Since the European Council summit of 28/29 October, Germany has been trying to impose its Collective Action Clause, entailing the private sector's participation in future restructuring of eurozone government debt.
Aside from the particularly bad timing of this proposal to which France has rallied, against Mr. Trichet's vehement opposition, it is above all the confusion created by this announcement that triggered the recent resurgence of the peripheral nation debt crisis, as the spread between German and Irish debt increased from 4% to 6.42% during the period. Bear in mind that this spread was just 2.3% at the beginning of August and 1.4% in January.
This is still another striking example of the damage caused by political posturing, as per the now well known rule of "unintended consequences" (Lehman Brothers, etc.).
The ESM (European Stability Mechanism)
In all the announcements made Sunday afternoon about the Irish debt bail-out plan, the most important one was the EurogroupEurogroupe (.pdf link here) statement about the form that the ESM (European Stability Mechanism) would take.
This ESM will be based on the same principle as the current €440bn European Financial Stability Facility (EFSF) in that it will make loans based strictly on conditions (austerity plans) granted to struggling eurozone countries, but with two major differences.
· First, this ESM is set to become a permanent structure, thus making it possible to avoid long and drawn out negotiations like those earlier this year, given its ability to act on an ad hoc basis, if need be. This is a significant step toward shared fiscal sovereignty, which exceeds the limitations of the Maastricht Treaty, notably the renowned article 125 on the functioning of the European Union (TFUE, link here), which prohibited any financial aid to a member-state facing bankruptcy.
· Second, this ESM seems to have no size limitation for the time being. This means that (if the German constitutional court of Karlsruhe give it the go-ahead) that the eurozone will be able to contend with any budget crisis of member-states, regardless of the magnitude of the financing needs, especially since Germany, the main eurozone economic power, benefits from acceptable capital market conditions.
The establishment of this ESM under these conditions might have looked very much a capitulation by Germany, if it had not been accompanied by the terms of these Collective Action Clauses (CAC).
The CACs (Collective Action Clauses)
The objects of these CACs is to enable a restructuring of sovereign debt of insolvent countries without requiring prior agreement from the majority of creditors.
All debt issued by eurozone governments from June 2013 will have to include this CAC. Government leaders insisted emphatically that debt issued before this date, including current bonds, will not be affected by this measure.
This move was thus supposed to trigger a real easing on peripheral national interest rates as of this morning, but as usual in this type of case, the devil is in the details.
Let's take a look at what the Eurogroup statement said:
Rules will be adapted to provide for a case by case participation of private sector creditors, fully consistent with IMF policies.
In all cases, in order to protect taxpayers ‘money, and to send a clear signal to private creditors that their claims are subordinated to those of the official sector, an ESM loan will enjoy preferred creditor status, junior only to the IMF loan.
For countries considered solvent, on the basis of the debt sustainability analysis conducted by the Commission and the IMF, in liaison with the ECB, the private sector creditors would be encouraged to maintain their exposure according to international rules and fully in line with the IMF practices.
In the unexpected event that a country would appear to be insolvent, the Member State has to negotiate a comprehensive restructuring plan with its private sector creditors, in line with IMF practices with a view to restoring debt sustainability. If debt sustainability can be reached through these measures, the ESM may provide liquidity assistance.
In order to facilitate this process, standardized and identical collective action clauses (CACs) will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro area government bonds starting in June 2013.
Those CACs would be consistent with those common under UK and US law after the G10 report on CACs, including aggregation clauses allowing all debt securities issued by a Member State to be considered together in negotiations.
This would enable the creditors to pass a qualified majority decision agreeing a legally binding change to the terms of payment (standstill, extension of the maturity, interest-rate cut and/or haircut) in the event that the debtor is unable to pay.
We restate that any private-sector involvement based on these terms and conditions would not be effective before mid-2013.
This formulation changes everything.
Indeed, if a country were to go from the liquidity crisis state to a crisis of solvency, after an evaluation by the IMF, the EU and the ECB, all it would take is for a majority of creditors to establish a restructuring process "allowing all debt securities issued by a Member State to be considered together in negotiations".
As such, debt issued before 2013, including current government bonds, will thus be concerned by the facilitation of restructuring allowed by the establishment of these CACs.
And private investors must consider that the ESM and the IMF will be setting the terms of conditions of any such restructuring, as they will have been the lone lenders in the first step ‘Liquidity crisis’.
I would be interested to know how they will be able to vote on the conditions of a restructuring plan when they are themselves considered senior debt holders ("ESM loan will enjoy preferred creditor status, junior only to the IMF loan") and will thus benefit from more favourable treatment than that of private-sector investors for whom they will have to decide with what sauce they will be eaten.
All this goes against the hopes that these statements were supposed to have raised, thus heightening investor confusion, with only one sure consequence.
Given the current state of legislative proposals, no private-sector investor will ever again participate in any eurozone government debt issue on which he has the slightest doubt, with the "unintended consequence" that the distressed eurozone countries will find themselves under permanent perfusion by the ESM.
And if there is any value in the Eurogroup statement, it is in the last sentence ("any private-sector involvement based on these terms and conditions would not be effective before mid-2013").
This looks more and more like a free lunch for the short end of the yield curve (below that of June 2013) of peripheral nation debt.
As such, I remain very much open to explanations on the matter of Greece's August 2012 debt issue which, with a price of 88.40, a coupon of 4.1, at a total of €7.84bn, continues to yield an effective rate of 11.90%, especially since Greece should benefit from a 4.5 year extension on its aid plan, based on European Commissioner Olli Rehn's comments.
Disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds, Thaler's Corner.
