The European Central Bank’s willingness to ride roughshod over bondholder rights risks pushing up borrowing costs for indebted governments by making investors less willing to lend.
The ECB swapped about 50 billion euros ($67 billion) of Greek bonds for new securities, identical to the old ones in every way save for identification numbers. The switch makes the ECB senior to other investors, exempting it from the largest sovereign restructuring in history as Greece rewrites the terms of its notes to ensure lenders forgive 53.5 percent of the debt.
“Bondholders are effectively being subordinated every time the ECB gets involved -- not legally, but economically,” said Saul Doctor, a credit strategist at JPMorgan Chase & Co. in London. “Foreign investors are going to be less willing to buy sovereign bonds when the ECB can exert itself.”
The ECB has immunity to the losses imposed by the bond-swap plan, designed to trim Greece’s debt burden by 106 billion euros and enforced by the threat of retroactive collective action clauses that prevent holdouts. Greek 10-year yields are almost 35 percent, valuing the securities at 20 percent of par, after Standard & Poor’s yesterday cut the nation’s debt rating to “selective default.”
“They’ve thrown away the rulebook of crisis resolution,” said Gabriel Sterne, an economist at London-based brokerage Exotix Ltd. “It’s a cynical move that will affect the world for years to come and they did it because they can get away with it. It’ll push up costs for other stressed sovereigns so they’re shooting themselves in the foot.”
The cost of insuring sovereign bonds against default has risen, with the Markit iTraxx SovX Western Europe Index of credit-default swaps on 15 governments at 344 basis points, up from 318 on Feb. 7 and approaching the record 385 set in November.
The International Swaps & Derivatives Association’s determinations committee has been asked whether credit-default swaps linked to Greek bonds have been triggered because the deal with the ECB gives official bondholders “a change in the ranking in priority of payment,” according to the group’s website.
The ECB said today Greek debt will temporarily be ineligible as collateral for loans after the S&P downgrade. The central bank said it will resume taking the securities once a 35 billion-euro guarantee scheme agreed by European governments comes into force in mid-March.
Investors are concerned the Greek restructuring may prove to be a blueprint for other countries. Yields for Portugal, which also required an international bailout, have risen every day bar three since Feb. 14. Its 10-year notes are yielding 12.78 percent, up from 11.9 percent on Feb. 13, the day Moody’s Investors Service cut the nation’s rating to Ba3 from Ba2. The rating is now three levels below investment grade.
More downgrades may come as ratings firms recalibrate their grades now that Greece has prioritized repaying the ECB over meeting its obligations to other lenders, said Michael Riddell, a fund manager at M&G Investments in London, which oversees about $323 billion.
“If people are more subordinated than was thought, then you’d expect some rating action,” said Riddell. “The ratings agencies have been miles behind the market during this debt crisis. They’ve been very slow to downgrade the euro zone sovereigns, so now that sovereigns are becoming subordinated, we should eventually see some action on the back of this.”
The ECB’s bond exchange with Greece shows how documentation of securities governed by local law can be changed to introduce clauses that reduce investor protection. Private creditors now risk losses both from the likelihood of imposed writedowns and from effective subordination by official lenders, according to Stuart Thomson, who helps oversee $121 billion at Ignis Asset Management in Glasgow.
“It’s the subordination of capitalism,” he said. “Governments raise money to grow their economies. If that fundraising is subject to governments changing the rules as they see fit, then that’s a subordination of the capitalist system.”
It costs a record $7.3 million upfront and $100,000 annually to insure $10 million of Greek debt for five years. That signals a 94 percent chance of default within that time, based on investors recovering 22 percent of their money.
Greece and Portugal are now the world’s most expensive governments to insure, topping Pakistan, Argentina, Ukraine and Venezuela. Developed sovereigns may be treated more like emerging markets in future because investors will demand bonds be issued under international law rather than the issuer’s domestic law, according to Doctor at JPMorgan.
The ECB also has subordinated bondholders of euro region banks with its three-year longer-term refinancing operations, the second of which starts today. The central bank lends against collateral, meaning that in a default creditors will be left with fewer assets to satisfy their claims.
That may not matter as long as the ECB is willing to step in and buy government bonds when yields reach unsustainable levels, said Jim Reid, a strategist at Deutsche Bank AG in London.
“Bondholders have to be slightly careful what they wish for,” he said. “If the ECB wasn’t buying, if there wasn’t official involvement, those countries couldn’t fund at all. It’s better to be subordinated than to not have them buying bonds.”
Italian 10-year bond yields have declined to 5.35 percent from the euro-era closing high of 7.26 percent they reached on Nov. 25. Spain’s 10-year notes now yield 5 percent, down from the 6.7 percent euro-era record close they reached on Nov. 25.
A refusal by government agencies to accept losses on the government bonds they hold may make it harder for countries to resume borrowing directly from investors on the global capital markets, according to S&P. It may also make the ECB’s purchases of bonds on the secondary market less effective, according to the New York-based rating company.
“Investors may worry that additional ECB bond buying will inevitably lead to further subordination of investors’ positions,” S&P said in a statement. “In extreme circumstances, yields could even reverse if concerns about effective subordination were to outweigh the effect of the ECB’s additional demand for sovereign debt.”
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