Monday, February 20, 2012

Subordination by the ECB is a done deal

Well, it looks like the subordination of sovereign Eurozone debt held outside the ECB has become reality.
Bloomberg: The Frankfurt-based ECB is exchanging its Greek bonds for bonds of an identical structure and nominal value, the only difference being that they would be exempt from so-called collective action clauses, the officials said late yesterday on condition of anonymity. One said the bonds have a face value of about 50 billion euros ($65 billion). An ECB spokesman declined to comment. Giorgios Zanias, chairman of the Council of Economic Advisors to the Greek Finance Ministry, didn’t respond to calls to his mobile phone.
The only thing right now that distinguishes the Greek bonds held by the ECB from the rest of the bonds is a different ID number on the certificates. But a much greater distinction will appear should the Greek government - via a legislative action - impose "collective action clauses" on the bonds NOT held by the ECB. Now the universe of bonds to be written down by some 70% is smaller and the existing bond holders can force the holdouts to accept the deal. But only the non-ECB bonds will be exchanged with such a large haircut. The ECB's holdings have effectively become a senior claim.

It is now clear that some institutions in the Eurozone are indeed "more equal than others". At stake is not simply the €50bn face value of Greek bonds. It is some €220bn of other Eurozone sovereign bonds held by the ECB (and other debt it is yet to purchase or take in as collateral) that have become de facto senior to any bonds held outside the central bank. The Greek bond exchange by the ECB has established a precedent. Now the more bonds the ECB buys the more subordinated the other holders become.

Typically corporate bond holders are concerned that incremental debt that is pari passu with their holding or worse yet senior to them is issued by the company, pushing their claim down in size, priority, or both. Many bond indentures limit or even prohibit such additional debt encumbrance. Now imagine that investing in sovereign debt will now require constant monitoring of the size of the ECB's holdings to see just how subordinated the non-ECB portion of the claim is. The bigger the portion the ECB holds, the greater the risk on the non-ECB bonds, and potentially the higher the yields as well. Yet after all this, the ECB will still need to figure out how to deal with the new Greek bonds it now holds. It is a poor policy decision by the ECB and will have negative repercussions for sovereign debt markets in Europe even before the subordination by the ESM becomes a major issue.
WSJ: Some policymakers are also afraid the plan could alienate investors. The head of Germany's Bundesbank, Jens Weidmann, voted against the proposal, according to a person familiar with the matter.

"It has always been slightly implicit that the ECB wouldn't be treated like other bondholders. Now it's explicit that they will be super-senior to everyone else," noted Lyn Graham-Taylor, a fixed income strategist at Rabobank International.

Richard Kelly, head of European rates and foreign exchange research at TD Securities, also points out that if the ECB is seen buying government bonds at times of stress, yields on these bonds may actually rise.

"If the ECB is in the market buying bonds, with the subordination of investors to the central bank, the actual losses will be distributed over a smaller pool of bonds, giving investors even larger losses."
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