ECB - Greek debt swap: stake in heart of bond market as opportunity for free lunch missed

A Bloomberg article discussed the rumored debt swap between the ECB and Greece.

According to the article, the ECB exchanged roughly 50 billion euros of bonds that were subject to being written down as a result of the agreement between Greece and the Private Sector Investors for 50 billion euros of bonds with the same interest payments that were not subject to being written down.

If true, this swap is problematic from two perspectives.

First, as the article says

“In Europe, all bond holders are equal, but the ECB is more equal than others, apparently,” said Thomas Costerg, an economist at Standard Chartered Bank in London. “This could set a dangerous precedent, and, by creating a de-facto two-tier market, this could discourage investment in other peripheral debt markets.”... 

Exempting the ECB from a debt restructuring may weaken the euro as it implies a senior status over other investors, Chris Walker, a foreign-exchange strategist at UBS AG in London, wrote in a research report today. 

“The risk of a voluntary restructuring morphing into a coercive one has arguably increased significantly,” Walker wrote. “If this ECB plan goes ahead it may appear that the ECB is receiving preferential treatment, raising questions about whether the ECB is senior to private-sector bondholders, not only in the case of Greek debt, but also regarding the debt of other euro-zone nations that the ECB may be purchasing.”...

In short, this swap is a stake in the heart of the sovereign bond market.

Second, the swap misses the opportunity for Greece to take advantage of the free lunch available when a central bank is an investor.

As discussed over a year ago on this blog and explained by Gillian Tett in her Financial Times column, central banks do not account for investments or have the same goals for investments as other market participants.  This creates what your humble blogger refers to as the opportunity for a 'free lunch'.

Central banks exist to support the financial system; they are not driven by profit motives. Since an institution such as the European Central Bank, BoJ or Federal Reserve can always create more money, “losses” are primarily an accounting issue. 

That point was hammered home by Thomas Jordan, acting head of the Swiss National Bank. 

He recently gave an interview to the FT in which he insisted that there was no need to panic if the Swiss bank temporarily suffered “negative equity” as a result of losses incurred by its bold interventions to weaken the franc. If that occurred, he explained, the central bank could simply rebuild its capital buffers through its normal operations; the central bank could not go “bust”, even amid red ink.

Since losses for central banks are an accounting issue, one needs to look at how a central bank accounts for an investment to see if there has been an accounting loss.

For central banks, an accounting gain or loss is calculated by looking at the total of all interest and principal payments received plus any proceeds from sale of the investment less the cost of the investment.  If the total cash flow is less than the cost of the security, there is a loss.

It is this accounting for investments that gives rise to a 'free lunch'.  So long as the central bank receives enough payments to cover its cost of the investment, there is no 'loss' to the central bank.

The ECB spent approximately 40 billion euros to buy 50 billion euros of Greek debt.  If the ECB exchanged this debt for new debt that would generate 40 billion euros of payments, it would not suffer an accounting loss. [The market value of this new 40 billion of debt would be approximately the same as the market value of the restructured debt after a 70% haircut.]

More importantly, since the ECB does not have a 'cost of funds' to carry an investment on its balance sheet, the timing for the receipt of the payments can be stretched out so that Greek's debt burden is further lightened. [I suspect that the Private Sector Investors would prefer to receive their payments sooner while the ECB should be willing to accept is payments later -- please note this effectively subordinates the ECB to the PSI and justifies the ECB receiving a higher total payout.]

But Jordan’s comments are notable precisely because they are so rare in their honesty; other western central banks have bent over backwards in the last couple of years to avoid discussing the issue in front of voters, even as they engage in novel forms of quantitative easing. 

And in the case of the ECB, its leadership has made strenuous efforts to avoid writedowns on its own sovereign bonds; witness its latest deal with the Greek government designed to provide protection against forced losses on its portfolio of Greek bonds – estimated to have a face value of about €55bn (but which it is thought to have paid about €40bn). 

ECB officials blame this stance on their fear that haircuts might spark investor panic. Some officials also argue that accepting haircuts could be technically illegal, since if the bank suffers a big loss, it would be forced to tap eurozone governments for more funds – and that might breach European Union laws that ban “monetary financing”, or central bank funding of governments. 

But behind these legal technicalities, there is emotion – or bureaucratic instinct – at work too: to many eurozone central bankers, particularly Teutonic ones, the idea that a central bank might lose money seems almost taboo, if not shameful; it undercuts everything that is supposed to make a central bank credible. 

Perhaps this is understandable; trust in central banks, after all, can be fragile. But, the practical consequences of this stance have been profoundly debilitating. 

For one thing, the ECB’s opposition to voluntary haircuts has made it harder to persuade private sector creditors to accept their own voluntary haircuts in any restructuring of Greek debt. 

It has also made it harder to assess any clearing price for Greek bonds and move towards a resolution. 

Indeed, the ECB’s pattern of behaviour has been oddly similar to the US banks during the Latin American debt crisis, as David Beim, a New York economist points out*: time and again, the central bank has avoided crystallising losses, preferring to play for time, in an effort to paper amortise the pain (or hope it goes away.)

Let me propose one more reason for the pattern of behavior.  It allows the banks to continue to mark their holdings of similar bonds to myth.