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Normally attempts at "Kremlinological interpretations" of policymakers' every word should be avoided. When an institution like the European Central Bank suggests a critical policy change during the Q&A session of its regular press conference, observers are left with little choice. A closer analysis of what Jean Claude Trichet said at his July 7 press conference1, apart from announcing the suspension of the ECB's normal collateral requirements for Portuguese government debt and guaranteed debt2, is therefore warranted.
The ECB's position on credit ratings of collateral is ambiguous. On the one hand, the ECB's clearly reserves the right to its own assessment of the quality of any member state's collateral3. On the other hand, the central bank, in consistently ruling out the acceptance of any collateral with a "selective default ratings" (SD) from all rating agencies, is implicitly deferring to the rating agencies. As discussed on this blog yesterday4, however, it is crucial to distinguish between the actions of rating agencies themselves in announcing an SD rating, and the consequences financial market participants like the ECB draws from such a rating.
Charles Dallara, director of the Institute for International Finance, the leading association of the financial industry, was quoted, for instance, as stating that "It may well be that some rating agencies reach judgments that involve a selective default….I don't think that a temporary period of selective default as it has been narrowly framed for sovereigns in the past is necessarily the worst thing that could happen here5." International banks evidently do not view an SD rating as the end of the world.
More interestingly, though, Trichet seems also not to consider an SD rating a disaster, when one listens carefully to his words. Certainly, the ECB president was once again forceful in stating on July 7 the ECB's official position of "No selective default and No credit event," meaning that SD rated collateral will be ineligible as ECB collateral in normal open market operations.
But when Trichet in his press conference was asked about this contradiction, he chose not to answer directly. Neither did he rule out other possible alternatives to the ECB's normal repo transactions as avenues to continue to provide Greek banks with liquidity.
First, Trichet did not rule out a Greek national Emergency Liquidity Association (ELA) organized by the Bank of Greece to provide Greek banks with required liquidity. As in Ireland's ELA in December 2010, such liquidity would be provided to Greek national banks through the balance sheet of the Bank of Greece only, and not the balance sheet of the ECB or European System of Central Banks. As discussed yesterday6, the credit risk associated with a Greek ELA would ultimately be transferred to the other eurogroup sovereigns through their guarantee of the solvency of the Greek government (and thus of the Bank of Greece). This way, acceptance of SD rated Greek collateral would not directly affect the riskiness of the ECB's own balance sheet, but only that of other eurogroup national governments.
Trichet also did not rule out a broader new program to provide liquidity to "dependent euro area banks" without access to private wholesale markets. Indeed, he called such measures "a work in progress" at his press conference7. A broader program for liquidity for "dependent banks" under conditionality could thus be launched at short notice, but it would be less discretionary than ad-hoc national ELAs, for which details and conditionality will certainly be arranged behind closed doors among the ECB, the national central banks and the relevant eurogroup finance ministers.
The bottom line is that several options remain available to Greek banks, even in the event of an SD credit rating, to obtain crucial liquidity. Immediate contagion risk through the European credit markets consequently looks limited in the event of an SD rating.
Finally, German and Dutch politicians predictably in the face of a likely "SD rating" for any Private Sector Involvement (PSI) in debt rollovers seems to have revisited the idea of restructuring existing outstanding bonds to lengthen their maturities8. This is a big mistake. It has all the flaws of the original Schauble proposal for a "soft bond restructuring" that does nothing to alleviate the unsustainable Greek debt burden. There is still no point in doing a full restructuring at a time when Greece still has a primary deficit and that does not reduce the country's debt burden materially. Restructuring is only sensible to do once, when the broader economic conditions are sufficiently stable, and there is time to forcefully put the debtor country back on a sustainable fiscal path with lasting market access.
Moreover, the German and Dutch revival of the threat of restructuring ignores the difference between an SD rating and a credit event. The former is a credit rating agency action (that as we have seen can likely be managed), while the latter is a credit default swap (CDS) market action that would cause sovereign CDS to pay out. Here it is important to note that while the credit rating agencies are saying that any kind of bond rollovers warrants an SD rating, the International Swaps and Derivatives Association (ISDA), which determines whether a "credit event" has taken place, has indicated that a voluntary bond rollover would probably not trigger relevant CDSs9.
The German and Dutch argument that with an SD rating imminent for a voluntary bond rollover, euro area countries might just as well pursue with their original plan to restructure, is consequently flawed. Restructuring now remains a bad idea for eurogroup taxpayers, too.
Notes
1. http://www.ecb.int/press/tvservices/webcast/html/webcast_110707.en.html
2. http://www.ecb.int/press/pr/date/2011/html/pr110707_1.en.html
3. In their decision on Portugal, the ECB explicitly states that "The Portuguese government has approved an economic and financial adjustment programme, which has been negotiated with the European Commission, in liaison with the ECB, and the International Monetary Fund. The Governing Council has assessed the programme and considers it to be appropriate. This positive assessment and the strong commitment of the Portuguese government to fully implement the programme are the basis, also from a risk management perspective, for the suspension announced herewith." The focus in the ECB's assessment solely on the actions of the Portuguese government obviously implies an (unsurprising) implicit rebuke of the Moody's junk rating justification for Portugal, which was premised on the "PSI precedent" from the ongoing Greek negotiations being applied to Protugal.
5. http://www.bloomberg.com/news/2011-07-06/greek-default-not-worst-outcome-for-banks-as-bondholders-discuss-options.html
7. See also comments along these lines by Lorenzo Bibi-Smaghi in Les Echos on June 29th, where he stated that the ECB has been working on such a program "for some time" and implying that there would be some conditionality attached to this, as Bini-Smaghi made a linkage to the need to reduce financial leverage in the system. In other words, presumably that participating banks would be required to raise more capital to have access to this type of extraordinary liquidity provision.
8. http://www.bloomberg.com/news/2011-07-05/iif-s-dallara-urges-european-officials-to-consider-greek-debt-buyback-plan.html
9. http://www.bloomberg.com/news/2011-07-06/greek-bond-rollover-probably-won-t-trigger-credit-swaps-isda-s-geen-says.html
