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Friday, February 17, 2012

Decoding the ECB bond swap

As Die Welt reported yesterday, it now looks as if the ECB will swap it’s circa €55bn (nominal) holdings of Greek debt into newly issued Greek bonds provided by the Greek state. Below we attempt to summarise what this actually means. It’s a bit techie – so bear with us.

There are basically three options for Greece: a debt write-down that creditors agree to voluntarily, coercive restructuring (where Athens uses contract-based provisions to not pay back its creditors) or disorderly default (all hell breaks loose). Today’s deal has reduced the risk of the latter while increasing the chance/risk of the first two. However, it still hasn’t answered the question whether the ECB will actually itself take losses – or participate in some form – in a Greek restructuring.

Why is the ECB swapping its current holdings of Greek bonds for new ones?

Under this arrangement, the new bonds will be distinguished from the old ones in some way (possibly through different serial numbers) allowing Greece to pass legislation which retroactively imposes collective action clauses (CACs) on the rest of Greek debt held outside of the ECB. (This is sort of like the government hiking the tax rate today and then trying to claim 10 years of back tax at this higher rate). While a number of bondholders could agree to take write downs voluntarily, the remaining ones could be forced to do under these CACs. But the ECB is now safe. This matters tremendously since, if Greece went for a coercive restructuring without any special protection for the ECB, the institution could be faced with major losses and huge dents to its credibility – since it continually denied that it was taking too much risk since it saw a Greek default as impossible. The Eurozone and Germany in particular is keen to avoid this (see here for a whole range of political reasons why).

Open Europe take: While we have sympathy with the ECB for trying to avoid losses, this is a rather strange move (and a result of their flawed policy approach we might add). The preferential treatment it now has on Greek debt, suggests that the ECB’s wider holdings of eurozone debt from its bond purchase programme (around €220bn) are senior to eurozone debt held elsewhere. This could create uncertainty in the bond markets of the southern eurozone states, as bonds held by private creditors are much more likely to be next in line for a write down. More importantly, it also opens the ECB up to legal challenges, since some bond contracts will have clauses protecting them against subordination (negative pledge clauses). Importantly this worrying precedence is reported to be the reason why Bundesbank President Jens Weidmann objected to the move, further highlighting the fundamental disagreements within the ECB itself.

Doesn’t this increase the prospect of a voluntary restructuring?

The swap seems to have gone down well with markets. The perception is that private creditors – those that still hold out – will be much more likely to now accept voluntary losses, which – finally – can bring a conclusion to what has seemed like endless talks between creditors and the Greek government.

Open Europe take: The risk of a disorderly default on the 20 March has radically decreased, which must be considered a good thing. The Greek threat of forcing a coercive default using CACs is now much more credible (it can be done with fewer legal complications) which should force private sector bondholders to pull their finger out since they could face far greater losses under a coercive restructuring. At the same time, Greece now actually has the tools to push through a coercive restructuring (via the CACs) and a larger write-down, meaning that this option is still very much a possibility. So perhaps the markets are getting ahead of themselves.

Does this provide any additional debt relief for Greece?

No. There has been some confusion over this point. Currently the swap is 1:1 meaning the ECB will not take any losses or provide any monetary benefit to Greece. The ECB does seem to have agreed to distribute its ‘profits’ (revenues from the interest payments) on the new holdings so that they can be used to aid Greece.

Open Europe take: As we have noted before, the official sector will take losses in Greece, now or in the future (better now). The ECB should not take direct losses but forgoing the difference between the purchase and nominal price of its holdings of Greek debt would be beneficial. On a side note this episode highlights the lack of transparency surrounding the ECB's actions in the eurozone crisis. Despite purchasing the bonds at a discount the ECB holds the bonds at nominal value on its balance sheet, therefore selling them at purchase price means the ECB would still book a loss on paper. This is not an argument against the ECB providing some debt relief to Greece in of itself (by selling the bonds at purchase price), but more that the ECB does not correctly display risk on its balance sheet and did not create enough safeguards against such an event when it first decided to purchase eurozone government debt.

Furthermore, the concept of redistributing ECB ‘profits’ is flawed. The ECB already pays out any profits it makes to eurozone member states. It is then up to them to use the money how they see fit – it is a political decision, meaning the ECB’s comments about profits being used to aid Greece in this sense are more or less irrelevant.

Is this the end of the discussion with the ECB and Greece then?

Not quite. Once the switch to the new bonds has occurred there could still be scope for the ECB to offload them and sacrifice the difference between the purchase price and nominal value of their Greek holdings. The voluntary restructuring will move ahead and if it does not provide enough debt relief the pressure on the ECB to provide some additional relief will increase again.

Open Europe take: As we note above, Greece will probably need help from the ECB at some point. The Greek negotiating position is now significantly weakened since the ECB has greater protection. The ball is firmly in the ECB’s court – not exactly desirable given the opacity and stubbornness which it has presented so far in the eurozone crisis.


Blankfiend said...

How is extending this swap to the ECB alone NOT a violation of negative pledge clauses in GGB's?

Open Europe blog team said...

Thanks for the comment Blankfiend.

As we note, it’s hard to see how these clauses won't be violated. There are rumours that some bondholders are already preparing legal challenges. So watch this space for updates.

The main issue is, it’s not clear what percentage of Greek bond contracts actually include negative pledge clauses. Those issued longer ago under Greek law may not include such clauses, which are more likely to be found in those issued more recently under English/foreign law. That said it was discussed during the negotiations on the Finnish collateral deal, so the eurozone was clearly concerned about it.

One does wonder whether they've simply accepted that a coercive restructuring will happen in which case it would matter less.

Denis Cooper said...

Surely the new Greek law could simply say inter alia:

1. Any negative pledge clauses are null and void.

2. Any bonds issued under foreign law will be treated as though they were issued under Greek law.

3. Nothing in this law may be questioned in any court in Greece.

Just by proposing to have this retroactive law passed to coerce private investors, while conniving to exempt the ECB from its effects, and even if in the end the law isn't actually used, the Greek government is destroying any residual reputation as a trustworthy counter-party that it may still have.

So as it has little or nothing to lose on the score of reputational damage it may as well go the whole hog.