Will the ECB Take a Haircut?

It appears that over the past 24 hours or so, the ECB has come under pressure to participate in Greece's PSI. Reports that the IMF were pushing for this has quickly been denied. The ECB has also formally rejected participating. Nevertheless, Dallara, representing private sector creditors, is insisting that all creditors, private and public, share in the adjustment.

We have written about the thorny issues raised by the ECB's bond purchases, leaving aside the objections that led to the resignation of both Weber and Stark. The more the ECB buys, while refusing a haircut, the greater the haircut on the private sector is required to voluntarily take to reduce Greece's overall debt burden to what the IMF says is sustainable, which appears to be 120% in 2020.

On one hand, the ECB sovereign bond purchases provides some liquidity to the private investors who want to get rid of their exposure and improve the transmission mechanism of monetary policy (or so claim ECB officials). On the other hand, their claim to senior status (first to get their money back, not participate in PSI) dilutes other investors. The legal basis of the ECB's claim for preferential treatment seems elusive and done largely claimed by fiat.

However, it would be surprising to see the IMF lead this charge. If the ECB's claim to be excluded from the PSI is rejected, why should senior status of the IMF and EU be accepted. Dallara seems to want the entire public sector to participate, which would make the haircut in the private sector less onerous and speaks to the principle of fair treatment among creditors.

There is a lack of transparency in the ECB purchases/holdings. It is not clear the among of Greek bonds the ECB owns or the price it paid. The general estimate is that the ECB holds 40-60 bln euros of Greek bonds that it bought at around a 25-30% discount.

There are a number of proposals for the ECB to sell its Greek bond holdings. Some suggest the ECB could sell its holdings back to Greece (with money borrowed from the EFSF) at cost, allowing Greece to retire that debt).

Market News International reports that there are discussions within the ECB to allow the national central banks that may have bought Greek bonds before the ECB's program to accept haircuts, as a compromise position.

While the ECB formally demands full repayment, since it bought the bonds at a discount, it could take some haircut notional and still be kept whole. The IMF, however, is less likely to accept a haircut, as it would likely fear the precedent.

The ECB's hand though could be forced if there is a credit event, a non-voluntary debt restructuring. Under such conditions, it would be more difficult to show some bond holders (ECB) preferential treatment over other holders of the same bond. This warns of potential knock-on effects of a hard restructuring.

The US Federal Reserve and the BOE bought largely their own government bonds in their QE operation. The ECB's balance sheet has exploded nut not with high quality assets/exposures. The sovereign bonds it has purchased seem largely distressed assets. It continues to broaden the collateral it is willing to accept. The quality of its balance sheet is a cause of concern in some quarters. The ECB critics warn that it is at risk of becoming a "bad bank". A haircut would likely require it to be recapitalized by the member banks.

Until now it has been the creditor countries, especially Germany, that has been opposed to ECB bond buying. If the ECB does not participate in the haircut in Greece, maybe other peripheral countries begin asking the ECB not to do them any favors. With friends like that...