay current on its obligations. It would pay the coupon on its PDI bonds in full, because those bonds carried no collateral. But it would ask the owners of the discount bonds, which included a rolling interest guarantee in the form of zero-coupon treasury bonds, to allow the release of some of that collateral. All the bonds would then come current again, and Ecuador would gain a little time to be able to construct a market-based solution to its debt problems.

The fact that discount bondholders had lost some of their collateral, Ecuador promised, would be fully taken into account in any restructuring plan.

By this point, however, Ecuador's promises didn't carry a lot of weight with the international financial community. There was major political turmoil in the country - only a couple of months later, the democratically elected president, Jamil Mahuad, was ousted in a military coup. Bondholders were furious at the unequal treatment of discount and PDI bonds, and mutterings were heard that the plan was an attempt to keep Ecuadoreans, who largely held PDI bonds, happy, while leaving discount bondholders, largely foreigners, with nothing.

Before long, bondholders, led most visibly by Marc Helie of Gramercy Advisors, had decided to group together to fight back. Ecuador needed the consent of 50% of discount bondholders to go ahead with its plan; a vote of only 25% was needed to accelerate.

Acceleration wasn't easy: no-one was entirely sure exactly what orders needed to be transmitted to the fiscal agent, Chase, or how they were meant to do so. Chase itself was wholly unhelpful. David Leverich, a senior supervisor in what is now JP Morgan Institutional Trust Services, explains that being "a fiscal agent is a very ministerial undertaking, and generally it is not incumbent upon a fiscal agent to pursue remedies on behalf of bondholders. When things go wrong, bondholders are on their own. It would not be incumbent upon the fiscal agent to step up and go to bat for the bondholders. The bondholders have to do that themselves."

They did.

Point of principle

If the decision to make Pakistan restructure its Eurobonds had been the official sector's way of making a loud point of principle, the vote to accelerate Ecuador's discount bonds was the buy side's way of doing the same thing.

The IMF had said and done nothing indicating that what Ecuador was attempting was in any way unacceptable; in fact, the country signed a letter of intent with the IMF at much the same time as it was defaulting on its bonds.

It was only through the concerted action of bondholders, led by the managers of relatively small hedge funds, that Ecuador's plans were scuttled.

But even Ecuador's attempts to force bondholders into acceptance of unequal treatment weren't sufficient to catalyze the formation of a bondholders' union. The key event triggering EMCA's foundation came just under a year later, when Ecuador actually went ahead and restructured its bonds, all by then in default, without any real input from bondholders.

There had been one brief attempt to set up a dialogue between Ecuador and its bondholders, in the form of something called the Ecuador Creditors Consultative Group. It had only two meetings, however, before Ecuador refused to take part again, complaining that the group was more interested in refashioning the international financial architecture than in engaging in a constructive attempt to achieve a market-based solution to Ecuador's difficulties.

"The one thing that became obvious very quickly at the first meeting was that the group around the table had some very diverse views and objectives, and it was going to be a very long, protracted process to get them to agree to anything," says Michael Corbat, a managing director at Salomon Smith Barney who was advising the Ecuadoreans. "We felt our responsibility was to listen to what bondholders had to say, decipher what was viewed as very important or precedent setting, where there would be hard lines drawn, and try to put something together. After two of those meetings, it was obvious we were rehashing the same things over and over, and we weren't getting anywhere."

Certainly, some bondholders were refusing to enter into substantive talks while the Paris Club remained absent from the scene. "We demanded that we involve the other creditor groups. When you sit down to restructure your debt, you need to determine how you're going to share that among all your different creditors," says Helie. "A group like the Paris Club, which provides financing that is often politically motivated, that is provided to support export sales, that had not taken previous haircuts in prior restructurings, I don't see how they should be treated as senior to the private sector who had previously taken haircuts. So the only way you can establish the principles of how you're going to relate one class to another is to sit down and outline this in an organized process.

And that's why the Ecuadoreans scuttled the whole process." Ecuador, understandably, was not interested in waiting for the Paris Club to rethink its entire philosophy on haircuts - financial jargon for a creditor's acceptance of a decrease in the principal value of his debt. And, in fact, the Paris Club hasn't budged an inch so far on the subject.

A former official from one Paris Club nation explains: "The rules of the game on when the official sector provides debt reduction are relatively clear. The Paris Club basically just doesn't do it, except for the poorest and most highly indebted developing countries. If the market were accurately assessing the risks in its exposure, it would have taken into account the fact that the official sector debt is not going to get written down."

Of course, until late 1999, the private sector said the same thing about sovereign bonds. The Brady negotiations of the 1980s were careful to leave bonds intact, and Soviet-era Russian debt that was restructured wasn't sovereign at all but obligations of Vnesheconombank.

Russia's sovereign Eurobonds remain untouched. Groups such as the Institute of International Finance were adamant that sovereign Eurobonds were inviolable.

So for the time being, bondholders and the Paris Club both feel that they're getting the dirty end of the stick. Though it is true that the Paris Club won't grant debt relief to the likes of Ecuador, it will reschedule those debts for as long as the country has an IMF agreement, and it is often the first class of foreign debt on which a sovereign defaults.

Ecuador, for instance, successfully issued a pair of Eurobonds in 1997 while in arrears to the Paris Club.

Lee Buchheit, a partner at law firm Cleary, Gottlieb, Steen&Hamilton, which has advised many of the sovereign debtors that have sought a restructuring of external debts with private creditors, points to distinctions between the approach of the Paris Club and that of private creditors. "The difference is this: the Paris Club is often prepared to enter into serial reschedulings of a country's official sector debts, but the Club resists the idea of reducing the stock of official sector debt owed by a so-called middle income country," he says. "The private creditors on the other hand do not wish to get trapped into annual debt reschedulings similar to those of the 1980s.

Private creditors typically want to see a resolution of the problem that will promptly restore value to their claims, and they may be prepared to entertain a request for debt reduction if they feel that this is necessary to achieve that goal."

The difference between the two approaches is the biggest reason why no workable definition of the Paris Club's comparability requirement could ever be drafted. Suppose the Paris Club reschedules Ruritania's obligations for the nth time, and requires, under comparability, that the country's Eurobonds also be restructured. The Paris Club action is a short-term solution, which in any case cannot last any longer than the length of the agreement Ruritania has with the IMF.

A Eurobond restructuring is, or should be, a long-term, once-and-for-all solution. So the next time Ruritania goes to the Paris Club to have its obligations rescheduled, either the Club will have to drop its rigid comparability requirement, or bondholders will have to go through another restructuring. The latter is on its face unacceptable, so the only way to keep comparability at all is if it is determined "in a pragmatic fashion, on a case-by-case basis", as Jean-Pierre Jouyet, chairman of the Paris Club, put it in a speech he gave in November.

Part of the problem lies in the way the Paris Club sees the world. "The Paris Club model is still too dependent on a state of the world where private-sector lending takes the form of bank loans," says El-Erian. After all, banks historically have behaved in a manner quite similar to the Paris Club, preferring to reschedule and renegotiate rather than write down the value of their loans. EMTA's Chamberlin says: "I think the official sector is a little behind the curve. They all seem to have been caught a little off balance by the whole transition from bank loans to bonds."

Jouyet was uncompromising on comparability: the IMF is responsible for setting the necessary level of private-sector involvement, he said. It's going to be a long time before this particular gap is bridged. "We all agree that the Paris Club cannot unilaterally determine what a restructuring is going to look like," says one EMCA founding member. "It's a collaborative process. A unilateral peremptory determination by the Paris Club about what's going to happen to private creditors is unacceptable."

The private sector also tends to be suspicious of the politicking in the Paris Club. Helie, for instance, considers that Paris Club members were so unhappy with the military dictatorships in Nigeria that they made no attempt to negotiate with them, allowing arrears to build up. "When the Paris Club claims that Nigeria doesn't have the ability to service all of its debt and therefore there has to be debt relief provided by the private sector, well, most of that debt is the interest and interest on interest and penalties accrued on the Paris Club debt because the Paris Club unilaterally chose not to do a deal with Nigeria," he says.

In any event, bondholders' insistence on Paris Club participation in creditors' discussion marked the end of any kind of formal contact between Ecuador and its bondholders. The collapse of the Consultative Group was pretty much the last thing that bondholders achieved.

After that Ecuador went it alone, advised by Salomon Smith Barney and JP Morgan. In August, it presented a unilateral exchange offer that eventually got taken up by more than 97% of bondholders.

But just because the bondholders accepted the offer didn't mean that they were happy about it. Their main objection was its unilateral nature: the fact that they had had no say in the way it was structured. But they also objected to the inclusion of exit consents that degraded the old bonds as holders switched to the new ones.

"That was a hot button for a lot of people, how terrible that process was," says McKenna, who responded by helping to set up EMCA.

"The process was essentially non-participatory from the point of view of the buy side," says EMCA co-founder Mark Siegel, a fund manager at MassMutual in Washington. "What they got in terms of a restructuring process was so exclusionary that they couldn't put a price on it in any way, and that fact was very distasteful for a lot of market players."

Sudden change

Suddenly, the dramatis personae had changed. Until the formation of EMCA, much of the official sector and the investment banking world had happily dismissed noisy bondholder complaints - the complainers were seen as being a vocal minority unrepresentative of creditors as a whole. Such people as Marc Helie at Gramercy or Jerome Booth at Ashmore Investment Management tended to take uncompromising positions, so there was a feeling that there wasn't a lot of point talking to them at all.

The founding members of EMCA were much more heavyweight. As well as McKenna and Siegel, they included Mohammed El-Erian, a fund manager at Pimco who is a former deputy director of the IMF, and Mark Dow, of Massachusetts Financial Services, who had previously served as an economist at the IMF and the US Treasury.

Even so, there is still some resistance to recognizing EMCA as the legitimate representative of bondholders as a whole. "You should know that the buy side is quite diverse, and the people who represent themselves as the buy-side community don't necessarily represent the full spectrum of buy-side views," says a former US official. It is statements like this that make many bondholders see red: one EMCA founding member says that the Summers-Geithner team was "stubborn, arrogant, and completely unconstructive".

Of course, Summers and Geithner are no longer at the US Treasury - they lost their jobs when George W Bush became president. The views of new Treasury secretary Paul O'Neill on private-sector involvement are untested, and a new team could take a different approach.

The all-important post of under secretary for international affairs will probably go to Stanford economist John Taylor, a big name in macroeconomic theory, but not really known in sovereign finance.

A hint of how the new Bush administration will behave might come from members of the old Bush administration, the last time the Republicans held the White House. The under secretary for international affairs then was David Mulford, now international chairman of Credit Suisse First Boston.

Mulford says: "I think that there is a struggle going on between those, on the one hand, who think that the IMF should still be in the centre of the picture, as an architect for how debt workouts are done. This approach necessarily involves a certain amount of dictation by the IMF as to how private creditors are treated.

This has been evident in Pakistan, the Ukraine, and Ecuador. On the other side are people who take the view that this is an ill-advised approach, because the attempt to corral, or to dictate to or strongly direct private creditors will result in withdrawal of those investors from emerging markets.

They concede that the IMF has a role to play, but they would leave the matter of how debt is to be restructured in the hands of the troubled debtor country to work out with its various creditors on a voluntary basis. I happen to believe the second approach is preferable, it's also the one I think the new administration is likely to prefer. For private creditors, bondholders and others, to be captured and herded around by the IMF is not a desirable system."

This sentiment is broadly comparable to EMCA's position, even if many EMCA members don't blame the IMF for the shortcomings of the recent restructurings. After all, the IMF was encouraging Ecuador to enter into good-faith negotiations with bondholders; it was Ecuador and its advisers that plumped for a unilateral exchange offer. And the terms offered by Pakistan and Ukraine to bondholders were generally perceived as being quite generous.

Mulford's question of who is to be in charge remains central to the whole debate. "Does it really make sense to have fragmented negotiations with different creditor groups - bondholders, banks, trade suppliers and Paris Club - with each group trying to assure intercreditor parity through vague formulations of a 'comparable treatment' undertaking?" asks Buchheit. "I think many sovereign debtors would like to see greater coordination in these negotiations. Under the existing system, no-one, except perhaps for the IMF, has a clear idea of what is being demanded by the various creditor groups or what the debtor may have agreed to give to other creditor groups."

Buchheit recalls that "if you go back in history, the managing director of the IMF, Jacques de Larosière, brought in the commercial banks, the official creditors and the multilateral lenders at the outset of the Mexican debt crisis in 1982 and bluntly told each group what he thought they must do in order to get Mexico through the balance of 1982 and 1983. In the case of the commercial banks, this involved both a rescheduling of existing debts and a $5 billion 'new money' loan. Nobody plays that role any more."

William Rhodes, Citibank's vice-chairman and a veteran debt negotiator who represented the banks in 1982, says: "There are a lot of different classes of creditors and it is difficult to get one group representing all of them." Besides, he says: "Countries prefer not to deal with creditor committees. It smacks too much of what a number of them went through in the '80s and early '90s. You can form all the associations you want, that's fine, but I don't see any group that is going to be able to negotiate with all classes of creditors."

Rhodes is co-chair of a new Committee on Crisis Prevention and Resolution in Emerging Markets that has been set up by the Institute of International Finance (IIF). The IIF set up the committee at the same time as releasing a report laying out nine principles on private-sector involvement in crisis prevention and crisis resolution in emerging markets. The IIF report was viewed as something of a sell-side response to a similar report, with its own principles, issued by the Council on Foreign Relations (CFR), and which was considered to represent more of a buy-side-driven approach.

One of the key differences between the two reports is on the subject of whether the participants in the debate should attempt to agree upon a set of principles regarding formal negotiations with creditors. The IIF only says that "formal negotiations with creditor committees remain a viable option" and then adds that "recent experience demonstrates that the London Club process need not be restricted to commercial banks but can be adapted to a broader group of creditors".

Sabine Miltner, the deputy director at the IIF's multilateral policy department, who drafted the report, says: "It's basically the London Club, not in its old incarnation, but in a new incarnation, in terms of being an inclusive club of the relevant private-sector creditors for country X. To just focus on one subset of the creditors may not be sufficient in terms of resolving the issue."

In the financial shorthand to which many participants reduce the debate, the IIF takes what is known as the "case-by-case" approach. Such an approach has been criticized by the New York Fed's Checki, who wrote in his paper that "case-by-case too often has become a slogan to ward off any and all suggestions for defining general approaches in advance of a crisis. Not surprisingly, this leaves many on the official side profoundly suspicious that case-by-case is merely a stalling tactic."

EMCA co-founder El-Erian lays out the case for more of an ex-ante approach, with a certain number of formalized principles accepted in advance by all the major players: bondholders, IFIs, Paris Club. "When we go and raise money for the asset class, we always get asked about what the workout process is," he says. "What are the rules? What are the procedures? No-one is asking for a guaranteed outcome. But people are asking for clear procedures. The idea is to have a set of guidelines that allow debt workouts without undermining the asset class.

It is the same thing that happened in the 1940s, which is have a set of guidelines that allow countries to adjust their balance of payments without resorting to trade restrictions or beggar-thy-neighbour policies."

Barbara Samuels, who wrote the Council on Foreign Relations report, has a similar take. "The fact is that we've got a glaring hole in the global financial system," she says. "When you think about it, it's really quite strange and twilight zone-ish. Here we are with a system that hasn't adjusted to the fact that the people and institutions who are really providing the capital aren't involved in the process."

Specific principles

The principles in Samuels' report are much more specific than anything coming out of the US Treasury, the IIF, the IMF, the Paris Club or anywhere else. Taking as their starting point current practice in corporate bankruptcy proceedings in the US, they go into such details as the formation of steering committees and relevant subcommittees, and the remuneration of the committees' advisers.

The hope was that the official sector could incorporate the CFR principles, or something like them, into its policies. If a country was playing by the CFR rules, then the IMF would lend into arrears; if it started ignoring bondholder requests for negotiations, then it should know in advance that the IMF would find such an action unacceptable.

The IIF has a similar hope: "IMF and Paris Club support for adjustment programmes should be formulated in a consistent and predictable manner within the framework of their established policies," it says.

It is precisely here that case-by-case falls down. "Bailout packages are destabilizing," explains one fund manager. "They force us to lend to countries that we think are not creditworthy because we fear underperformance if we're not exposed to a country that is suddenly rescued by an IMF bailout.

"It's impossible for us to predict who is going to be the beneficiary of those bailouts if there are no rules as to how they are going to be applied. The sooner we have these principles in place, the better. I think everybody in EMCA agrees that there is a problem of excessive discretion on the part of the official sector."

Certainly, the IMF has never really laid out the criteria whereby Turkey, for instance, gets a large amount of aid very quickly, while Ecuador was forced to negotiate for months, exacerbating a rapidly deteriorating situation.

The head of Latin American operations at one bulge-bracket US bank says that the way the IMF treated Ecuador was a "travesty".

"Ecuador was like a smoker," he says. "We all know smoking's bad. They had had bad public policy for many years. But now their house is burning down. I'm a smoker. We all know that's bad, and I shouldn't do it. But if my house is burning down, if I call a fireman, if my neighbour calls a fireman, they will come and put the fire out. They will not ask: 'Oh, but you weren't smoking in bed, were you? Because if you were smoking in bed, then we're not coming.' I think that's what the IMF and the World Bank did to Ecuador. The IMF is the world's fireman. And they told Ecuador: 'You were smoking in bed, we're not coming.' I do believe that Ecuador's interests at that point in time were not particularly well served, and I think the degree of crisis and therefore pain and suffering of the people of Ecuador was greater than it otherwise had to be. Ecuador wasn't helped."

EMTA's Chamberlin agrees. "If it had been Argentina or Mexico or a big country that really mattered, you'd have had the New York Fed involved, you'd have had the Treasury involved," he says. "But Ecuador needed somebody who could help keep people engaged."

Ecuador's finance minister, Jorge Gallardo, is more forthright. "Lend to a smaller emerging market country and you will be expected to accept your losses with manly fortitude if the borrower runs into trouble.

But lend to a country with the capacity, or the perceived capacity, to destabilize the international financial system and no unpleasant reschedulings, restructurings or write-offs will be required."

Ecuador's timing was unfortunate. To be sure, the crisis happened just after the IMF had announced that there would be no more bailouts, and when the Fund quite welcomed the chance to get tough pour encourager les autres. But the general consensus is that the real reason Ecuador was left unrescued for so long was that it was simply too small to matter.

Even the official sector has come close to admitting this: "the public sector feels constrained about acknowledging the distinction between systemically important countries and other countries in principle - although it observes this distinction in practice," note Checki and Stern in their New York Fed paper.

But when faced with one set of principles it could adopt, the IMF balked. "While Directors considered that the principles on debtor-creditor negotiations, as proposed by the CFR, could provide one of a number of possible approaches to reaching a collaborative agreement, they generally did not consider it appropriate for the Fund to endorse these principles," the introduction to the IMF paper says. Displaying much more sympathy for sovereigns than for bondholders, the acting chairman said that "a rigid application of such a framework might put the sovereign debtor at a disadvantage in negotiations with its creditors".

That opinion is understandable, seeing as how the IMF's shareholders are precisely the sovereigns that might one day start getting involved in such negotiations. But it also points up the conflicts of interest inherent in giving the IMF any sort of coordinating role when it comes to debt restructurings.

Negotiated settlements with sovereign bondholders are sufficiently rare that no-one knows whether negotiated settlements would produce viable outcomes for debtors and creditors or simply entail a protracted process that would ultimately mean richer deals for bondholders and debt service burdens that would soon prove unsustainable for troubled countries. One former US official fears this. "The problem is that there's such a burden on the countries to get into good grace with the market as quickly as possible that to do exchanges successfully you have to make them very sweet for investors if you're going to get large participation," he says.

"Those two things conspire to produce outcomes that are probably going to stretch the capacity of the country to afford them. Ecuador is the best example of this, but there are other ones.

"Solutions now available produce outcomes that are a little too rich for the market and too onerous for the country, and that's not that great for the system. Negotiated solutions might push it further in that direction, too rich for the markets and therefore less financially viable for the country."

If anything, Pakistan and Ukraine were even more generous to their bondholders than Ecuador was to its. But the difference in the eastern nations was that a much smaller part of total foreign debt was sovereign bonds: they could afford to be generous to bondholders because such generosity wouldn't break the bank. In general, Latin American nations have by far the largest sovereign bond debt burdens. The further east you go, the smaller countries' sovereign bonds are as a proportion of total foreign debt or GDP.

In any case, Cleary, Gottlieb's Buchheit, who has been involved both in unilateral offers to bondholders and in negotiations with bank advisory committees, isn't so sure that bondholders would necessarily come out of a formal negotiation with a better deal. "A sovereign that decides to approach its bondholders in the absence of a formal negotiation must anticipate the creditors' complaints and reasonable demands," he notes.

"If this prediction is not done accurately, or if the package presented to the bondholder community does not visibly respond to the creditors' legitimate concerns, the sovereign runs a serious risk of not attracting the very high level of creditor participation that is required to close one of these deals successfully. It is not self-evidently true that a sovereign will give more away in a formal negotiation than it will voluntarily incorporate into a unilateral offer in order to attract widespread support from the bondholders."

EMCA's Siegel is surprisingly sympathetic to the official sector's view of the exchanges done so far, especially Ecuador's. That deal, he says, "was prima facie better than the market expected. But it's not a medium-term solution for the country and while in the near term Ecuador's credit profile probably improved a lot, in the medium term it probably deteriorated. It was not obvious that that deal was anything more than short-term good for holders, because it was not clearly medium-term good for Ecuador."

Siegel, then, is of the opinion that a negotiated settlement might have been better than the unilateral exchange offer was, both for the sovereign and for the bondholders. This view often leads to raised eyebrows in the official sector and on the sell side, which tend to be more prone to consider such negotiations a zero-sum game: what bondholders gain, the sovereign loses.

One thing that would certainly have been the subject of negotiations, had any occurred, would have been Ecuador's oil. The Brady bonds of some oil-producing nations come with warrants that start paying out if windfall oil revenues emerge. Such warrants generally cost the country very little to embed in a debt instrument, but can be attractive to bondholders who might come to worry that their deal was too generous.

But there was a good reason Ecuador didn't include any warrants on oil or privatization receipts in its exchange offer. "In the recent case of Ecuador, the threat of litigation limited the authorities' scope for maneuver," notes the IMF report. "Specifically, it precluded mobilizing resources through a new oil-backed facility, as investment banks were not willing to accept the legal risk that bondholders holding distressed claims might be able to interfere with security mechanisms in the form of pledged assets or receivables."

Free-rider problem

What Ecuador's bankers ran up against was the free-rider problem. In any bond exchange, some bondholders will choose to hold on to their original bonds, rather than tender them for the new ones.

The country is then faced with a dilemma: on the one hand, it can ignore the old bondholders, in which case it remains in default on old obligations and is left open to litigation. On the other hand, it can pay the old bondholders what they are legally owed, which will infuriate the new bondholders, who accepted new bonds that pay out less favourably.

Embedding oil warrants in the new bonds would have increased the size of Ecuador's free-rider problem, adding sovereign assets that the old bondholders could attach in a New York court.

In turn, that would increase incentives for bondholders to hold out, rather than tender their bonds into the exchange offer. And the whole structure of the exchange offer was designed to make the new bonds as attractive as possible and the old bonds as unattractive as possible.

Ecuador in the end decided to pay off the hold-out bondholders rather than endure protracted litigation. "There's a point where you cross a line. Once you hit 97%, 98%, that remaining couple of per cent has high legal and nuisance costs," says Salomon Smith Barney's Corbat.

"It became economically feasible to take them out. Also, Ecuador had a windfall based on high oil prices, and it had more money than it had been anticipating, so it made sense," he says.

Still, even Buchheit, Ecuador's counsel, has written in an article on exit consents that "paying the hold-outs in full and on time makes the bondholders who accepted the [exchange] offer look pretty silly".

Add the experience of the Ecuador free riders to a recent court case in which a hold-out creditor of Peru got paid out in full, and it now looks much more attractive to hold out than it did at the time of Ecuador's offer.

"The fact that the Ecuadoreans just settled with the Eurobond holders and that they're continuing to service the other debt is kind of bizarre," says EMCA's McKenna. "I think it has a very high potential to incentivize greater hold-outs in future restructurings."

Certainly, Ukraine opted not to take such a route. It has been trying to mop up stragglers by reopening its exchange offer, but not offering more than it offered anybody else. Ukraine had many thousands of small individual European bondholders, and some were probably unaware that any exchange offer was under way.

It poses less of a threat in terms of litigious bondholders only because the amounts involved are so small that most professional vulture funds would find it difficult to find enough defaulted debt to make it worthwhile suing.

The IMF, though, is also worried about free riders. "The recent success of the litigation strategy employed by a distressed debt purchaser against Peru may have the effect of encouraging creditors to hold out in future debt restructurings," says its latest report.

The winner of the Peru case, Elliott Associates, didn't even need an oil receivables fund to attach. Once it received its court judgment against Peru, it simply attached Peru's next Brady bond coupon payment, thereby preventing it from making any debt payments before it settled.

Once again, an Andean country found itself with appalling timing: after years of litigation, the court judgment against Peru finally came as president Alberto Fujimori was being forced to resign and the last thing it needed was a technical default on Brady bonds.

Interestingly, the IMF's take that Elliott almost forced Peru to default on its Brady bonds is indicative of a broader trend in emerging-market debt: considering defaults not really to be such until after the grace period on the payment has expired. Peru did, in fact, miss a coupon payment on its Brady bonds, and only paid up at the end of the 30-day grace period.

EMTA's Chamberlin sees this as a slippery slope. "I think we are in an era where we are slipping towards the idea, through lack of discipline, incompetence, technical glitches, rogue creditors, etcetera, that the due date occurs at the end of the grace period instead of at the beginning, where it belongs," he says. "I think that's horribly wrong."

Whether a country pays its coupons on time or only within the grace period can have big repercussions. There was always a chance, for instance, that during the IMF meetings in September 1999, Ecuador might have been persuaded to pay its bond coupons in full. Or the holders of discount bonds might not have voted to accelerate, and the country would have remained current on its obligations. But that would have been no comfort at all to holders of hundreds of millions of dollars' worth of synthetic Ecuadorean bonds issued at the height of the emerging-markets carnival in 1997.

Synthetic sovereign bonds are horribly complicated credit derivatives that often use currency swaps and step-down coupons to convert low-yielding dollar-denominated Brady bonds into high-yielding Deutschmark-denominated instruments. They were structured by such firms as Credit Suisse First Boston, Dresdner Bank, Merrill Lynch, JP Morgan and HSBC Trinkaus, and often ended up with yield-hungry retail investors. The synthetic bonds automatically defaulted to worthlessness in the case of a credit event, which was usually defined as Ecuador being in default on a coupon payment for more than five or seven days.

CSFB's Mulford picks up the story. "There were private firms like us, and Merrill Lynch, and others, who had created instruments based on Ecuadorean Bradys. And those defaulted in the face of non-payment by Ecuador in seven days instead of 30 days as set out in the original instruments," he says. "By the time the authorities got around to deciding what to do, there were already bondholders who'd been defaulted on and weren't going to get anything."

Mulford uses the example of synthetic Ecuadorean bonds to show why entities such as CSFB might want to be involved in creditor negotiations even if they don't directly hold Ecuadorean debt. "Intermediaries may decide they'd better be involved and try to sort things out," he says, "although technically they don't have a responsibility to do so."

The chances are, however, that the sovereign will have enough on its plate dealing with its own creditors to worry about holders of derivatives to whom it owes nothing. The strategy of distressed sovereigns so far has been to avoid negotiations with bondholders in order to keep the tactical upper hand.

The IMF report, for instance, says that the Ecuadoreans "considered that a move toward negotiations would increase creditors' leverage, and, by limiting their ability to maintain the initiative, would reduce their ability to secure agreement on the most favorable terms." Debtor countries, the report continues, are also concerned that "entering into formal negotiations would help facilitate organization and cooperation among creditors, and could thereby substantially increase creditors' leverage during the restructuring process."

Tactical decision

But now that the EMCA has been formed, there's a large chance that debtor countries will have very little choice. "The country will have to make a tactical decision how it wishes to approach its creditors," says one veteran negotiator. "If a significant group of creditors says this is a situation where we think a negotiation is appropriate, and we will refrain from accepting an offer that isn't preceded by negotiation, obviously that's a factor the sovereign has got to take into account."

EMTA's Chamberlin puts forward one hypothetical. "You want to do an exchange offer," he says. "If I come to you with Abby [McKenna] and Mohammed [El-Erian] and Keith [Gardner, of Western Asset Management, another EMCA founder] and say we hold 35% of your debt, what do you do? You and Solly want to launch an exchange offer, you've got 35% of your bondholders saying they want to sit down and talk to you."

Formal negotiations are not a foregone conclusion, says Chamberlin. "You're going to do one of three things. One, you're going to sit down and talk to them formally. Two, you're going to nibble round the edges, kind of find out what they're up to. Or three, you're going to unilaterally launch your deal, but it's going to be a sweeter deal than it was going to be before you heard from the 35%.

The bondholders are afraid of a scenario in which they are overwhelmed by events. Because they all feel like they're disassociated from each other, and they can't congregate and prove the collective muscle that they've got.

They get picked off one by one. That's what they fear. And it's a real concern. But once they've got a core group of players, I think they're pretty powerful. I think now that they've got together, they will start to realize how powerful they are. And countries will, too. Countries will get nervous."

Of course, it may not work like that in practice. Bondholders might prove reluctant to give up their time to formal negotiations; they might be even more reluctant to give up their ability to trade in a sovereign's debt while they are undertaking negotiations that might give them privileged information.

"If you sit a bunch of people from the buy-side community round the table, as we did on many occasions, and you ask them, do you really want to be in a position where you structure the world so there's a presumption in favour of negotiated solutions when you need a restructuring, a lot of them walk away," says a former US official. "They don't really want that.

What they really want at a minimum is to make sure that there is a fair amount of pressure on the sovereign to tell the investor community as a whole, in a timely manner and on a level playing field across the investment community, salient facts about its economic and financial situation, and give them the opportunity to sit at a table and talk to the government about possible solutions."

EMCA's McKenna is careful not to say that she wants a negotiated solution in every case. What she does want is more of a voice. "Salomon Brothers and JP Morgan, or whoever is doing an exchange offer or restructuring for a sovereign, is being paid by the sovereign," she says.

"Their interest is not in protecting creditor rights or necessarily getting the best deal for creditors. They're getting paid x million dollars by Ecuador or Russia to get the best deal for Ecuador or Russia. It's only fair, to level the playing field, that somebody around that table should be negotiating on behalf of bondholders. And it doesn't need to involve every portfolio manager from every institution sitting on that committee and being restricted on the debt. None of us want that. We definitely want quick solutions, it's just having a voice in that process and making sure that our rights are represented."

But Nazareth Festekjian, a managing director at Salomon Smith Barney who helped to structure the Ecuador deal, is downbeat. "In any bond restructuring, a bondholder group is formed and, to the extent the deal is not attractive, the leader of the group will try to convince the rest that they can get a better deal," he says. "Otherwise the bondholder group unravels."

Whether there will be formal negotiations in future debt crises remains to be seen. It is possible that bondholders will be content simply to have more of a voice; it is also possible that sovereigns will not want to give up the unilateral leverage they have enjoyed so far. Much will probably depend on how talks start off, and whether the creditors' committee and the sovereign concerned can get past philosophical differences to hammer out a solution.

EMTA's Chamberlin is optimistic that they can: the very fact that bondholders now have an institutional voice, he says, should "have the effect of exerting somewhat of a moderating influence on some of the more extreme creditors."

The one thing that is certain is that what happened in Pakistan, Ukraine and Ecuador will not be repeated. For the time being, and until a few more of these cases come along, the international financial community will remain on a learning curve. Though it might leave some in EMCA unhappy, case-by-case will, of necessity, be the dominant paradigm for the foreseeable future.