As investors replace commercial banks as emerging markets' biggest creditors, sovereign debt restructurings are going to get downright nasty. Here's how one bondholder held an entire country hostage.
Jamil Mahuad had it all worked out.
It was late August, and Ecuador's president had just days remaining to pay $96 million interest on two separate Brady bond issues. His ravaged country, suffering its worst crisis since the Great Depression, was perilously low on cash. As the International Monetary Fund waited in the wings with a critical aid package, Ecuadoran officials huddled with Salomon Smith Barney bankers on a debt exchange plan for the Brady bonds that would avoid a default.
Then Mahuad changed his mind: Rather than treat all investors the same, he decided to pay the current interest on just one of the bonds. The other bondholders, he figured, could use the interest collateral securing their bonds to cover their missed payment.
The solution -- bondholders would get their money, and a trapped Ecuador wouldn't have to pay out so much cash -- was simple, even a stroke of genius, right? Hardly. Mahuad had failed to reckon on a soft-spoken, long-haired investor named Marc Helie. A buyer of distressed emerging-markets debt (okay, a hedge fund vulture investor), Helie had seen an eerily similar scenario unfold in Russia last year, when bondholders like himself had been stiffed by the Russian government. There was a principle at stake, and he was in no mood for a reprise.
Quickly, Helie rallied fellow investors against what he saw as a unilaterally imposed nonmarket solution that discriminated against certain classes of debt and that, worst of all, might set a precedent for how sovereigns could treat investors in the future. Gaining the support of 35 percent of the bondholders, Helie and company forced an acceleration of the Brady bond payments. Suddenly, the country was in default on nor just the $1.4 billion of unpaid Brady bonds, but on nearly half of its $13 billion of external debt as well.
Thanks to Helie, instead of an orderly restructuring, Ecuador now faced a full-blown, life-threatening debt crisis. Outraged investors could go to court to seize any of the country's assets -- including overseas bank accounts or oil exports -- and rumors abounded that they were about to do so. Mahuad was forced to make a national radio address in which he implored his countrymen to remain calm and vowed to "confront" any legal suits filed by creditors. As if to underscore the disaster, the Guagua Pichincha volcano overlooking Quito began to spew ash over the city, temporarily shutting it down.
A pretty impressive fallout considering that Helie manages all of $10 million.
Presidents, prime ministers and central bank chiefs have battled with hedge fund managers for years. They've defended attacks on their currencies, their economic policies and their credibility. But never before have they had to put up with anything like this bondholder insurrection. If George Soros is the man who broke the Bank of England, then Helie may go down as the man who broke the back of Ecuador.
Helie is to bondholders what advocates like Lens Fund's Robert Monks and Nell Minow were to shareholders when they began their brand of vocal guerrilla activism a decade ago. "I'm a creditor advocate," says Helie. "A creditor is a creditor, and if there is an event of default, then everyone has to share the burden."
But the import is far wider than that of shareholder activists. Instead of removing an incompetent CEO or shaming a spendthrift board, Helie's actions affect 12 million people in one of the poorest countries in Latin America. And they come at a critical juncture for global markets, as leading world policymakers search for ways to shape a new financial architecture that will funnel capital into developing countries like Ecuador and integrate them into the world economy while smoothing out the boom-bust cycles of worldwide capital flows.
To be sure, Helie and his pint-size Gramercy Advisors hedge fund may well pass from center stage, but the movement he helped start won't be easy to stop. His concerns -- that countries not be allowed to default with impunity and that all creditors be treated equally -- are those of investors everywhere.
The stakes are enormous. Over the past decade emerging-markets governments increasingly have turned to private investors for funds instead of to big commercial banks. Since 1990 they have issued almost $180 billion of bonds. Never before have bondholders had so much power; now they are asserting it, as these countries run into trouble and seek to restructure.
Nowhere is that shift more evident than in Ecuador, where banks have been completely eclipsed by private investors. But other countries are involved in their own new wave of restructurings -- or will be. Helie has been battling for a place at the table in Russia (see following story). And market participants are predicting that Pakistan will default on a $150 million Eurobond payment by year-end, followed closely by a Eurobond default from Ukraine.
For years, bondholders have been considered sacrosanct. Countries paid their bond obligations in full, even when they were stiffing official creditors and commercial banks, because they feared they would lose access to capital markets otherwise. In the eyes of many, this practice created a "moral hazard" that encouraged bond buyers to invest recklessly -- secure in the notion that they would be bailed out by either the Group of Seven governments afraid of financial contagion or the emerging-markets officials they lent money to. Policymakers at the IMF and the U.S. Treasury want to "bail-in" bondholders during future crises by forcing them to take a hit, instead of being made whole with official money. Indeed, though IMF …