Carrion at Ecuador's Gate.

The International Monetary Fund and bondholders flex their muscles over the developing country's debt.

LAST SEPTEMBER, A FEW DAYS BEFORE Ecuador became the first country ever to default on Brady bonds, bankers in New York were scrambling to arrange financing for the small Andean nation bludgeoned by natural disasters, a banking crisis and chronic mismanagement.

Without fresh funds, President Jamil Mahuad's options were stark: Miss the debt payments due in August or stop paying government workers. "We told Ecuador if you can get an IMF [International Monetary Fund] letter of intent, we can do a deal," says one banker, who took part in the failed refinancing effort but asked to speak anonymously.

Such desperate financial juggling acts are nothing new for the poorest, countries. But this time, IMF chief Michel Camdessus didn't go along with the usual script, refusing to back a US$400 million loan program for Ecuador. Many people involved allege that the Fund encouraged Ecuador to default on its bonds to show that it won't always be around to bail investors out of emerging market disasters--a charge vehemently denied by IMF officials.

Bondholders, however, were not keen to learn the IMF's lesson about "burden sharing." Immediately after Ecuador announced its intention to default, word got out in Latin American debt markets in New York that so-called vulture funds were amassing the country's debt at rock-bottom prices and were prepared to sue the country for payment on the debt.

Since then, Ecuador has become a battleground between the IMF and investors over the principles of lending to developing countries. At its core, the debate centers on whether creditors will forgive bond obligations and who gets stuck with picking up the tab.

Marc Helie, head of a vulture fund, Gramercy Advisors, whose sole mission so far is to collect on defaulted Ecuadorian and Russian debt, has emerged as one of the loudest defenders of bondholders' rights.

A self-described creditor advocate, Helie proclaims a brave new world of bondholders, bringing market forces to bear on failing developing countries like Ecuador to an extent never seen before in the long-winded decorous Latin American debt negotiations of the 1980s that ultimately gave rise to the so-called Brady bonds. These bonds are named after former U.S. Treasury Secretary Nicholas Brady, who led the effort to convert hundreds of billions of dollars in existing Latin American loans into bonds. "Bond investors are now the dominant creditors, not the banks," Helie says. "And they have a different way of looking at things and different interests. More importantly, they don't have conflicts of interest [such as future business with the countries]."

Although Helie says he prefers a negotiated settlement with Ecuador, he's unabashed about threatening an eventual lawsuit, warning such a case would hobble the country's trade and commercial activities with the United States and other western countries where courts would support creditors' claims. "Having that claim in place would he extremely disruptive for Ecuador," he says. "How are they going to be able to carry on normal trading activity? How will they be able to import goods?"

Helie's voice may be the loudest in a field of traditionally reticent funds in part because he is a relatively small creditor to Ecuador with a portfolio of only $10 million in debt. Traditionally, bit players in major debt workouts tend to drive the hardest bargain because governments will pay off a small claim to facilitate a large deal with major creditors. Helie claims to represent numerous funds' interests, but it is unclear how much pressure large investors will eventually put on the small Andean nation.

Everybody takes a hit. Many lawyers and investors note creditors have never succeeded in getting their hands on a country's assets through U.S. courts. Bondholders will be loath to let Ecuador off the hook too easily, but an eventual write-off on its debt may be the only realistic option. The reason? Foreign debt payments consume half of Ecuador's tax revenues and total foreign debt nearly equals its $14.5 billion annual output.

"They've had a natural disaster of huge proportions, which wiped out their banana and shrimp exports at a time when oil prices hit an all-time low. It's not as if they're squirreling away money," says a bondholder, who asked not to be identified. "Everybody is going to have to take a hit. The point is not what bondholders will tolerate, it's what the country can pay."

Michael Hunter, president of Dart Management, another major bondholder, which is controlled by the wealthy Dart family of the United States, has an uncomfortable sense of deja vu about forgiving Ecuador's debt. As a debt negotiator for Lloyds Bank in Ecuador's 1995 debt restructuring, Hunter signed off on a 45% write-off on defaulted bank loans, which were then turned into Brady bonds backed by U.S. Treasury notes.

Hunter warns that any debt write-offs under the U.S. government backed solution for Ecuador could have "a big impact on all Brady bonds," he says. He contends the prospect of countries' demanding debt restructuring for bonds is much scarier for investors than the default by tiny, tattered Ecuador.

Hunter's employer certainly has a litigious reputation. Dart waged a legal battle against Brazil over its defaulted loans in the 1980s for years after the government reached a Brady agreement with other creditors. Dart's past fight has certainly fueled talk of lawsuits.

But Hunter's wrath, like that of many investors, is aimed squarely at the IMF and the United States and other governments, which they say have used Ecuador as a teaching tool for bondholders in emerging-markets crises. "The IMF and U.S. authorities denied this, but the feeling is they encouraged Ecuador to default," Hunter says.

Ecuador's creditors now demand that the Paris Club, a league of development banks and export-import banks from rich nations whose lending is largely politically driven, should also forgive part of their approximately $2.5 billion in Ecuadorian debt. "Now bondholders want to know what the official sector will do since this was their wonderful idea," Hunter says.

While bondholders and the IMF point fingers at each other, Ecuador has gone hat-in-hand to the multilateral development banks for $17 million to pay top investment banks for advice on how to sell some three quarters of the country's banks that failed this year.

Analysts and investors in New York say the government needs to perform major surgery on its economy to win the IMF's approval for $400 million in loans--and convince creditors it's looked under every rock for every last cent to pay off debts. "It's a Mexican standoff," says Siobhan Manning, emerging markets analyst at PaineWebber. "Bondholders are likely to take a tough stance because Ecuador's debt is too small to break the back of any banks."