EU Permanent Bailout Mechanism Leaked to BBC – Bad Outcome for PIIGS Gov’t Bondholders?

The BBC has obtained a leaked copy of the EU draft communique on the so-called permanent bailout mechanism. Attentive readers may recall that current programs extend only to 2013, leaving a big question mark as to what would happen next, given the high odds that the countries perceived to be at risk would not be out of the woods by then.

The result, which is not out of line with previous ideas that have been voiced, may nevertheless rattle the relevant bond issues further. Key points:

New bailout funds would be senior to existing government debt (this is a standard feature of IMF rescues and bankruptcy financings)

Restructuring is a requirement in the “unexpected” instance the government in question is determined to be insolvent

Future government bonds (from 2013) will need to include terms that make restructuring less difficult

Note that these changes would require an change in the EU treaty, which in turn means a referendum in Ireland. In addition, the treaty wording change is broad, and would allow for the creation of senior e-bonds. In other words, it would represent a major step towards fiscal union.

Key details from the BBC:

The decision may significantly raise the future cost of borrowing for over-indebted eurozone governments….

In future, Brussels may require a crisis-stricken eurozone government to force losses on its existing private lenders – including investors in government bonds – before it would provide a bail-out package.

And if a government got into trouble later down the line, it would be required to default on its other debts, while continuing to make payments on its rescue loans…

From June 2013, government bonds will also have to include “collective action clauses”, which would make it much easier for an insolvent government to get the consent of its lenders to any future debt write-offs…

The rhetoric in the communique comes in stark contrast to the actual bail-out of the Irish Republic in November.

In that rescue, Brussels is accused of having insisted that Dublin honour in full its guarantee of the Irish banks. Many Irish are angry that this has landed taxpayers with the bill for repaying loans made to its insolvent banks….

The planned Lisbon Treaty amendment is short and open-ended, leaving European leaders flexibility to structure the new arrangement however they choose.

It states only that: “The Member States whose currency is the euro may establish a stability mechanism to safeguard the stability of the euro area as a whole. The granting of financial assistance under the mechanism will be made subject to strict conditionality.”

The EU is inching towards recognition of its underlying problem, that its banking sector is too large relative to the size of the underlying economies, and therefore bank creditors will need to take losses. The mechanism will evidently be through restructuring of member country debt, but if the banks start to look too wobbly, the ECB is likely to let them pledge assets in return for cheap loans, in a repeat of the Fed alphabet facility playbook. The question would then become how big a balance sheet Germany will allow the ECB to carry.

And of course, if the Irish refuse to approve the treaty change, what then does the eurozone do?

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19 comments

  1. jon richards

    At the risk of sounding a bit thick, aren’t bondholders / creditors supposed to be at risk if the underlying bonds default? I realise in the last 2-3 years the financial world has been turned on it’s head and as soon as any institution / bank / country gets in to trouble, a bail out is now expected or even presumed and that’s become the new normal, but in a normal functioning capitalist system, if a country or institution defaults I was under the impression that bondholders were meant to take a loss / haircut. Isn’t that the risk of doing business? otherwise what’s the point of buying nice safe risk free German bonds paying 2.5% interest when I can go out and buy Greek bonds paying 9%. Are institutional investors and bankers now so arrogant that they believe they never have to lose? Have attitudes changed so much in 2-3 years or am I missing something?

    Yours an avid reader in London

    1. philip

      Jon,
      I think the key thing that you are missing from that analysis is that for the most part today’s bondholders ARE tomorrow’s bond buyers. So “sticking it to the current holders” fails immediately at tomorrow’s bond auction, when no one shows up until you pay 5% more. Since everyone realizes how that game plays, or at least how quickly and unpredictably awful it might be as the world plays the game of “guess who just took a huge loss yesterday” over a 24 hour period, no one bothers to actually play the game and they cut rught to the next phase which is “how can today’s governments borrow more of the bond buyers’ money to indebt the people of tomorrow and enrich themselves?”

      1. jon richards

        Hi Philip,

        I do realise that that today’s bond holders are tomorrow’s buyers, but that doesn’t change the fact that there is always an implicit risk when buying any financial instrument.I don’t see default as ‘Sticking it’to the current holders, but the normal playing out of a process when the issuer can no longer honour / pay the debt. Surely this is why different countries / institutions have varying interest rates, to show the potential risk involved, that risk is default / haircut. I am well aware that the appetite for bonds from that country will diminish post default and higher interest rates would be necessary, as in Argentina a decade ago, but fundamentally that is the system within which we operate. A cost / benefit anaylsis must be done between defaulting and in future having difficulties to raise finance or alternatively to keep trying to pay off debts that will result in increased interest payments and a declining vicious circle, exactly the situation many think Ireland is currently in. I am not anti banker per se and not interested in sticking it to the man, just expect normal default processes to happen as and when it’s clearly necessary.

  2. Thomas Barton, JD

    AEP has an essay at the Telegraph today that puts all this empty rhetoric to rest. The endgame is here for the euro and the playbook is empty, the cupboard is bare, and empty rhetoric about 2013 is just one last plaintive cry of the College of Europe. Spain and Portugal will blow the whistle on the last play of the euro, be it this week or the last week of January. I hope the euro’s demise will hasten the collapse of at least one of our four mega-banks and thus make 2011 a year for a seachange rather than the continuation of the Fraud of Liquidity in a land of Insolvent Titans.

  3. Maju

    Acrobatics without safety net IMO.

    The first thing Brussels should agree to is a controlled devaluation of the euro. Anything else is stupid lawyerism and does not address the real problem: that EU is non-competitive in the global market. The euro needs to be less like the Deutsche mark and more like the franc (or any other historical currency except the Italian lira): it needs to be more flexible and more adaptive to the needs of not just Germany but all member states equally.

    Anything that does not address the excessive value and rigidity of the euro is a fail.

    As for the rest, it’d look like a good idea to have banks get their share of loses – but not in the future: now (including retroactivity for Ireland and Greece). If they fall, no big deal: we can always create public banks to take on their failed role.

    It is a bad idea to put “rescue packages” (armed robberies) in a pedestal and to give these loans any special privileges. I can only foresee with this pitiful attitude that in the short run, it will be “rescue packages” which will cause default of the troubled euro-states.

    “And of course, if the Irish refuse to approve the treaty change, what then does the eurozone do?”

    It can always kick Germany out. That would help more than all this toxic package.

  4. auskalo

    Dear Yves,

    Europe, along with USA and Japan will do financial engineering to avoid german banks sinking, while making noise USA style about strong € and other silly things.

    We all are in a race to the bottom. But which one will be first, UK, California, Spain?

    The casino will decide.

  5. Gilles d'Aymery

    Ms. Smith,

    Why do you not have an e-mail address to contact you?

    If you are such a naked capitalist, why don’t you highlight real anticapitalists?

    Here is an example:

    [link whoring deleted by Yves, note this is only the third time in the history of this blog that I have edited a comment]

    Take 10 minutes of your worthy time and call it as it is.

    Will you?

    Thank you.

    1. Yves Smith Post author

      I have repeatedly indicated I hew to Barry Ritholtz’s comment policy, which I regard as web standard (I’m actually far more lenient in terms of enforcement than he is).

      You have just 1. insulted me; 2. demanded I comment on something (a violation of Ritholtz rules that leads to immediate revocation of comment privleges) and; 3. link whored. You seriously expect me to respond?

      I’ve edited your link whoring out. It is not hard to figure out how to contact me, the fact that I don’t make it as easy as you’d like is to prevent me from being overwhelmed with traffic. But the fact that you did not bother and instead grouse is not endearing.

  6. Hugh

    I’m with auskalo on this. How is this different from Japanification, or what should we call it, Americanation? This looks like another promise to do something if the need arises, which it probably will, but not to look into eurobanks’ balance sheets. As people have been saying for 20 years now, how can you reset the financial system if no one knows how big the problem is because no one is willing to look at those balance sheets, declare the losses, and move on.

  7. Peter

    Any Treaty changes in Europe will force a referendum in the UK because of the political position of the Conservative Party. This will be tricky. The UK electorate is also more difficult to bully with a “you got it wrong on your first vote, so vote a second time” approach beloved by Brussels.

    Thus any treaty changes would have to be for the Eurozone only and for Eurozone members not for the EU.

  8. DiSc

    On the one hand, the choice is clear between further fiscal integration or a euro breakup. On the other hand, I am not so sure I want the current leadership to be the one who carries through the change.

    Judging by the way e.g. Merkel and Sarkozy have reacted to the crisis so far, maybe it would be to everybody’s advantage if they just kept on muddling through. I shiver at the thought of what could happen if they actually decided to do something relevant.

    PS: Wow, this post is barely out and there are already more troll comments than genuine ones – is Ms. Smith such a thorn in the eyes to the powers that be?

  9. I love Sarah Palin

    “I have repeatedly indicated I hew to Barry Ritholtz’s comment policy, which I regard as web standard (I’m actually far more lenient in terms of enforcement than he is).

    You have just 1. insulted me; 2. demanded I comment on something (a violation of Ritholtz rules that leads to immediate revocation of comment privleges) and; 3. link whored. You seriously expect me to respond?”

    Ms Yves, Did you change your diaper today?

  10. Hubert

    Smart analysis in the last two paragraphs.
    My 2(Euro-)Cents: Nominally the Germans will be outvoted in the ECB – there are more aggressive moneyprinter than timid moneyprinter countries. The question will be how far Paris-Berlin will want to go into infighting. My 80%-conviction-prediction is that Berlin will make a lot of noise for the home crowd and quietly cave in every time like they did in May 2010.
    If the Irish (or others) do not want a new treaty we are back to the ECB – where we stand anyway. Inflate, Eurozone – or die …

  11. Rodger Malcolm Mitchell

    The post reveals the fundamental difference between the EU’s Monetarily Non-sovereign nations and the monetarily sovereign U.S. Here we are casually talking about nations renouncing their debt, something unthinkable for the U.S.
    .
    When a nation gives up its monetary sovereignty, it gives up its national power. It becomes a junior, minor league organization, similar in nature to a state or county in the U.S. That the EU nations willingly should have emasculated themselves, just to avoid currency exchange inconvenience, is astounding.
    .
    What’s even more astounding is that most American politicians, columnists and even economists, don’t realize the U.S. is monetarily sovereign.
    .
    Rodger Malcolm Mitchell

Comments are closed.