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Suck it up

10 January 2012 By Neil Unmack

The European Central Bank’s refusal to participate in the big Greek debt swap and take losses on its holdings is looking stranger by the day. It looks increasingly like it might confer the ECB an informal preferred creditor status that would have the unintended consequence of undermining its own bond-buying programme.

The debt swap, a.k.a. “private sector involvement”, is supposedly voluntary in nature, and targets 200 billion euros of privately-held debt. This doesn’t include the Greek bonds on which the ECB spent an estimated 36 billion euros in 2010.

But the central bank’s position that it stand aside is becoming harder to hold. The voluntary debt swap is looking increasingly coercive. Greek and euro zone leaders are hinting at dire consequences if bond holders don’t sign up, and Athens could insert retroactive clauses in its debt to force them to do so, or punish those left behind.

If the ECB is spared, investors will reason that its bonds carry an implicit seniority, adding another layer of subordination onto peripheral sovereign debt. That privileged treatment would then be factored into the yields of Portuguese, Irish, Spanish or Italian debt. Ironically, the more peripheral debt the ECB buys, the more it could erode confidence in euro sovereign debt.

Losses would be limited for the ECB, as it bought debt below par. Assume an average purchase price of 75 cents, and the total loss would be about 17 billion euros, given a PSI haircut of 60 cents. That could be offset by gains on other peripheral sovereign holdings as they mature, so long as Greece’s restructuring is a one-off.

There may be ways of fudging the losses. The ECB could sell its bonds at cost to the European Financial Stability Facility, the euro zone’s bailout fund. But that would use up more of the EFSF’s resources, and a sweetheart deal might anger bondholders. Alternatively, the ECB could take the pain when the second round of restructuring happens, perhaps next year. By then many of its Greek holdings may have matured, bringing down losses.

In any case the euro zone will pay in some form or other. It will need to funnel funds to Greece to repay maturing debt, including the ECB’s. Those loans may have to be extended or written down. ECB or not, a public sector loss looks inevitable.


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