The European Central Bank’s End Gam(e)bit

The ECB changed the rules of the game by swapping their bonds with new Greek bonds, the swapped bonds eligible to bypass the necessary haircut that private bondholders will need to eat through the Private Sector Involvement. Getting to a Greek bailout may happen, but this now subordinates sovereign bonds for all other Eurozone countries. This signals to PIIGS that this Greek “bailout”, or rather, a final gambit for banks to cash in before the storm comes, is a one off. Once Credit Default Swaps are triggered, it will signal for other sovereign bondholders to dump their holdings since as the endgame has come.

The new ECB Greek Government bonds will not be forced under the Collective Action Clause which may cause all private bondholders to take a % haircut, a write down of their bond values. The ECB has subordinated all other private bondholders, and in a move to make their bonds safe from the CAC. They have essentially skirted the rules to get around the CAC as to not take a loss on their bonds, protecting Eurobankers’ bonuses, and will have to slot in the CAC on private bondholders as a retroactive implementation. The ECB made these decisions unilaterally, writing their own rule book. The private bondholders bought their bonds in 2009, 2010, but Greece will pass a law making those bonds retroactively subject to the CACs. There is a bit of unknown as to whether this will stand in Greek courts, and if someone challenges the ruling and the CACs cannot be implemented then this will obviously mean a default since hedge funds hold a certain percentage of those bonds which had been sold off in the past few months. Without the CACs the PSI will need 100% of bondholders to agree to the haircuts and the hedge funds are in a prime position. These hedge funds bought credit default swaps, betting that Greece will default and they will cash in if the move for CACs fails.

Bloomberg reported on the ECB bond swaps on February 17, 2012;

The ECB will exchange its Greek debt for new bonds with an identical structure and nominal value, though they’ll be exempt from so-called collective action clauses the government is reportedly planning. That implies senior status for the ECB over other investors, according to UBS AG, and the use of CACs may lead to credit-default swaps protecting $3.2 billion of Greek bonds being tripped.

“It may appear that the ECB is receiving preferential treatment, raising questions about whether the ECB is senior to private-sector bondholders,” according to Chris Walker, a foreign exchange strategist at UBS, the world’s third-biggest currency trader. “If a coercive default does indeed eventually take place then a CDS event seems very likely with all the negative consequences for risk appetite that may bring.”

Subordination of other bondholders behind the central bank is a problem “not only in the case of Greek debt, but also regarding the debt of other euro-zone nations that the ECB may be purchasing,” London-based Walker wrote in a report. The ECB’s plan “will likely lead to euro weakness,” he wrote. Still, it’s “a sign of progress toward an eventual Greek debt restructuring.”

Greece will introduce legislation next week that may allow CACs that force bondholders to accept debt writedowns, Naftemporiki reported. Swaps on Greece may be trigged if the CACs are used because all investors would be bound by a majority agreement to accept a proposed debt restructuring.

“One of the basic principles of bond markets is you cannot impose subordination on a particular set of bondholders,” said Padhraic Garvey, the head of developed-market debt at ING Groep NV in Amsterdam. “The probability of triggering CDS has increased because the ECB has protected itself.”

ECB officials previously rejected the possibility of a credit event triggering swaps, arguing it would encourage traders to bet against indebted nations and worsen the crisis.

The introduction of the clauses doesn’t in itself trigger default swaps, though using them does, according to rules of the International Swaps & Derivatives Association. David Geen, ISDA’s general counsel, declined further comment.

Credit events that trigger swaps can be caused by a reduction in principal or interest, postponement or deferral of payments, or a change in the ranking or currency of obligations. Any of these must result from a deterioration in creditworthiness, apply to multiple investors and be binding on all holders. ISDA’s determinations committee rules whether contracts can be tripped.

“If indeed this maneuver is intended to protect the ECB from forced losses, then the risk of a voluntary restructuring morphing into a coercive one has arguably increased significantly,” UBS’s Walker wrote. “A private-sector bondholder that has been suddenly and unexpectedly subordinated may have a reduced incentive to continue to hold onto that debt.”

As usual, Zero Hedge reveals the reality behind the circus, telling of bond subordination’s impact;

How this will impact the sovereign bond market in the long run is anyone’s guess, but it will hardly be positive. Especially when one considers that going forward even bonds issued under UK-law, should Greece attempt to strip these, will be percevied as insufficiently secure. Which means that the bond market going forward will no longer look at new sovereign bond issuance with the view that all bonds are created equal and have a pari passu standing, but that at any given moment one may be primed arbitrarily, or see any and all covenant protection stripped.

…one thing we are sure of: if the runaway central planners of the world believe they can legislate their way into an ‘upper hand‘ over the bond market, in ever more desperate attempts to avoid the day of reckoning, they will fail without any shadow of a doubt. Because demand for risk comes first and foremost from a sense of stability, of fair and efficient markets, and equitability: something which has long been missing in the stock market, and which may very soon be taken away, by force, from the bond market as well.


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