Friday, February 17, 2012

17/2/2012: ECB Swap Creates a New Structure of Seniority

This week marked a significant point of change in the very fabric of the fixed income markets. On Friday, the ECB announced that it has completed the swap on the old Greek bonds it held on its books for new bond.

The ECB swap in effect exchanged old Greek bonds for bonds of identical structure and nominal value, implying that the ECB has received the full face value of the bonds it has purchased in the markets at the discount on the face value. The ECB will also not forego the coupon payments due on the bonds, implying that over time, ECB will book profit from its purchases of Greek bonds. It is worth noting that this is based on the reports in the media, citing various official sources. The ECB has no inclination of clarifying any details of the transaction.

The ECB also precluded National Central Banks (some of which do hold Greek bonds) from participating in the swap. However, the ECB has signaled that it might (again, no commitment or compulsion) distribute the profits earned from the Greek bonds purchases to the national central banks of the countries contributing to the bailout.

Currently, the ECB holds some €219.5 billion worth of sovereign bonds (primarily those of PIIGS states) that it has began accumulating since May 2010.

The greatest significance of today's swap is not, however, in the fact that the ECB is likely to make a tidy profit from its operations designed to help Greece. No, the real significance is that in one step, the ECB has completely re-shaped the seniority structure of sovereign bonds issued by all of the euro area governments.

Before the swap, the seniority of bonds was established under the bonds terms and conditions alone, implying equal treatment of all bondholders, with any variation in sovereign bonds security arising from any potential (and highly costly and uncertain) court actions by investors against the sovereigns. Now, the structure has ECB as the holder of the Super Senior bonds with ECB seniority imposed over and above all other bondholders.

In addition, by not bringing into the swap National Central Banks, the ECB threw open the possibility of another sub-tier of seniority emerging over time. In the case of imposition of Collective Action Clauses by Greece or any other sovereign, such clauses will automatically imply non-zero probability of a loss on bonds held by the NCBs. Arguably, they too might follow the ECB line and demand, collectively or separately (as Germany, the Netherlands and Finland are currently already doing) that their holdings of bonds should also be exempt from such a clause. This means that ECB swap opens up a possibility of a new tier of security forming - the tier subordinated to Super-Senior ECB holdings. This can take a form of a Senior tier or Senior Secured tier (if collateral or other security arrangements are put in place, e.g. some sort of an escrow account etc).

The unknown at this stage is the issue of seniority of non-euro area sovereigns holding euro area government bonds. In particular - will China and Japan, the US and Australia etc demand some sort of Senior or even Super-Senior seniority now that the ECB has elevated itself to the level of IMF?

This means that any private investor in Government bonds (note, these are themselves senior to special Government-issued bonds, such as postal certificates, domestic savings bonds etc) is now left a holder of the Junior or Subordinated bonds, despite the fact that on the 'box' the bonds are identical to those held by the ECB, NCBs, Foreign Governments, etc.

The entire market for euro area bonds is now wholly mispriced when risk-return relationships are concerned. Just like that, in a blink of an eye, the European system destroyed legal and financial order and undermined private property rights.

Note: The above arguments are taken from the simple investment risk perspective. Legal perspective is yet to be defined and I welcome any comments on this and/or links to it.


artied said...

Does this mean that the ECB has been learning lessons from the Irish Goverment which broke new ground 2 years ago with retrospective legislation which changed the ranking of creditors with its innovative 'Liablity Orders'.

It is going to get very hard to price debt when it seems that when the going gets tough the tough change the 'going'....

Not so much kicking the can down the road as taking your ball and going home....if you can pardon the mixed metaphor

Anonymous said...

Eh Nothing changed today, this happened when TFEU Art 125 came in as that is what is at issue. Greece, like Ireland, is subject to EU law which overrides domestic law. Greece, like Ireland, cannot force either the Union or other Member States to assume the liabilities of its Central Government.

This clearly cannot apply to other CBs outside the EU since it is based on EU law.

Just because an EU Member State never defaulted before does not mean that we can ignore EU law when it comes to structuring any default.

Just because commentators never bothered to review EU law on this doesn't mean that the law was changed today.

Draghi was clear in the press conference last week that he was happy to pass any profits back to Governments via CBs for them to pass the benefit back to Greece, but he was equally clear that the ECB cannot take losses, and that any profits have to be shared with the shareholders pro rata their investments in the equity of the ECB.

Anonymous said...

Previous comment hits the nail on the head. It is also clear that Draghi intends bringing bond buying by the ECB to a halt (which should please the Bundesbank).