Changing the Rules of the Game

The ECB just changed the rules of the European debt game.

From Zero Hedge:

The ECB, on its own and without judicial or parliamentary review, has swapped their Greek debt for new Greek debt that is not subject to any “collective action clause.” They did this unilaterally and without the consent of any other sovereign debt bond owners of Greek debt. They did this without objection of any nation in Europe. They have retroactively changed the indenture, the contract made by Greece with all of the buyers of their bonds, when the debt was issued. There is no speculation involved in these statements, there is no longer any guesswork on what might be; the ECB swapped their bonds for new Greek bonds with the assent of the Greek government and it is now a done deal.

We know now that the ECB can retroactively change the rules, change an indenture, so that if the ECB can do this with Greece then it can certainly do it with any sovereign debt in Europe.

Since the ECB can now retroactively change any bond contract to whatever it likes and with any nation in its dominion then the valuation of European sovereign debt must be re-examined for what it really is which is no longer what anyone previously thought. Starkly put; the bonds issued by the sovereign nations in Europe are no longer pari passu, on equal footing, with the bonds issued in the United States. We have just passed a clearly defined “break point” where the legal rules were changed to the great disadvantage of all the private debt holders.

The European Central Bank, in a very misguided attempt to protect itself, has now opened Pandora’s Box. I doubt if they even realize what they have done; but they will, most assuredly they will. The consequences of their horrendous mistake will soon be upon them as institutions not coerced or forced into buying European sovereign debt will be leaving the playing field en masse as the realization dawns upon investors of just what has taken place.

The point of this is quite shocking.

From Bloomberg:

The European Central Bank is swapping its Greek bonds for new ones to ensure it isn’t forced to take losses in a debt restructuring, three euro-area officials said yesterday.

Bill Gross of PIMCO sums up:

Now perhaps the protestations are just the vain rumblings of creditors who don’t like having to take a haircut: after all, all investments carry such a risk. On the other hand, it’s one thing to duplicate money to pay back debt (the “normal option”) and it’s quite another to effectively enforce a change to the terms of private contracts by curtailing pari passu. But — in this case — the “normal option” of printing the money to pay back the debt is not available to Greeks.

The point is that if the ECB can do this it means that all debt denominated in Euros is subordinated. This will (eventually, once the market gets the message) cause a collapse of demand in European sovereign debt.

Either borrowing costs will massively spike, crashing the system, or the ECB will go on a money printing binge. These two options have been discussed above. German attitudes to monetary expansion are frosty to say the least, but at this stage I think all options are on the table.

25 thoughts on “Changing the Rules of the Game

  1. I bet this is one of your least-commented posts of the year.

    Shame, because it’s actually one of the most important. And you’re about a month late to the party. ZH was writing about this last month.

    But I agree with your take on it: Germany won’t accede to fast and loose money printing. The memory of 1923 still looms large. Which is precisely why they’re setting up for a rigged game.

    • Well I wasn’t covering the European situation in much detail, mainly because for all the noise that comes out of Europe day by day the problem has been the same since 2009 — either they devalue to bring the PIGS out from underwater (a temporary reprieve) or they face collapse. These developments suggest we are edging closer to option 2.

  2. actually I’m confused. why ECB is doing that? they’re a central bank, they can’t go bankrupt, they can run negative balance accounts, they can call the Fairy of Funny Money to make accounting wanders. ECB is “non-printing” for months and the next LTRO (if it arrives) will be in trillions – Greek bonds are just drop in the sea not worth the hassle. they don’t want to finance any gov directly because it’s illegal for them, so they change rules, which itself violates law? this all doesn’t add up.

    is this some kind of smoke and mirrors to divert market’s focus?

    there are rumours a plan is being baked to kick Greece out on 23rd March, full blown capital controls etc. the world’d expect spanish inquisition sooner than kicking Greece out so fast which makes it perfect time to do it now..

    • Well I think the idea is that the more Greek debt subject to CAC in the hands of the Greek government, the easier it will be for them to force cramdowns on the hedge funds with a supermajority. I figure Greece would be more likely to win in the case in an Athenian court than in Brussels.

      But you’re absolutely right: this is puzzling, and I still don’t think we have the full picture. The view that they are shooting to kick Greece out of the Eurozone could be true, but I don’t see how it is connected to this.

      The thing is, given the fact that all Eurozone debt is now tainted, I think it’s probable that this is all a badly-planned mess.

  3. Rulers in Biblical times did this and found no one would lend to them crashing the economy.

    Read: Economic Analysis in Talmudic Lieterature by Roman Ohrenstein and Barry Gordon.

    Remind me to not recommend European Bond funds to my clients, unless the interest rate is usurous!

    • Rulers in Biblical times did this and found no one would lend to them crashing the economy.

      Exactly. This could lead to a dramatic exodus from European debt.

      I still haven’t read the Talmudic analysis…

      • investors worldwide are already paying for the priviledge of holding US and German bonds while one would expect flee from these assets with negative rates. we could expect no one lending to Russia or Argentina after their defaults, while those countries quickly returned to markets. some countries finance themselves via pension funds effectively turning them into obscured taxation system.

        banks will continue to participate in this debt orgy because the system is designed to keep them so, and they are already state controlled by central banks and regulators. pension funds will again put money in “no-risk this time for sure” debt again.

        sad things are:
        1) markets seem to have memory capacity of c.a. 3 weeks.
        2) current system doesn’t need any real private investors anyway…

  4. This is fantastic news, as far as I’m concerned, and I hope the ECB proceeds to royally rape bondholders. Frankly, if you’re dumb enough to continue buying government bonds, you are subsidizing these kleptocracies and allowing them to continue to rob their own peoples and the users of their currencies. Any losses you suffer are just reward. What were you expecting, that these governments would somehow find solvency at the bottom of the quantitative easing bottle?

    Meanwhile, did the ECB specify if gold was still pari passu? I thought not. If you desert the safety of gold and chose to invest in government bonds in search for a few percentage yield, you will probably get raped and it will be the least you deserve. Dumbass bond investors, you’re not the only bitch in the house; meet Karma.

    • Right. It seems like the fixed income investors are just on the edge of discovering what we critics of paper already knew long ago — all paper comes with massive counter-party risk.

      Still, there are a class of hedge funds (seemingly mostly staffed by lawyers) who specialise in distressed paper, and who have scored great results in the past (e.g. Argentina, D.R.C, Peru) going after distressed paper issued in a stable jurisdiction, e.g. London or NY. And a significant chunk of the Greek paper was issued in London, and that chunk is trading at a premium on the Greek-issued paper. So it looks like the paperbug hedge funds will fight to the death to get a pound of flesh out of Greece. My guess is they will win, but their payoff will come in massively inflated Euros, or worse in Drachma.

  5. From my point of view, it was a deft move that fully indemnified the American insurers of the Greek bonds that are held by the ECB and member banks. (Those insurers would be Merrill Lynch and JP Morgan via their London derivative exchange, although both have been under FDIC protection for several months now.) In addition, it may preclude a technical default event that might be claimed by other holders of the Goldman-Sachs-packaged-Greek-debt. This lets the US investment banks walk away without a scratch. [I should say, “lets the US taxpayers walk away,” since the FDIC would have had to make the ECB banks whole again. AIG redux.]

    It sure took a long time to put this deal together. But of course we knew that the banks wouldn’t be the ones to take the fall — for if they did (for once) it would probably rip a hole in the fabric of the universe.

    I really have no idea what the end game is — I’m not sure who does.

    • Well given that Bill Gross — the biggest bond trader in the world — is now buying Zero Hedge’s view that this subordinates all Euro-bonds, it seems like the cost of all this might well be ripping the bottom out of the European sovereign debt market.

      Of course the headlines have gravitated back to Iran today (and I’m still fairly confident that that is hollow and that there won’t be a war before November unless Iran goes postal and strikes first). It seems like there is a race on for which part of the global economic system is to break first.

  6. There are no easy options. ECB did this because otherwise the SMP program (buying EMU debt from secondary markets) would have been deemed unconstitutional (taking losses on those purchases would have been seen as funding the EMU countries).

    I’d argue that the banks would still buy govt. debt with LTRO money for the time being. Yes, they may lose money, but it would be even more catastrophic for them if their host countries would default.

    And no, the banks are not depositing back to the ECB the money from LTRO:

      • I’d argue that the banks would still buy govt. debt with LTRO money for the time being. Yes, they may lose money, but it would be even more catastrophic for them if their host countries would default.

        Yes of course there will be continued buying. The problem is that if overall demand for debt falls — as would be expected now that Gross & others feel that all Euro-debt is subordinated — that buying will be taking place at lower prices and thus higher, and possible unsustainably high rates. The real crash in demand may come from global buyers, rather than Eurocentric ones. Whether LTRO is sufficient to sustain price levels is questionable. Certainly Bernanke’s QE & Twist operations have proved sufficient in America… for now. Whether Draghi (and more importantly, the German people) can commit to such an operation — possibly on an even longer timescale than America post-08 and Japan post-91, as well as in paper from many different sovereigns — remains to be seen.

        The balance sheet offers almost no information at all as to what happens with that money that was injected into the system.

        Politically, I think this is extremely problematic.

  7. I think that global buyers may even ignore the possibility of EMU exit and continue to buy debt from countries they believe are healthy. That is, they may continue to buy Italian debt for example, because Italy has an actual functioning economy and has been known to always pay back its debts (they were at 120% debt/GDP even 10 years ago I think) – even if those debts may be paid back in a slightly devalued lira.

    My take on what they wanted to happen: they wanted to kick Greece out of EMU (but surprise! it turns out it’s them who don’t want to leave) and then, being able to say they were harsh on Greece and the banks, they’d have fuel to continue further political integration, with the ultimate purpose of more enhanced ESM-type mechanisms (more trillions in them) for ringfencing the remaining countries and maybe ultimately the issue of Eurobonds.

    Another thing: I’m beginning to question the common wisdom that EMU must fall, then Japan, then the US. I think there’s a distinct possibility that they may all fall together, or all come together to an agreement for solving the imbalances in the global economy and the global debt crisis.

    • PS: I’m always wary of what someone like Gross says. He’s not some kind of independent philosopher/thinker, he has trillions in the game and some of his commentary may be self-serving.

    • I’m beginning to question the common wisdom that EMU must fall, then Japan, then the US. I think there’s a distinct possibility that they may all fall together, or all come together to an agreement for solving the imbalances in the global economy and the global debt crisis.

      This is the medium-term goal. There are a lot of barriers, Chinese and Russian disdain being the biggest ones, but probably also European and American hubris.

      Of course, Europe may still kick Greece out of the EMU, as has been suggested by other commenters, and certainly a lot of the commenters on Zero Hedge and other blogs. This was Joe Wiesenthal’s take on it:

      In a post last night, economist Tyler Cowen asked: “Is the goal simply to irritate the Greeks so much that they leave the Eurozone on their own?”

      Here’s what might be going on.

      Sometimes in life you give someone a “shot” at something that maybe they don’t deserve. You hire them, despite the fact that their qualifications were marginal. Or something like that. Bottom line is, you think you’re doing them a favor, and you’re also putting your reputation on the line a little bit. But you expect that they’ll step up and really appreciate the opportunity they have. And you expect they’ll kill it.

      And when they fail — which is likely, because they might not have deserved the opportunity — you’re furious at them, because you gave them this great opportunity and they totally blew it, and they made you look like an idiot at the same time. And you just hate them for it.

      And that’s what’s going on now. Europe feels like it gave Greece a “shot” with Euro membership, and multiple bailouts. And now it looks to Greece, and sees people rioting, and the reforms not happening, and they’re furious like never before. Merkel, Schaeuble, and the rest just can’t fathom that Greece was given this great shot to be a rich, wealthy European nation and it’s totally blowing it.

      Personally, I’d say this is a vey foolish idea. If they want a sustaining and sustainable Eurozone they need full fiscal and institutional integration. Trouble is, I don’t think Europeans want that, and the ESM-type mechanisms you mention would be temporary reprieves.

      As for Gross, well he’s just repeating Tyler Durden’s point. And, unlike a lot of corporate media, I’m not accusing Zero Hedge of being a front for hedge funds to push rumours that they then trade on.

      • I think that even the original (i.e. current) architecture of the Euro would have been workable if it were not for the “innovations” in the banking system during the last 10 years. That is, overindebtedness would have always been solved through defaults by punishing the the irresponsible lenders (i.e. those tight spreads between Northern and Southern European countries), while the defaulting countries would have gotten some post-default aid.

        I read somewhere that a Greek default would have been totally manageable 10 years ago. That’s no longer the case with the shadow banking system and the incomprehensible web of derivatives.

  8. Pingback: The Greek Non-Rescue « azizonomics

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