ECB?s role in the PSI+ process

March 20 may not be as significant as March 25, national liberation day in Greece, but it may turn out to an important one if the country fails to secure sufficient funding to repay a 14.4-billion-euro bond expiring on the same date. The pause in the talks on the bond exchange, known as PSI+, should cause concern but may be just another phase in a complex multi-step game where players have different vested interests and strategies. In this regard, dealing with the issue of the European Central Bank free riding PSI+ is important for its success.

For the last few weeks, the government had been expressing optimism it was close to reaching a agreement with its private sector bondholders whereby the latter would accept a 50 percent haircut and receive 15 percent in cash and 35 percent in new 20- and 30-year bonds in exchange for their old bonds. The only unresolved issue was the coupon on the new bonds, according to the government.

The messages from the private creditors? side were not so encouraging. They were saying the two sides were far apart even though the Greek side was ready to accept some of their other key demands, namely that the new bonds be subject to British law instead of Greek law, which meant any legal disputes would be settled in an English court.

Friday?s announcement by the main representatives of the private sector institutions, that their consultations with Greece and the official sector on the voluntary bond exchange had paused, was interpreted by most analysts and others as a worrisome development.

According to them, this development increased the chances Greece may introduce and impose collective action clauses (CACs) retroactively if a certain majority of existing bondholders, i.e. 75 percent, accepted the agreed PSI terms, imposing its will on the holdouts.

However, this approach has a number of problems which are usually ignored or downplayed. The ECB has bought a considerable amount of Greek bonds on the secondary market estimated at between 40 and 60 billion euros. It is the single biggest holder of Greek bonds. Will the ECB vote in favor of imposing CACs on the rest of bondholders to increase the chances that the minimum threshold of acceptance is attained or will it choose to abstain?

Right now, officials claim the ECB belongs to the public sector and will not participate in the PSI, implying it will not show up to vote when and if the assembly is called. However, it will be difficult to get more than 70 or 75 percent or even 65 percent of existing bondholders to vote for PSI without the ECB if it comes down to that.

If one assumes the required majority of bondholders accepting PSI will be achieved without the ECB?s vote, the haircut will apply to all holdouts irrespectively. This means the Greek bonds held by the ECB will have to be subject to the 50 percent haircut and the rest of the agreed terms of the bond swap, most legal experts say. Any attempt to exclude the ECB from the haircut on the basis that it is part of the public sector is certain to be met by law suits by other holdouts claiming discrimination against them, among other things.

In addition to the above complications, the enactment of CACs will most likely be deemed a credit event by the appropriate committee of the International Swaps and Derivatives Association (ISDA), the organization that oversees the over-the-counter market for credit default dwaps (CDS). Readers are reminded that one pays an amount, called the spread, to buy CDS contracts on Greek or other sovereign bonds in hope of either profiting from the appreciation of the spread, a form of speculation, or hedging one?s bond portfolio against a moratorium of payments by the issuer.

The net notional amount in Greek CDS is relatively small, around $3-5 billion, so it is not expected to cause problems when CDS are triggered after a credit event. Therefore there are two risks here. First, a good amount of these CDSs have been written by a few banks which have to compensate the buyers and likely require recapitalization. Second, contagion to other sovereign CDS markets.

However, things may get worse if a voluntary restructuring of Greek debt takes place which is not termed a credit event and CDS are not triggered. This is because the holders of CDS of Italian debt etc. who bought them to hedge their bonds may assume CDS are worthless. This will create a strong disincentive for buying EU periphery bonds since they will not be able to hedge them.

Where does all this leave us? There are a number of private sector participants who believe the threat of Greek CACs has no teeth, at least as long as the ECB — the biggest single holder of Greek bonds — is allowed to free ride and therefore show no strong interest in participating in the PSI. Of course, there are some who do not wish to participate anyway, hoping either to be paid in full at expiration or be compensated when CACs are enacted and the CDS they hold are triggered.

One way to resolve this issue and make Greece?s threat of using CACs be taken seriously is to have the European Financial Stability Facility (EFSF) or Greece buy these bonds from the ECB at acquisition cost, estimated around at 70 percent of the nominal value. This way, Greece could also reduce its public debt by an additional 10-15 billion euros in addition to the 100 billion hoped for from PSI+. Of course, this requires more loans in addition to 130 billion euros from the second bailout package.

So, March 20 is indeed an important day in the Greek calendar but it may turn out to be an uneventful one if the public sector gets its act together and deals with the ECB?s free-riding issue in its Greek bond holdings.

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