-- [B] BRIDGE ANALYSIS 1: Hurdles to a successful Ecuador bond swap -- By Felix Salmon, BridgeNews London--July 28--As bondholders start to digest the details of Ecuador's bond exchange offer, the market already seems to be pricing in a successful deal. However, there are controversial aspects to the proposed deal in the short term and questions about its long-term sustainability. * * * Bondholders in general--and collateralized and Par bondholders in particular--all seem to have reason to feel aggrieved. BONDHOLDERS ASKED TO JUMP FIRST While Ecuador's Brady and eurobonds amount to a substantial part of Ecuador's total debt stock, the country is going to have to come to similar deals with both its domestic creditors and its bilateral creditors if it is to have a sustainable debt burden going forward. The market has been very enthusiastic about the fact that the terms of Ecuador's exchange offer are more generous than most observers had expected. However, the corollary to that is that Ecuador's future debt burden is going to be more onerous expected. "The question is whether or not they've proposed something that's not a little bit too optimistic in terms of their ability to pay," says Gene Frieda, head of emerging markets research at 4Cast in London. Ecuador is projected to have almost $4 billion in domestic debt by the end of the year--not far off the $6.4 billion in bonded debt being restructured. Now that Ecuador has adopted the dollar as its currency, the distinction between domestic debt and foreign debt has largely evaporated. On Wednesday, the president of Ecuador's foreign debt negotiating commission, Jorge Gallardo, announced that $1.4 billion of bonds issued by the Agency for the Guarantee of Deposits (AGD) would be restructured under the same terms as the Brady bonds. But if there's one thing that bondholders have learned from dealing with Ecuador over the past few years, it is that it's best not to trust the country to do something until it's definitely done. Gallardo also announced that Ecuador would meet with the Paris Club of bilateral creditors in September. But a deal there is by no means a foregone conclusion: there was a meeting in May which ended in stalemate. The Paris Club has made it clear that it is not willing to grant Ecuador debt relief of the sort being asked of bondholders. The hope in the markets is that the Paris Club will give Ecuador a deal whereby most short-term payments are put off for a year or so. That should, the theory goes, be enough time forthe Paris Club to come to a deal granting debt relief to either Russia or Nigeria, which would set a precedent which Ecuador could use to get debt relief of its own. But while the U.S. is understood to be sympathetic to such a scenario, there's no evidence that the other members of the Paris Club are as inclined to be so generous. Many bondholders would like to see some sort of Paris Club agreement before taking the first step themselves. BONDHOLDERS MAY NOT GET ALL THEIR COLLATERAL Most holders of Ecuadorean bonds remember the last time the country restructured its debt, when it finally came to a Brady deal in 1995. Ecuador's creditors granted the country debt relief amounting to some 40% then, only to see the country descend into chaos and default once more. Under the terms of the Brady deal, some $3 billion of Ecuadorean bonds -- the Pars and Discounts -- are collateralized by Treasury bonds. The collateral comes in two parts: the rolling interest guarantee, which covers two coupon payments, and the principal guarantee, which comprises zero-coupon Treasury bonds with a face value equal to the principal amount at the bonds' maturity in 2025. It seems as though Par and Discount bond holders will not receive extra cash in the exchange for their rolling interest guarantee, although they will receive the cash value of the principal guarantee, worth some 23.5% of the face value of the bond. But Par and Discount bond holders have another reason to be aggrieved. They only receive the full cash value of their principal guarantee if 85% of bondholders agree to the exchange before Aug. 9. There is a very good chance--at the height of the holiday season--that the 85% threshhold will not be reached by that date. If this happens, the yield used to calculate the value of the principal guarantee will be increased by 60 basis points, diminishing the amount of cash bondholders receive. PAR BONDHOLDERS SEEM TO GET A BAD DEAL Ecuador's Gallardo was at pains to point out on Wednesday that all classes of bondholder will be treated equally. The lead managers have applied the same discount rate of 11.25%, or 475 basis points over Libor, to the sovereign cashflows on all the bonds in order to calculate the quantity of new bonds that holders will receive for their existing securities. However, on the face of it, the outcome seems to be unfair to Par bond holders. Par and Discount bondholders were understood to receive roughly the same deal in the original Brady deal, with Par bondholders receiving fixed-rate bonds and Discount bondholders receiving floating-rate bonds. Both mature in 2025. Under the terms of the new deal, according to an analysis by Pablo Goldberg of Merrill Lynch, Par and Discount bondholders will both receive 23.495 cents on the dollar for their principal guarantees, while Discount bond holders will receive slightly more cash for missed coupons than Par bond holders (8.214 cents on the dollar, as opposed to 5.042 cents on the dollar). But the real shocker comes in the number of new 30-year bonds that each class of bondholder will receive: a holder of 100 Discount bonds will get 58 of the new 2030s in return, while a holder of 100 Par bonds will receive only 40. -- [B] BRIDGE ANALYSIS 2: Why Ecuador's bond exchange might not work -- By Felix Salmon, BridgeNews London--July 28--The fine details of Ecuador's bond exchange offer mean that smooth passage is hard to guarantee. But there are broader obstacles to its success, which Ecuador has not so far addressed. * * * THE FREE-RIDER QUESTION Probably the largest unanswered question is what is going to happen to bondholders who do not accept the deal. Ecuador and its advisers are certain not to answer that question until after August 9, when the exchange offer expires. But the free-rider question, as it is known, will not go away. Ecuador's Brady and eurobonds are subject to New York law, just as the new 2030 and 2012 bonds will be. Their documentation is unambiguous that they are senior debt: that Ecuador can issue no bonds with greater rights to payment. "New York law is very favorable towards bondholders who are not being paid," says Julian Adams, senior fund manager at Aberdeen Asset Managers in London. A bondholder who did not exchange his bonds could take Ecuador to a New York court as soon as the country started paying interest on its new securities, claiming equal right to those funds. Since the cashflows of the performing new bonds are lower than the cashflows of the non-performing Brady bonds, any bondholder who successfully took Ecuador to court in that way would get a much better deal than the bondholders who accepted the exchange offer. Most exchange offers come with a critical mass, to help minimize the free rider issue. The debtor undertakes not to go ahead with the exchange until a certain percentage, say 85%, of the bondholders agree to it. That guarantees that free riders will comprise no more than 15% of outstanding bondholders. However, the Ecuador exchange deal does not have a critical mass provision. While Ecuador is obliged to go ahead with the deal if 85% of bondholders agree to its terms, the country is free to accept any bonds tendered for exchange, no matter how few they may be. Bondholders therefore have no guarantee that there may not be a very large number of holdouts who could be in a very strong position to force Ecuador to give them better terms on their holdings. In fact, one of the largest holders of Ecuador's debt is understood to be U.S. millionaire Kenneth Dart, who is famous for buying distressed debt and holding out until the very last minute to squeeze extra concessions out of the debtor. THE CARLOS SLIM FACTOR But the single largest holder of Ecuadorean debt is understood to be Mexican billionaire Carlos Slim, who bought up some $250 million worth of Brady bonds through Telmex, the telecommunications giant he controls. Carlos Slim's plan, most observers say, was to swap his holdings of Ecuadorean Brady bonds for stakes in Ecuador's state-owned telecommunications companies. But the Ecuadorean government was not playing his game: it has made no provisions for swapping sovereign debt for equity in state-owned companies, and says that any such action would be unconstitutional. It has even ruled out using privatization proceeds to pay down its stock of sovereign debt, like most other country in Latin America. Carlos Slim has made a lot of money, on paper, with his Ecuadorean bet. He is understood to have bought Par and Discount bonds at about 30 and 33 cents on the dollar respectively; they closed on Wednesday at 40 and 47 3/4. But his holdings are so large that they will be very difficult to sell in the secondary market, and in any case he might be so aggrieved that he has failed to attain a stake in Ecuadorean companies that he refuses to go along with the exchange. EUPHORIA IN THE MARKET Ecuadorean debt skyrocketed on Wednesday as details of the exchange offer dripped into the market. But the lead managers, JP Morgan and Salomon Smith Barney, still have not distributed the official term sheets or offering circular, and most bondholders were completely in the dark for most of the day. So while the initial reaction was positive, it was based on a small number of people with information about the deal in a relatively illiquid market where buyers outnumbered sellers. The vast majority of Ecuadorean bonds are closely held and never trade. Ultimately, it will be the votes of those bondholders, and not the votes of intraday speculators, which will determine the success or failure of Ecuador's exchange offer. And large bondholders will wait to hear what Ecuador has to say in its roadshow before they come to any final decision. End (Back) to felixsalmon.com