Will the European Central Bank torture logic to prevent a euro meltdown? Absolutely

07/05/2011 2:54 pm EST


Jim Jubak

Founder and Editor, JubakPicks.com

The Greek debt crisis is like an onion. Peel away one layer and you find another—and then you cry.

Remember last week? The big test was two votes by the Greek Parliament on a new austerity package. Pass that, the Greeks had been told by the International Monetary Fund, the European Union, and the European Central Bank or we won’t give you the $17 billion you need to avoid defaulting on your government debt in August. So the Greek’s voted to cut their budget, raise taxes, and sell off government assets.

But that only moves the crisis from worry over a default in August to worry over a default in, well, July.

EuroZone leaders are supposed to be putting together a second rescue package for Greece with a vote on the package around July 11. A second package is necessary because the first rescue package, passed last year, was designed just to get Greece to 2012. The hope was that Greece, by that time, would be able to access the financial markets for its debt financing needs. That turned out to be overly optimistic and now the EuroZone is trying to put together a new package that would take Greece to 2013 or 2014.

Germany has been insisting that the second package include some kind of haircut for current Greek bondholders so they would share the pain of taxpayers who would be asked to dig deep into their pockets to fund a new package. The European Central Bank and the big ratings companies such as Standard & Poor’s balked at anything that required mandatory participation with Standard & Poor’s, Moody’s, and Fitch Ratings all saying the mandatory participation would trigger a default rating on Greek debt.

The French then leaped into the gap with a complex proposed that included a voluntary roll over of maturing Greek debt into new, longer-term Greek bonds. As we headed into the Fourth of July weekend that seemed a likely compromise formula.

But today Standard & Poor’s threw a spanner into the wheels. Even the French voluntary plan, the ratings company said, would trigger a default rating on Greek debt.

That would seem to be a huge problem since the European Central Bank, which has lent $140 billion to Greek banks with Greek government debt as collateral, would seem to be unable to accept Greek debt with a default rating as collateral for lending Greek banks the money they need to stay liquid. That could trigger a run on Greek banks, the collapse of the Greek banking system, and then, potentially, runs on banks in Portugal, Ireland, and other EuroZone countries.

But there might be an out.

Turns out that the bankers who run the European Central Bank are willing to get very creative when it comes to interpreting their own rules. First, outgoing central bank president Jean-Claude Trichet said today that the bank would continue to accept Greek sovereign debt as collateral for loans to Greek banks as long as one ratings company didn’t grade Greek with “default.” At the moment Standard & Poor’s and Fitch have both said that the French plan would trigger a default rating, but Moody’s has not given an opinion.

The bank isn’t willing to rely on just that very think reed. The European Central Bank could continue to accept Greek government debt as collateral even after a default rating—if the default rating seemed likely to be in effect for just a short-term. Both Fitch and Standard & Poor’s have indicated that they would be likely to remove the default rating if Greece was able to make its interest payments after the implementation of the rollover plan that had triggered the default rating. The precedent that everybody is pointing to this morning is Uruguay’s default in 2003. S&P cut its rating to selective default on May 16, 2003, and then lifted that rating to B- on June 2, 2003. Uruguay had arranged a debt swap with bondholders on May 16, the day of the default rating.

The mess has sent everyone back to the European Central Bank rulebook that says that the bank “may be warranted” in rejecting defaulted bonds as collateral.

See, those looking for a way out have said, the rules don’t say the bank absolutely can’t accepted defaulted bonds.

If you think that’s tortured logic, I’d certainly agree. But when you’re trying to avoid the meltdown of an entire banking system, what’s a little bit of creative reading?

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