What’s at stake: The report of the Von Rompuy Task Force and more recently the conclusions of the European Council have brought about the potential for a limited treaty change that would enshrine changes in the European Economic governance, set up a permanent crisis resolution mechanism and flesh out more clearly the role of the private sector (bail in). The stance on rescheduling/restructuring seems to be changing in EU policymakers’ minds and the conflict reported between President Trichet and the European Council has probably more repercussions than currently anticipated. The European Council will revert to this matter at its December meeting with a view to taking the final decision both on the outline of a crisis mechanism and on a limited treaty amendment.
Eurointelligence explains how Sarkozy and Merkel bullied the European Council into accepting the idea of small treaty change in 2011 to be ratified by 2013. The Bilateral Deauville summit Statement fleshed out the possibility of a treaty change which most saw as unrealistic. Treaty changes need to be approved at unanimity but there is a window of opportunity with the entry of Croatia in the EU which will force to revise the treaty in any case. The reception has been relatively cold, including from the European Commission, but the determination of Germany seems high.
Jean Claude Trichet warned the EU council that it had no idea what it was unleashing by putting this on the agenda while Axel Weber, along with Chancellor Merkel, argued that in future crises “bondholders need to be part of the solution and not part the of the problem”.
Lorenzo Bini Smaghi who has in several public speeches since October argued that a voluntary rescheduling would be a possibility is going further and proposes that the EFSF gets preferred creditor status along the lines of the IMF which is not the case at the moment. He points to the experience of the IMF which shows that there have been cases of debt restructuring associated with Fund programmes, even though debt restructuring is not considered in the Articles of Agreement of the IMF. Out of 113 IMF support programmes over the last 20 years, only 19 countries defaulted or restructured their debts. Mr. Bini Smaghi did suggest that more work be done on designing “collective action clauses” for future euro-zone debt issuance, which would make it easier to trigger debt restructurings if necessary, over the objections of individual bond holders. “It might be more promising and pragmatic to further explore this avenue,” he said.
Wolfgang Münchau writes that Germany’s quest for an orderly insolvency stems from its own economic philosophy of Ordnungspolitik – an expression that has no counterparts in any other European language but that conveys the idea that the government should only alter the framework within which economic agents interact. But the notion, which works more or less in a domestic context, cannot be easily transplanted to the eurozone, because of the network effects in a monetary union with decentralised fiscal management.
Tweaking European Treaties
Jacob Funk Kirkegaard argues that the hard constraint on adopting such revisions remains the desire by EU leaders to avoid national referenda to approve them. Fortunately, there are escape hatches. The Lisbon Treaty’s Article 48 envisions two types of EU Treaty changes: the “ordinary revision procedure,” which calls for an intergovernmental conference and national referenda in several member states according to their national constitutions, and the “simplified revision procedure,” which has less onerous requirements. Under the simplified scheme, if the EU Council consults with the European Parliament, European Commission, and the European Central Bank (ECB), and agrees unanimously on the change, it may revise the EU Treaty, so long as the adjustment does “not increase the competences conferred on the Union in the Treaties.” Because a simplified revision cannot transfer more power to the European Union as a whole, the permanent mechanism will likely affect only the eurozone members. Being excluded from its application, the United Kingdom will find it relatively easy to sign up. Second, a simplified revision cannot entail the option of suspending members’ voting rights in the EU Council for violating the restrictions on excessive deficits under the Stability Growth Pact (SGP). A simplified treaty revision thus drives a stake through this part of the Franco-German Deauville proposals.
The European Commission has produced a report on October 20th on a Framework for Crisis Management in the Financial Sector where it essentially discusses the different options to write down banking sector debt and convert into equity. In particular, the costs of resolution should be borne by the shareholders and, as far as possible, the creditors of the institution in question reflecting the normal order of ranking and if necessary by the banking industry as a whole. Paul Calello and Wilson Ervin from Credit Suisse proposed quite early in 2010 to move from bail out to bail in of the financial systems. The general idea is to convert unsecured and junior creditors into equity holders at moments of stress and therefore strengthen the regulatory equity and financial standing of the bank.
Impact on bond yields
Yields on Irish, Portuguese, and Greek bonds have already risen dramatically since the EU Council last week. Calculated Risk reports that as of yesterday, the Ireland-to-German spread has increased to a record 525 bps, and the Portugal-to-German spread has increased to 417 bps - just below the record set in late September. The Greece-to-German spread is at 892 bps. Andrew Flowers argues that primary impetus causing investors to shun the weaker peripheral countries is the pressure coming from the administrators of the EFSF to enforce burden-sharing on private bondholders in the event of any future bailout.
FT Alphaville relays a JP Morgan surveys that asked how much the prospect of bail ins would cost in additional spread requested by investors to take on such risks. Survey responses indicated that the implementation of bail-in frameworks is likely to have a material impact on the pricing of senior debt. Firstly, respondents indicated that the greater loss outcomes associated with bail-in regimes are not being priced in, despite the existence of special resolution regimes which already may imply similar loss outcomes for senior bondholders. Secondly, the average risk premium that investors would demand for a single ‘A’ bank under a bail-in regime would be 87bp.
Ambrose Evans-Pritchard argues that while the Merkel initiative addresses the current imbalance in bail out costs by insisting that bondholders, meaning banks, take losses if things get rocky, there is never a good time to implement a change, since investors will reprice assets based on the weaker guarantees going forward. The issue is that spreads on Ireland and Greek debt have already widened in the last month; this move will push them out further, making any efforts to access the markets more costly. And there is plenty of debt issuance planned.
Jean Quatremer argues that markets again don’t get what Brussels is doing. There was never any question of restructuring (that is to say, to cancel all or part of the debt or to spread repayments) inventory of existing debt, but those that will be incurred after the revision of Treaty of Lisbon that the bloc has decided to launch, that is to say from the mid-2013. For Europeans, the sustainability of the European Financial Stability (EFSF), which establishes a financial solidarity between states in the euro area should not become absolute guarantees given to investors: they must also assume some risk.
AIB bailed them in already
Anglo Irish Bank (AIB) announced a long awaited exchange offer of its junior debt in what seems to be the first European experience of a bail in this crisis. Markets were surprised by the harshness of the terms which imposed a 20% haircut and the swap into a new government guaranteed bond provides some support but falls short of the goal of a bail in which should normally reside in strengthening the capital base which isn’t the case here, thereby making given the AIB subordinated debt exchange the main features of bail in without the benefits.
FT Alphaville reminds us that such a “burden sharing” arrangement isn’t completely new and was actually implemented with Bradford and Bingley in 2009 and ended up spilling over across the banking system, in particular to RBS and HBOS and in fact it might provide a template across the EU. Nouriel Roubini writes that with the Anglo Irish crisis, the government now looks like it is willing to have a hit being taken by the sub debt holders. The government should go further down that road and also restructure the banks’ senior unsecured.
ECB or EFSF or both to the rescue?
Money Supply writes that the big question now is: will the rescue fund be needed? The ECB’s largest weekly bond purchase was about $23bn, after all, and the Sovereign Wealth Funds – in Norway and Russia that are backing away from Irish and Spanish debt – command $663bn between them. What proportion of that is invested in Spain and Ireland, we can’t be sure, but the (very short) list of Russia’s remaining investable countries suggests the Russian holdings in each country were significant.
Alphaville notes that if Irish government bonds start to be treated as toxic for collateral purposes, where precisely does that leave the European Central Bank and its tightening regime? It’s hard to end the ECB’s ample provision of liquidity if there’s nowhere else where Irish bonds will be accepted as cheap collateral.
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