Monday, January 16, 2012

Sovereign debt write-downs and what makes central banks safe

ZeroHedge has been running a number of excellent posts discussing the Greek sovereign debt situation.

As Tyler Durden predicted, banks have been selling their Greek sovereign debt exposure to activist hedge funds.  In turn, these funds are trying to use their holdings to block a write-down and extract better terms.

Tyler raised the issue of what happens to the ECB's 40+ billion holdings of Greek sovereign debt.  Are these holdings going to be subject to a write-down or do they become senior to all other debt holders.  If the latter, naturally, this will depress demand for sovereign debt of other troubled countries.

However, and this is a big, however, does the ECB actually need to have its holdings made senior to other countries?

In an earlier post, UBS discussed how the ECB has a couple of items going for it that make it different than any other investor.  First, it has no cost of carry.  Second, it does not need to write-down its investments to market value.

What does this mean for Greek sovereign debt?

Imagine that Greek sovereign debt is written down to 20 - 30% of par value.  Now assume that the average yield on the Greek debt to the ECB is 5% and the average discount from par is 10%.

If the debt is written down to 20, the ECB would have an 'unreported loss' of 70 - (100 par - 10 discount - 20 new value) since the ECB does not market its investments to market value.

On the remaining 20, the ECB would continue to earn interest with no offsetting interest expense.

Assuming the ECB can rollover this debt at 5% at maturity into new Greek debt, in 70 years, the ECB will have recouped its investment and suffered no loss!

Obviously, the time it takes to recoup its investment drops if the initial haircut is not as large.

The fundamental point I am making here is that there is no reason that the ECB needs to become senior to other debt holders.  In fact, if the ECB were to really get involved in a sovereign debt restructuring, it might push for a larger write-down and far longer maturity than the other debt holders might prefer!

If the ECB did become involve, it is possible that the headline would read "ECB leads cram-down on hedge funds".

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