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ECB trades crap for slightly less crappy crap

February 18, 2012

Yesterday I read this New York Times article on how the ECB is trading its short term Greek bonds, with Greece, for longer term bonds.

Specifically, in order to avoid holding bonds that Greece is officially planning to “voluntarily” default on, the ECB is turning in that super crappy crap for other bonds that Greece hasn’t yet decided how much they’ll default on.

Just to spell it out even more, the plan to get private bondholders more excited about trusting the European bond market has been this:

  1. have the the ECB step in (around the beginning of 2012) and provide liquidity and faith in the bond market,
  2. negotiate that the Greek bonds maturing in March 2012 are given a 70% haircut,
  3. make sure credit default swaps on those bonds are not activated (why we need it to be “voluntary”),
  4. change the terms of the bonds’ contracts so that the holdouts of this voluntary deal can be safely ignored, and
  5. have the ECB trade those bonds for longer-dated bonds at the last minute so they don’t actually have to take losses.

I’m not sure about you, but if I’m a private European debt holder my confidence in the bond market is not stronger right now. The argument for why the ECB is doing this is that they aren’t allowed to be seen giving money to Greece, by their charter. It’s odd to me that this charter, of all the various rules that have been broken here, is the one that is being fixated on as the important one we can’t break.

There are complicated politics going on, I am sure. I’m no expert in European politics, but this is about as European and about as political as things get.

Ignoring all of that, as a private bondholder, I’m putting a “ECB back-door swap” premium on all of my European debt from now on. Except maybe for German debt since I think Germany would rather jump out of the Euro altogether than default on its debt. But every other country is fair game. Bottomline is I short French debt today.

Categories: finance, news
  1. B
    February 18, 2012 at 8:28 pm

    An idea that has been in vogue in economics for some time now is the importance of establishing ‘credibility’ or ‘reputation’ when playing a (Bayesian) game.

    For instance, suppose that a country has a prior 0 \leq p \leq 1 that if it runs up a huge deficit, then the ECB will bail it out. According to this theory, the ECB cannot be seen to be giving money to Greece, since then every EU country will reset such prior to p=1-\epsilon, and feel free to run up deficits and ask the ECB for a bailout, undermining the economic union. According to the theory, the ECB would ideally have changed the structure of the game already by making it impossible to bail out sovereign economies (this is an example of commitment, as in the game of ‘Chicken’), so that countries would have no reasonable choice but to assign prior p=0.

    Of course, by this stage the game has been given up, and anyone will realize that a decent bet is that p=1-\epsilon. It’s probably just not politically wise to go as far as to say this officially and set off a bank run. (There’s an obvious parallel here with the US Treasury and ‘too big to fail’ banks in 2008.)

    The theory is amusing, but its prescriptions seem to have limited bite in the real world.

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