New Greek Deal Is A Black Hole For ECB, Not A 'Ring Fence'

by: Jonathan Bernstein

As widely reported, the ECB has tried to “ring fence” itself from potential losses if Greece restructures its debt. Assuming the deal gets implemented as planned, the ECB will exchange its Greek debt holdings for new debt that will be repaid in full, while private sector bondholders of the same debt issues will get, as of this writing, about 46.5 cents on the euro.

The deal might well enable the ECB to escape losses on Greek debt in the short term. But in the long term, this deal will force the ECB to provide more support to PIIGS countries, than would otherwise have been the case. That’s where the black – or blacker – hole will be.

Before this deal, the universal rule was that all holders of a given series or class of debt receive equal treatment in a restructuring, unless one of them actually transfers new money to the debtor (which ECB did not do; the deal rolls over existing debt so Greece can “pay” the debt that comes due next month). By discriminating so blatantly against private investors, the ECB has ensured that going forward, the ECB will become even more the buyer of only resort for PIIGS sovereign debt.

To see just how damaging this deal is, let’s consider how investors in distressed debt actually think. Assume we have a company or country that has some predictable cash flow stream, but the debtor owes more than it can repay. Job One for the potential investor is to determine, how much debt of each lien (senior, subordinated, and so on in the capital structure) that ongoing cash flow can support.

In restructuring, you assume that debt will be written down to sustainable levels, so from there you can estimate what the payout should be for each class of lender when the debtor restructures. Allow for expenses of the bankruptcy, estimated wait time for the payout, and a cushion for uncertainty. Then apply your desired rate of return and see what you might bid for such bonds.

But once you assume that ECB will be untouched in any PIIGS restructuring, that will leave decidedly less for other bondholders. Therefore, future potential investors in the debt of any PIIGS country will factor in the ECB’s de facto seniority above that of all other creditors and drop their bids accordingly. Moreover, after a drubbing like this, private sector investors may fear that the Troika could come up with other ways of separating them from their cash, leading private capital to doubt that euro bond risks can be estimated at all. Under that line of thought, one can expect private investors to just stay away.

This is exactly what the Germans say they don’t want. The Germans know all too well what hyperinflation looks like, so Article 123 of the Lisbon Treaty prevents the ECB from supporting governments, since that smacks of money printing. If the ECB forgave a portion of the debt owed by Greece, that forgiveness would could count as direct support. Which is why the current deal precludes debt forgiveness by the ECB.

But now ECB will buy even more PIIGS debt (and print more euros) than it would have without this deal; it will just do so indirectly. Which will eventually make Germany unhappy, since the Bundesbank has the largest percentage ownership share of the ECB.

Even more than before, the only natural buyers for PIIGS debt are the commercial banks domiciled in the respective debt issuing countries. That is, the principal buyers for Italian debt will be Italian banks, and so on. If Italy restructures, for example, its banks will hold distressed sovereign Italian paper anyway, so they might as well play along for now

And how will the banks pay for the new bonds? Well, they will continue to borrow from the ECB via Long-Term Repurchase Operations (LTRO). So ECB support for PIIGS sovereign debt will be even more entrenched; but this way Angela Merkel can tell her constituents that ECB is living up to its mission by lending to banks not countries. Her taxpayers won’t send one euro to those deadbeat Greeks!

For the record, ECB owns about E 219 billion of peripheral countries’ debt. But as LTRO outstandings grow, what could stop the ECB from deciding that sovereign bond collateral held by commercial banks and pledged to LTROs, might also become senior to bonds owned by private investors? Nothing that I can see.

In the long run, this ploy will be bad for the euro (lower international private sector inflows, for starters), but since investors already know about LTRO, it’s hard to know how much of that effect has already been priced in. In sum, this deal might be one more reason to short euros when they bounce, assuming you can navigate the daily headline noise; the gold market seemed to like the deal today as well. No surprise there.