Thou shall not default, the ECB commands it

Dealing with Greece’s biggest holdout

by Joseph Cotterill 

If you didn’t believe us that the European Central Bank will do everything it can to achieve seniority for its Greek bonds in the country’s debt restructuring, hopefully Thursday’s ECB press conference convinced you.

Not only did ECB chief Mario Draghi obsfuscate — twice — on whether the bank is prepared to take losses on its Greek debt, but Vitor Constancio, the vice-chief, made a point of emphasising that Greece is negotiating private sector involvement.

The implication being that the ECB’s €40bn-plus holdings should not be seen as private, despite having originally been issued by Greece as private bonds. (The ECB bought the bonds in the secondary market.) Since that suggests the ECB shouldn’t be affected by any
attempt to coerce private bondholders to write down their €205bn debt by 50 per cent, there’s a bit of a problem here…

…Mostly to do with the old principle of equality of treatment among creditors in sovereign debt restructuring. The threat to this principle is why the ECB’s role is important. It’s why so-called retro-active collective action clauses are a problem, given that they’d affect all Greek-law bonds (including the ECB’s) unless there’s a procedure to exclude the ECB. Which brings us back to creditor inequality, etc.

We’ll go into the full gory legal problems of the ECB’s apparent claim not to be lumped in with private bondholders in a later post.

But if you’re just tuning in to this subject and wondering how the ECB got into this farce in the first place, we recommend points made by Gabriel Sterne of Exotix in a recent note:

Thus the principle of comparability of treatment between creditors in the event of sovereign debt restructurings – entrenched for over 50 years since the first Paris Club rescheduling agreement in 1956– appears on the verge of being sacrificed. This is the latest governance-related casualty of the crisis that has so far included CDS; sovereign ratings independence; and the IMF’s previously unwavering respect of the laws of bond issuance…

That’s the basic issue and it’s not just the ECB, it’s also the IMF. That last point there is a reference to the IMF’s acceptance of the retro-active collection action clause as critical to making Greek debt sustainable. It’s another awkward position forced on a respected institution by the Greek bailout. As Sterne continues:

The ECB is in a difficult position. The IMF’s references to “near universal” participation do not, we think, include ECB holdings of GGBs. So in a strict financial sense, the ECB would appear to do well out of the restructuring. They bought GGBs at a discount to par and will not take part in the debt restructuring. This is a strategy of which any hold-out investor in GGBs can watch jealously.

We are not suggesting that the ECB acted opportunistically.The role of GGB purchaser of last resort was forced upon it by a variety of factors, including inability of European politicians to provide sufficient fiscal reform and support. And reports suggest the ECB, cognisant of risks, has been the most reluctant of all the major institutions to agree to PSI. Furthermore the ECB’s reluctance to suffer haircuts is understandable; realising losses could severely damage the credibility of the EU’s most effective crisis resolution institution. It faces a terrible dilemma. Accepting ECBI would severely damage the ECB; not accepting ECBI will damage the effectiveness of future ECB purchases. Holders of government bonds of other EU sovereigns will know that in the event of PSI being required, their haircuts will be bigger, the greater is the share of the ECB debt holdings.

That’s why the ECB is obfuscating: it got itself in a difficult position which it can’t easily back out of. This is in a way the biggest Greek bailout sunk cost of them all, even beyond the IMF’s predicament.

So we’re happy to report that Sterne has come up with one suggestion — the ECB writes down its holdings to the prices at which it bought them since May 2010. The prices will have been higher in 2010 and early 2011, so it’s a smaller write-down in comparison to the other creditors, and so has a smaller impact on reducing Greek debt, but at least it keeps the idea of comparable creditor treatment (dimly) alive.

It’s also similar to a bondholder proposal reported by the FT’s Richard Milne, in which the ECB would write down its holdings to a level between their par value (ie 100 cents in the euro) and the average purchase price (65 to 75 cents).

Though at the rate the ECB is stone-walling, we’re not holding out hope.