Sunday 19 February 2012

(non)Compliant ECB. SMP and the PSI

As of writing this Note the ECB-Hellenic Republic swap of the SMP holdings is unconfirmed. However, most market participants think that in one way or another it must happen in order for the PSI to proceed smoothly.
Mechanics of the swap
  • Greece issues a new debt series under Greek law with new ISIN (Identification numbers) and exchanges these new bonds with the bonds that the ECB owns in the SMP
  • The new bonds may be identical to the swapped ones apart from the ISIN number. 
  •  Greece should destroy the old bonds immediately; otherwise the Greek debt has increased by 50billion. Also I am not sure as to the legal repercussions of holding your own bonds for more than few days or perhaps weeks. 
  •  ECB gets repaid and passes the profits to the NCB which in turn they pass it to Greece if they so wish. This would be fun to watch as the NCB’s would participate and incur losses with the bonds they own in their investment portfolio (estimates of 10billion). One can imagine an NCB making losses in their own investment and feeling very reluctant to pass the distributed SMP gains to Greece. 
  •  Perhaps the Greek side should demand this on paper. i.e. if the NCB’s do not return this profit then it is automatically subtracted from their country’s  loans to Greece. 
  •  The intention of returning some of the profits back to Greece raises some interesting compliance questions (see below). 
  •  Could perhaps find a way to do this swap with retail investors too? Who knows.
Compliance Issues of ECB swap
The exchange according to press reports happened (or is going to happen) at par which raises many compliance issues on off-market transactions. i.e. ECB selling (actually through the NCB’s) something worth in the market 20 for 100 and the same for Greece. In fact, the ECB is explicitly prohibited from buying directly from a Government in the Primary market. So how this could be done? Our conclusion is that they did not do a transaction but just exchanged the holdings in the Euroclear accounts (the ISINs). This is a rather obscure yet powerful trick structurers use.

Effectively the ECB not only did not transact because it cannot but also in order to avoid to write the mark to market loss in their books. They just restructured their debt bypassing the normal procedure. They swapped their holdings for something that is worth a lot more and apparently agreed to pass the difference back to the issuer. This smells to me like a gross violation of all the compliance rules Europe and MIFID has introduce. Also by signifying their intentions of returning the difference to the issuer, this may be taken as a conspiracy to defraud the rest of the investors. Passing it to the NCB as shareholders is also very similar to the process of layering a transaction. Compliance departments in banks around Europe should note this. If this is how it happened then the precedence may be excellent defence for them next time they are restructuring insolvent banks or when banks try to hide or move losses. On the other hand, perhaps the ECB has thought of this and are ready to issue an official exemption.
According to Greek press reports the offer would be launched on the 8th March and would be concluded on the 11th of March. Here we mean the actual offer not the indication which may begin as early as 22nd February.
We are led to believe that the ECB’s exit is a threat that CAC’s are imminent. Many report that the law would be passed as early as the 22nd February, together with the start of the PSI process. This does not mean that the CAC’s would be activated however. Again according to press reports the Hellenic Exchanges have established an electronic link and platform with the various custodians and bondholders would be able to submit their preference with security and without knowing what others have done. Furthermore, this would be done per ISIN. The voting would also happen within this electronic platform. Would it be concurrent? In other words once a bondholder expresses his wish he is also called to vote? What of the retailers? Many unanswered questions.
We are led to believe that there would be no-mopping up or hoover up law as suggested in the original paper by Buchheit & Gulati[1] but CAC’s would be retrofitted per ISIN. This is interesting and would tie up with reports on an ISIN swap with ECB for the following reason: 
  •  The Hellenic Republic now owns 50bor so billion. Would they vote and thus totally rig the voting or not? 
  •  In theory they should destroy the bonds immediately. This would pose the following problem. Suppose that the ECB owned 8billion of the 14.4billion of the March12. A group of private holders (or even a single one) with 2.5billion originally had a 17.3% of the issue. Now however with the destruction of 8billion it owns 39% which may be a blocking minority if the CAC’s threshold is at 66 2/3. Of course this issue becomes more acute for smaller issues.
Thus the voting is not assured unless perhaps the threshold is as low as 50% and is done not on the total outstanding volume but on the votes cast. In other words if retail investors for example do not participate they do not count in the voting.
CDS deliverable
One has to assume that the restructuring would be a credit event and that there would be the need for a deliverable bond. Which one would it be? Could it be the newly created ones for the ECB? We doubt this as the ECB would not participate in the process. Are they going to leave some ISIN’s out? Which ones?
In every way one looks at the whole process the inescapable conclusion is that it would set precedence for future sovereign restructurings both on the tools and legalities. The fact that the ECB may be allowed with tricks (some even dodgy) to escape would seriously raise the question of subordination and of methodology.

[1] How to restructure Greek Debt., Buchheit & Gulati, Draft from: