Tuesday 24 January 2012

Europe must relieve ECB before the PSI

The ECB helped Europe in its hour of need. Now it is time for Europe to return the favour to the ECB.

This is crunch time for Europe, Greece and the ECB. The PSI has reached an impasse not because the coupons demanded by bondholders are too high but because bondholders can afford to Free Ride along the ECB.
By insisting on a voluntary PSI with the largest bondholder the ECB, exempted, a huge free riding problem has been created. This more than anything else (coupon, English law etc) is the major obstacle for a successful PSI. Europe must come up with the money to take the Greek holdings out of the ECB’s SMP program NOW. It would do it anyway at some point in time. Let us see why:
  • ECB stays out, the PSI proceeds in a voluntary manner. Greece would have to find the money to repay fully this 45-55billion. This probably means the EU (Germany) providing new loans to cover these redemptions in the next 3years (market believes that the ECB holdings concentrate in the near maturities).
  • ECB participates in the PSI and takes the losses. Then, barring magic tricks, the National Central Banks (ECB shareholders: Germany 19%, France 14%, Italy 12.5%) would have to cover the losses.
  • Greece default through the use of CAC’s or otherwise. The ECB would have to write down the value of the Greek bonds again. Therefore shareholders pay again.
We thus see that in all plausible scenarios, the EU (Germany) would have to come up sooner or later with the money to cover either the losses or the redemptions at Par. It is better to do it now and change the odds in the PSI offer and give Greece and Europe a fighting chance. By removing the ECB early, holdouts would have very little to stand on. In addition, insisting on a special status for the ECB, Europe risks contagion to other countries whose bonds the ECB owns.
The ECB is NOT a creditor (preferred or otherwise) towards Greece (through the SMP) but a bondholder who bought the bonds in the secondary market. Whatever the reasons of the ECB, they cannot play a part in the decision process. If we allow distinguishing holders of bonds with regards to their investment or buying motives then we should grade the debt according to who owns. The ECB is a supranational entity but does not enjoy unlimited immunity[1].
The relief can come either by giving the money to Greece to buy (at cost) and destroy the bonds immediately or by exchanging the ECB holdings (at cost) with EFSF paper and then passing the bill again to Greece if Europe does not want to shoulder the pain.
Selling the bonds back at purchase price can be justified by the size of the holding (20% of total outstanding) and also by the particular needs of the buyer. The bond market is an OTC market.
Allowing during a default or through CAC’s a special status for the ECB would be detrimental to the other peripheral countries. It would mean effective subordination of every other bondholder since it would create a two tier system. The European Government market would immediately re-price to reflect the increased risk.
Europe must act fast to remove that risk factor from the market. Doing so, would show leadership and the determination to deal with the European Peripheral debt crisis.

Historical Context
Back in 2010 as the Greek debt tragedy was unfolding the ECB took the controversial decision to support the Greek government bond market with outright purchases of Greek bonds. The ECB had to act swiftly on the face of EU inaction and squabbling. It justified this though their mandate on Financial Stability.  Despite the fact that article 123 (TFEU) explicitly prohibits Credit facilities or outright purchases of government debt the ECB was allowed to violate the spirit of the law. The exact wording was “purchase directly from them by the European Central Bank”. Since the purchases were in the secondary market and not in the primary (at issuance) the ECB had only to comply with the “without prejudice” it its other mandate i.e. Price Stability and Monetary policy. This gave rise to the so called Securities Markets Program (SMP) sterilization. Thus on a regular basis the ECB withdrew the same amount of liquidity from the system as it was supplied by their direct purchases.
Despite the heavy intervention by the ECB to the tune of 45-55billion (in nominal) the Greek bonds continued their accelerated descend. As a result the ECB silently suspended the purchases of Greek bonds and was thus left with around 45-55billion of Greek debt. Bonds acquired by the ECB were also marked at purchase price and amortized to Par at maturity.
Problem was however, that the ECB, as explained above, does not mark the SMP holdings to market but at purchase price. Attempting to mark the Greek bonds at the current levels would generate losses that would not be covered by the equity (10.8billion). Unless the ECB waves a magic wand and comes up with some revaluations or other accounting gimmicks it would need to go back to its shareholders to raise the requisite capital. And this apart from the humiliation of having a Central Bank going bankrupt also requires taxpayers’ money. As the largest shareholder is the Bundesbank this means German money.
JC Trichet very quickly identified this problem and tried in March 2011 to sell the SMP holdings to the newly created EFSF. Unfortunately, his recommendation was not adopted by Europe’s politicians and this was also a source of friction between the ECB and the EU. The EU politicians refused to take responsibility of the losses that the Greek bonds generated.
In July 2011 the council of Europe decided to restructure the Greek debt in a very unconventional way. In order to avoid default and the ECB taking heavy losses it demanded the PSI restructuring to be voluntary. It also assigned 100billion for bank recapitalization to soften the blow of the Greek debt write-downs. This decision unfortunately turned the benign intention of the ECB into a huge headache. Europe should deal with this first before any PSI restructuring.

[1] Gruber & Benisch, ECB Legal Working Papers, No4, June 2007, Privileges and immunities of the ECB