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One of the biggest problems European leaders face right now in alleviating the euro crisis is being overlooked amid all of the excitement about the ECB’s expected September 6 announcement to support troubled eurozone nations by buying their government bonds.The ECB has to give up seniority on their bond purchases in order to coax private investors back into the market again, but if it does, it will alienate German taxpayers who are ultimately footing the bailout bill in the first place, and that may mean there will be no more money for future financial rescues going forward.
This leaves the ECB and the eurozone’s EFSF/ESM bailout funds in a damned-if-they-do, damned-if-they-don’t sort of situation.
It’s good to get a handle on the basic arithmetic underlying the issue, because it really crystallizes the debate.
SocGen’s head economist Michala Marcussen explained in a note to clients today how seniority comes into play in the event that a country like Spain or Italy defaults on its debt:
Assume a government needs to reduce its total debt by applying a haircut (HC) of 50% to put public finances back on a sustainable path. If all debt is government bonds and there is no seniority, then this entails a loss given default (LGD) of 50%. If 20% of the debt is held as senior (S), then to obtain a 50% debt reduction, a loss of 50% / (1-20%) = 62.5% must be imposed on the private government bondholders.
LGD = HC / (1-S)
So, the more bonds the ECB, EFSF, and ESM buy with seniority, the more they will scare away private investors and make troubled eurozone governments permanently dependent on ECB/EFSF/ESM support.
The market should find out soon what European leaders will decide regarding the seniority issue – ECB President Mario Draghi reassured at the central bank’s August 2 meeting that “the concerns of private investors about seniority will be addressed.”
If the ECB does give up seniority and alleviates investor fears, it will support markets in the short term, but it could get really complicated really fast if those countries – who, to many, have unsustainable amounts debt – have to restructure.
The EFSF and ESM might even have to backstop the ECB against losses the central bank would take on a debt restructuring, according to Marcussen. That kind of thinking highlights the circularity and confusion in Europe at a time when the exact opposite – the ECB backstopping the ESM by granting it a banking licence which would allow it to borrow from the ECB – is also being proposed.
So, if the ECB/EFSF/ESM do give up seniority on future bond purchases, Marcussen is concerned that “both the willingness to support future financial assistance programs and popular support for the single currency would suffer,” and that while lowering the losses private investors would face, “the absence of seniority could increase the probability of default in the medium-term” by troubled countries like Spain and Italy.
Then, all bets are off.
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