Sovereign debt restructuring: The cost of abandoning equal treatment
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Sovereign debt restructuring: The cost of abandoning equal treatment

The ECB doesn’t have to take the same losses on Greek debt as the private sector – but it should.

The Institute of International Finance’s principles for stable capital flows and fair debt restructuring set forth an approach to voluntary negotiations between distressed borrowers and their creditors based on transparency, dialogue, good-faith negotiations and equal treatment.

In the wrangling over the extent of private-sector debt forgiveness needed to return Greece’s finances to a sustainable path, one must wonder how much good faith has been shown and how much transparency. Certainly the principle of equal treatment of creditors was jettisoned very early on.

There was no legal obstacle to the European Central Bank resisting calls to take its share of the burden by writing off a portion of its substantial claims on Greece, even just giving up the discount to par value at which it purchased Greek bonds from international banks. The ECB was within its rights. Bonds issued under Greek law – most of its outstandings – carry no provision for pari passu treatment of different creditors. The ECB and indeed bilateral sovereign creditors are allowed to hold out for preferential treatment and their ability to achieve it comes down to power not principle. After all, they bought bonds and provided loans only to bail out original creditors in the first place.

The banks may have complained at being asked to take an unequal share of the losses and the IIF used the threat of a failed negotiation triggering credit default swap contracts and bringing wider disruption to the sovereign bond markets as a negotiating tactic. But there’s only so far the banks can push the ECB, considering it is all that stands between most of them and oblivion.

However divisions between official-sector parties to the Greek debt restructuring negotiations are revealing. The IMF showed it no longer stood shoulder to shoulder with the ECB when it declared achieving a sustainable debt position for Greece the overwhelming priority and called on various principals to find their way to provide the debt forgiveness to achieve that.

As Euromoney went to press the outcome was undecided. Parties were wrangling over various possible combinations of coupon cuts, GDP warrants and ECB forgoing profits on bonds purchased well below par. No-one dared to ask the key question: whether or not bringing Greece’s debts down to 120% of GDP will make them sustainable or might be a waste of effort that risks further undermining the peripheral sovereign bond markets.

The IIF has claimed to speak for the bulk of private-sector creditors but it is not entirely clear what volume of outstanding Greek debt it accounts for. There is at least one hedge fund manager on the IIF steering committee. Some hedge funds will have bought at such low prices that they could make money even after a substantial write-off from par value. The suspicion is that many other hedge fund owners of Greek bonds would not be too upset by a disorderly default that triggers payouts on the CDS that some no doubt have insured themselves with.

More worrying than any of this, the abrogation of the principle of equal treatment for all holders of the same class of security will come at a cost. No matter that there is no legal challenge to this or that the ECB and sovereigns extending bilateral loans can claim superiority on credit extended to stave off default in the first place. Good faith counts. As the Greek negotiations wore on at the end of January, the price action in Portuguese government bonds became alarming, with yields on three-year bonds rising to over 19% at one point.

Time and again the official sector has said that Greece is unique and that there will be no more cases of bondholders being asked to write off their loans. The market doesn’t believe that anymore. With the official sector protecting its own financial position and allowing the private sector to go hang, no one does. Private sector bondholders are pricing in subordination on top of the other risks to Portugal’s sovereign credit.

Portugal’s new government has said it will not ask for relief and points out that voters at the last election overwhelmingly backed parties championing austerity.

Let’s see how they react when Greece gets a big slice of its debts forgiven.

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