Uncomfortable days for ECB

These are uncomfortable days for owners of Greece’s government bonds. For the European Central Bank, the country’s largest bond holder, they are especially so.

With negotiations close to breaking down on “private sector involvement” in a fresh Greek bail-out, the ECB is under pressure from the International Monetary Fund and the financial industry to take a hit. The ECB faces the dilemma it always feared: might it have to take substantial losses on the estimated €35bn-€40bn it spent on Greek bonds, with potentially damaging consequences for itself and the eurozone?

The ECB started buying Greek bonds in May 2010, when the eurozone debt crisis first erupted. The objective of Jean-Claude Trichet, president, was to stabilise financial markets. The assumption was that bonds bought at market prices would be held until maturity, when the ECB would book a tidy profit.

Having taken action when the private sector held back, it justifiably feels it should not have to pay a price now, said Erik Nielsen, chief economist at UniCredit. “In an emergency, the fire brigade goes in – but the deal is that it is protected.”

Economists estimate that a 70 per cent “haircut” on the face value of the ECB holdings could leave a loss of more than €20bn – a significant but not disastrous sum given the size of the reserves held by the ECB and eurozone national central banks. But the ECB’s resistance to accepting losses is not just principled. Agreeing to take a loss could be viewed as providing financial assistance to Greece – and in violation of the European Union’s ban on central banks funding governments.

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One possibility discussed by the ECB’s governing council would be to sacrifice its anticipated profits. These could also be substantial – economists’ estimates of the difference between the price paid by the ECB and the face value of its bonds range from €5bn to more than €15bn. It has also earned interest. Alternatively, the eurozone’s national central banks could take losses on Greek bonds held in their own portfolios – although the sums involved may not be large. But such steps would be controversial within the ECB and outside.

The ECB may be unable to control the course of events. Athens has threatened to force a deal with bond holders by inserting, rectro-actively, “collective action clauses” to bring a recalcitrant minority into line. Although the ECB may support such action, it would attempt to have its own holdings excluded – perhaps by having them swapped for other bonds that did not include CACs or transferred to the European Financial Stability Facility, the European Union’s bail-out fund. But the risk is of a legal challenge from other bond holders claiming unfair treatment.

In such a situation, the ECB may anyway decide the least worst course is simply to accept a loss. The risk of the central bank being treated as senior to other bond holders is that its intervention in other governments’ bond markets becomes less effective. Investors in Spanish or Italian bonds would also fear preferential treatment for the ECB. “It’s a very bad message to send to markets,” said Stephane Deo, European economist at UBS.

One thing is clear: the ECB would make clear that ultimately it was eurozone taxpayers who picked up the bill, if necessary by providing fresh capital for their central bank. A strongly held view in Frankfurt is that governments should realise the consequences of pushing the ECB into a corner.