Pushing Non-Official Holders of Local-Issued European Debt into Subordination

I spotted some interesting commentary on the maturing March 2012 Greek bonds. After buying at 40-45 cents, it seems the hedge funds are trying to unload in a bidless 35-cent market. The ECB has the largest stake, bought at 70 cents. This official holder’s dominance of this market, and refusal so far to participate in haircuts, is making the whole exercise futile and severely subordinates any potential non-official holder or future buyer of European sovereign debt. Reuters reports that the ECB is split and confused on this issue. The IMF’s LaGarde says, “If the level of Greece’s privately held debt is not sufficiently renegotiated, then public creditors will also have to participate.” Apparently, the IMF was also confused as this was retracted or denied. As I wrote in "Stick it to the Local Issued Bond Holders,” this is one of two serious subordination fiascos, the second being a slew of UK-law non-local  issues that restrict collective restructuring actions (see chart at the “Stick it” link).

The always-alert analyst Simon Johnson writes about this issue in Europe:

“In the event of default (i) any non-official bond holder is junior to all official creditors and (ii) the issuer reserves the right to change law as needed to negate any rights of the nonofficial bond holder.

“We should not underestimate the damage these steps have inflicted on Europe’s €8.4 trillion sovereign bond markets. For example, the Italian government has issued bonds with a face value of over €1.6 trillion. The groups holding these bonds are banks, pension funds, insurance companies, and Italian households. These investors bought them as safe, low-return instruments that could be used to hedge liabilities and provide for future income needs. It was once hard to imagine these could ever be restructured or default.

“Now, however, it is clear they are not safe. They have default risk, and their ultimate value is subject to the political constraint and subjective decisions by a collective of individuals in the Italian government and society, the ECB, the European Union, and the International Monetary Fund (IMF). An investor buying an Italian bond today needs to forecast an immediate, complex process that has been evolving in unpredictable ways. Investors naturally want a high return in order to bear these risks.

“Investors must also weigh carefully the costs and benefits to them of official intervention. Each time official creditors provide loans or buy bonds, the nonofficial holders become more subordinated, because official creditors including the IMF, ECB, and now the European Union continue to claim preferential status.”

The CDS cost on Portugal has blown out to 1350 points, and the 10 year is over 15%, suggesting that it’s exposed in its next financing rounds in May and June. Of course, in a world of gaming the credit insurance rules to avert default so as not have to pay claims and constantly subordinating nonofficial bondholders, one wonders if the hedge funds — let alone banks using LTRO — will be sucked in. About €25 billion in UK-law Portuguese bonds trade out of €104 billion and the ECB hold €20 billon, leaving €59 billion in the hands of local-issue holders, namely Tia Miriam (Aunt Millie) pensions and Portuguese and Spanish banks.

Perhaps anticipating problems ahead, Spain wants the Europe rescue fund to be bigger, thus allowing for even more subordination of non-official holdings. As one can see in my local bond issue article, Spain is a big issuer of  UK-law bonds with €318 billion issued out of €505 billion. Against this condition, the ECB will make available a three-year loan (LTRO) at 1% for insolvent banks with tiny slivers of capital to go speculate on financing European debt.

Barclays estimates the European monetary authority purchased a total of €46 billion in Spanish debt since August, 22% of the total investment of its Securities Market Programme (SMP). Barclays also estimates that Italian debt purchases made up 43% (€90 billion) of the SMP, while Greek debt made up 17% (€36B), Portuguese debt made up 10% (€20B), and Irish debt made up 9% (€19B). In the year prior, the ECB plopped down an estimated €77.5 billion on Greek, Irish and Portuguese debt.

Open Europe’s end of 2011 estimates of ECB portfolio of PIGGS soverign debt exposure.

In addition, after the first LTRO, €832 billion was lent to financial institutions and the ECB has received a massive amount of asset backed securities as collateral in return. Contrary to popular belief, the ECB has already transferred substantial private risk to taxpayer backed institutions, and now there is talk of even more on Feb. 29.

Source: WSJ

There’s not much transparency or detail on the ECB balance sheet, but this is what it looks like at present, €2.7 trillion in assets against €81 billion as capital and reserves, leveraged 35 -1. This is a very large, very bad bank. The second chart shows where the bill is sent for new backing when this thin capital is wiped out. Italy gets 18.4% of the bill and Spain 12.2%. Presumbly, Portugal’s 2.6% contribution gets picked up by the others. Perhaps the ECB can send free rounds of such bills to member states before it loses all credibility and political support, but not for long. At that point, the ECB will be facing Italy and Spain, or worse. In this environment, some are asking for the ECB to increase bond purchases dramatically.

Source: Open Europe

It looks like the Fed is verbally trying to set up the same approach, and both central banks are accepting poorer and poorer sludge and collateral to back its various liquidity schemes. I doubt if financial institutions will do much if anything with this, other than transfer as much risk as possible on to the central banks and then duck. If so, it is nothing more than a social-loss sludge operation.