ESM, just like the IMF, will force bond holder subordination

Looking through the statement made by Standard and Poors on Friday, one paragraph stands out.

Standard and Poor's: As we noted previously, we expect eurozone policymakers will accord ESM de-facto preferred creditor status in the event of a eurozone sovereign default. We believe that the prospect of subordination to a large creditor, which would have a key role in any future debt rescheduling, would make a lasting contribution to the rise in long-term government bond yields of lower-rated eurozone sovereigns and may reduce their future market access.

This statement points at the crux of the issues faced by the eurozone bondholders - the risk of becomig subordinated.  But wait, wasn't the concept of "subordination" off the table in the last round of discussions?

It is not easy to assess exactly what is the latest agreement, given the numerous iterations of various negotiations in the eurozone. One thing that has always been clear is that Germany viewed any support provided by the (yet to be formed) European Stability Mechanism (ESM) to a member state of the eurozone as requiring private investor "participation".  In their view private investors had to agree to some form of a "haircut" before ESM provides a loan to a troubled state or take further losses in a default before any losses accrued to ESM. That concept is often described as "private investor subordination".

Reuters (May 25th, 2011): "We have decided on a long-term euro mechanism. And for Germany it is of existential importance that it foresees private sector participation in the event countries are judged insolvent," Merkel told a party conference of her Christian Democrats (CDU) in Berlin.

And the idea of private investor participation was indeed written into the original ESM proposal.

The ESM Term Sheet: An adequate and proportionate form of private-sector involvement will be expected in all cases where financial assistance is received by the beneficiary State. The nature and extent of this involvement will be determined on a case-bycase basis and will depend on the outcome of a debt sustainability analysis, in line with IMF practice, and on potential implications for euro-area financial stability.

Since then, Merkel kept bringing up this concept of "IMF practice" or "IMF rules". So what does it mean to have the ESM consistent with IMF practice?  Let's take Ireland as an example. There is no question that the current holders of Irish government bonds have become subordinated to the IMF.

ISDA: On 18 January 2011 the first drawdown (5.8B EUR) of the IMF loan to the Republic of Ireland occurred (see http://debates.oireachtas.ie/dail/2011/01/20/00067.asp under Point 78). The IMF certainly enjoys de facto preferential creditor status in accordance with its status as an International Financial Institution and the IMF has claimed preferential creditor status with regards to their loan to the Republic of Ireland – see the press conference transcript (http://www.imf.org/external/np/tr/2010/tr120210.htm) and the pg 100 of the IMF report (http://www.imf.org/external/pubs/ft/scr/2010/cr10366.pdf).

In the event that the Republic of Ireland is unable to meet its financial obligations at some point in the future no one denies that the IMF loan will be repaid first or that bondholders will not receive scheduled payments if the IMF loan is in arrears. From a practical perspective the existing Irish bonds have become subordinated to the IMF loan.

ESM in its original form can not buy bonds in the secondary market and has limited ability to participate in the primary markets. It's only approach would be to provide loans to sovereign governments in a fashion similar to IMF and become senior to the bond holders.

This version of ESM is certainly not giving sovereign bond investors a great deal of confidence. Imagine a scenario where Italian bond auctions fail. ESM would step in with a loan to Italy with a prerequisite that existing bond holders take a haircut negotiated with the Italian government in a debt restructuring process.  Now if you are one of those bond holders, you would be facing the Italian government and the ESM backed by Germany and France.  What are your chances of getting a fair deal? We see how well negotiations are playing out in Greece, even with investors agreeing to a 50% haircut and no ISM involvement.

As Europe came close to the brink in autumn of last year, it became clear that the "IMF approach" for ESM needs to change.  After a set of rapid fire negotiations between France and Germany it looked like Germany will indeed capitulate.

The Guardian (Dec 5th): In a major concession from Merkel in what was otherwise a German-inspired package, the leaders agreed that private investors in eurozone debt would not be forced to accept losses in the event of a default, with the exception of the case of Greece, where "haircuts" for the banks and private investors in Greek debt were agreed last July.

In an unexpected move, Berlin and Paris also called for the eurozone permanent bailout fund, the European stability mechanism, to be launched next year rather than in 2013 as previously planned. The Franco-German package is to be turned into a formal joint proposal to be handed to Herman Van Rompuy of Belgium, who is chairing the EU summit on Thursday and Friday. It falls to him to twist arms, and to get the rest of the EU and eurozone to support the package.

The talk was that the facility would only cover newly issued bonds of the eurozone members. Nevertheless ESM now looked more like a true bailout fund, a bazooka, rather than another IMF. The French Prime Minister Francois Fillon went on television the day after to say that "a decision was made by Merkel and Sarkozy that was critical, yet wasn’t sufficiently explained ... Germany agreed to give up the participation of the private sector, private investors, in case of sovereign debt restructuring.”  That's clear enough.  But German officials fired back the same day:

Bloomberg (Dec 6th): Germany rejected comments by French Prime Minister Francois Fillon that Chancellor Angela Merkel agreed to drop demands on investors to accept losses in any sovereign default, saying that International Monetary Fund rules will ensure private-sector involvement.

“We only made it clear that the kind of [private investor participation] you had with Greece is an extreme case that won’t be repeated,” Steffen Seibert, Merkel’s chief spokesman, said by text message late yesterday. So-called collective action clauses “will stay, so the investors will only encounter risks in Europe that they already know from everywhere else in the world.”

By "everywhere else in the world" Germany was insinuating that even after the new treaty, the ESM facility will not be taking a haircut side by side with the bond holders in case of a default, and instead operate like the IMF. But with the news of a potential new eurozone treaty, the markets had since shrugged off this comment, as Italian and Spanish bond markets stabilized.  The recent noise around negotiations with Greece has also drowned out any unresolved problems with ESM. That is until the S&P downgrade raised the issue again. As the structure of the new eurozone treaty emerges in the months to come, the ESM true status will become more clear.  But for now we are back at square one with ESM following the "IMF rules", which clearly (as in the case of Ireland) lead us to the concept of creditor subordination.


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