The nod-and-wink lender of last resort

How unlimited are 'unlimited' purchases of sovereign bonds, and can the ECB legally accept losses on par with private creditors?


At his press conference on December 4, 2014, the ECB President Mario Draghi was asked if the ECB would be pari passu with other creditors. Mr. Draghi replied:

“[…] we don't want to cause unintended monetary policy tightening in choosing forms of seniority which would be counter-productive. You all see this point, I believe.”

I certainly did not see the point, but not for want of trying. The issue is a simple one. If the ECB buys the bonds of a eurozone sovereign and the sovereign is unable to repay in full, then would the ECB bear the same loss as the private creditors?

It was something of a relief when the ECB Governing Council Member Benoit Coeure clarified the principle of how the ECB is required to operate: 

"It is illegal and contrary to the treaty to reschedule a debt of a state held by a central bank. The European treaties are very clear on this."

In other words, the ECB must be repaid in full.

This arcane exchange is central to the ECB’s future, not only for its proposed 'quantitative easing' plans but also for its Outright Transactions (OMT) programme. Tomorrow Advocate General Pedro Cruz Villalon of the European Court of Justice (ECJ) will deliver  a much awaited opinion on the German Constitutional Court’s challenge of the OMT. The opinion will be considered by the ECJ, which is expected to reach its judgement by May this year.

The OMT brought calm to the eurozone in the midst of one its recurring existential crises and, as importantly to its supporters, it finally created the basis for the ECB to function as a lender of last resort. The German Court, however, was not persuaded. A lender of last resort to sovereigns helps them tide over temporary payment difficulties. The OMT, the German Court said would bailout insolvent governments.

The German Court’s challenge rests on two features of the OMT: the ECB’s promise to buy unlimited quantities of the bonds and its willingness to be pari passu with private creditors -- in other words, if the sovereign were to default on its repayment obligation, the ECB would bear the same loss as the private creditors.

On both these core OMT features, the ECB has adopted a 'nod-and-wink' approach. On unlimited purchases, Jorg Asmussen, a former Governing Council Member, said in his submission to the German Court:

“[…] we announced that our OMT interventions would be ex ante ‘unlimited.’ We have no doubt that this strong signal was required in order to convince market participants of our seriousness and decisiveness in pursuing the objective of price stability. At the same time, however, the design of OMTs makes it clear to everyone that the programme is effectively limited, for one by the restriction to the shorter part of the yield curve and the resulting limited pool of bonds which may actually be purchased.” 

In other words, the OMT would be described as unlimited because otherwise markets would not be reassured, but it would be effectively limited because otherwise it would violate the European Union’s Lisbon Treaty.

A more serious disconnect applies to the pari passu provision. In its Press Release announcing the OMT, the ECB said: 

“The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

In emphasizing its acceptance of pari passu status, the ECB recognized that financial markets were principally interested in being relieved of the full burden of default. Thus, the ECB stepped beyond the traditional central banking domain of managing temporary financial disruptions into the sovereign insolvency arena. 

The pari passu provision is the OMT’s distinguishing feature and the key reason that made it a market favourite. The OMT’s earlier incarnation -- the Securities Markets Programme (SMP) -- was discredited precisely because the ECB overrode the pari passu requirement on its holdings of Greek debt. The bond contracts had specified the sharing of losses; but when those bonds were restructured in March 2012, the ECB exchanged the distressed bonds -- in a side-deal with the Greek government -- for new bonds that were not subject to the losses imposed on private creditors. Thus, the ECB remained whole. This, of course, meant larger losses were borne by bondholders whose securities were not purchased by the ECB. The adverse reaction that followed required that the OMT be seen to relinquish the ECB’s 'seniority' claim -- the claim to being repaid ahead all others. 

The German Court has concluded that such promised equal treatment in creditor status renders the OMT unconstitutional since it increases the likelihood of a 'debt cut' -- the risk that the ECB will not be repaid in full -- and that contravenes the Treaty. That is exactly the same as Mr. Coeure’s interpretation. And, indeed, as I have argued, that is also the ECJ’s interpretation, with particularly strong strictures against the ECB taking on a sovereign’s commitments.

Of primary interest in Advocate General Pedro Cruz Villalon’s opinion will be whether and how he reinterprets the past ECJ position on no bailout of sovereigns. His answers to the two central questions will be critical: how unlimited are “unlimited” purchases of sovereign bonds and can the ECB legally accept losses on par with private creditors? Absent clear answers, the nod-and-wink strategy will continue. That, however, will be in an invitation for markets to test the ECB’s word and resolve. And the test, sovereign attorneys Lee Buchheit and Mitu Gulati predict, could be merciless.

This article was first published in Bruegel. Reproduced with permission.