ECB Purchases, Debt Buybacks, and Back Door Defaults

As the ECB return to the sovereign bond market, reportedly buying significant amounts of Portuguese bonds yielding more than 7 percent, every official in Europe continues to insist that there can be no sovereign default by a Eurozone member. This indisputable tenet is also sustained while proposals fly about allowing the EFSF to finance bond buy backs either directly in the secondary market or by lending for that purpose to the sovereigns in distress.

If one disregards all the euphemisms, technical jargon, and intentional deceiving terminology, what is being discussed is how to go about a default without actually being seen as defaulting.

It is true that the suggested buy back is a market mechanism and participation is voluntary. And it is also true that if a bond holder realizes a loss voluntarily is not the same as one that is forced to take the loss. But the one that is realizing the loss voluntarily is doing so not because it is his preferable course of action but because he believes that he is not going to be fully paid by the issuer and that his loss would actually be higher in the future. A voluntary restructuring may be better than a forced default but in practice both are the expression of the unlikelihood of the issuer to fulfill his obligations. Therefore, buy backs (i.e., voluntary restructuring) may be more amicable, may not trigger CDSs or violate obscure clauses in European treaties but are in practice a default. In actual fact, the countries involved end up paying to the private sector that bought the bonds less than its face value.

If this is the case, when it comes down to it, this is exactly what the ECB is already doing. The ECB is not a governmental entity. It is independent and supranational. But it is certainly not part of the private sector and by buying in secondary markets what is by now distressed debt is clearly reducing the exposure of the sovereign to the private sector that is willingly accepting a haircut. In other words, the proposals about buy backs by the EFSF will probably be agreed in some way or another, because they are more elegant than a straightforward default. But this should not distract attention from the fact that a silent default is already ongoing at the ECB level.