Thomas Glaessner and Malay Mittal at Citigroup have an excellent 12-page research note on Ecuador today, which is unremittingly bearish. They put the probability of a credit event in the next few months at "almost 80 percent" – which is much higher than is priced into 1 year CDS, insofar as those CDSs are trading.

But who owns the CDS exposure to Ecuador which has already been written? The answer, surprisingly, is: Venezuelan banks, which wrote a lot of first-to-default (FTD contracts) on baskets of credits including Ecuador. If Venezuelan public banks will take a bath in the event of an Ecuadorean default, might that make Venezuela think twice about extending $1 billion of credit at 7% interest in just that situation? Probably not, according to Citigroup, but it's worth bearing in mind. (Indeed, the whole Vene-loan thing makes relatively little sense. There's a nice quote from Alberto Ramos at Goldman Sachs today: "Paradoxically, while the govt repudiates the notion of external debt and the burden imposed by it, it welcomes further external indebtedness from Venezuela.")

Citi sees Ecuador being able to raise money not just from Venezuela but from CAF (the Andean Development Bank) as well – even if Ecuador defaults not only to bondholders, but also to the World Bank. A World Bank default, of course, would be all but unprecedented, and would place Ecuador firmly as an outlier even by Argentine standards. But Ecuador has already made noises to the effect that it will not pay the IDB – another preferred creditor.

Indeed, an Ecuadorean default would be unprecedented on many levels, even if Ecuador stayed current on its obligations to the IDB and World Bank. For one thing, it would be the first-ever default which didn't happen in the midst of an economic crisis; and for another, it would be the first-ever default by a fully dollarized nation. The effects of default on dollarization are a huge unknown: I've heard speculation that the fact that Ecuador uses the dollar as its currency will make it much easier for creditors to attach Ecuadorean assets, but I have no idea how true that is. What's more, because of the terms of the 2000 exchange, if there's an event of default on the 2012s or the 2030s they immediately balloon and become obligations worth some 130 cents on the dollar, as I recall – plus any past-due interest, of course. In other words, Ecuador's debt ratios will all go up substantially the day after a default.

What's certainly true is that this is going to be a very, very fraught default, if and when it happens. Defaults tend to be accompanied by the defenestration of whoever is president at the time, and they also tend to be accompanied by a run on the local banking system. If Correa values his job, he'll want to make sure that the Ecuadorean banking system will be able to continue to function even in the absence of lines of credit from abroad; he'll also want to make sure that Ecuador has no assets outside the country which can easily be attached by irate creditors. Both assurances will take time, which is why I think that Ecuador is unlikely to default as soon as February 15.

On the other hand, the Citi report concludes that the costs of default to Ecuador, at least in the short term, are relatively low, thanks largely to official-sector weakneess:

The lack of collective action by official creditors also contributes to the sense that countries have, that such a course of action is largely not accompanied with dire costs or consequences in the short-term, even if it may dampen future investment and growth.

There's one huge unanswered question, however: What's going to happen to the bonds? Economy minister Patiño is talking about a haircut, not an outright repudiation of the debt. In order to do that, he's going to have to do some kind of bond exchange, where he swaps new, low-coupon bonds for the old, high-coupon bonds. But you can't do a bond exchange without financial advisers from Wall Street, and I can't think of a single Wall Street bank which would take that mandate. Finding banks to take the Argentina mandate was hard enough – and in that case some kind of default was clearly necessary, and the fees involved were stratospheric. Neither is likely to apply in the case of Ecuador.

Indeed, given that Ecuador's rationale for defaulting on its bonds in the first place is that the 2012s and 2030s are the results of an illegal operation, I'm not entirely sure that Cleary Gottlieb, Ecuador's lawyers who were largely responsible for issuing those bonds in the first place, would accept a mandate to restructure those bonds. And if Ecuador's thinking of defaulting without legal representation in place, all manner of chaos might be unleashed.

Will Ecuador Engage in a Debt Restructuring for 2007?