Greek bond yields have soared this month on speculation that Athens may have to restructure its 327 billion euro sovereign debt by choosing one or more of several options: extending maturities, lowering interest rates, or cutting the principal.
The first two options would have a softer impact on debt holders and therefore be more acceptable to private and official creditors. But some economists believe cutting the principal in a so-called "haircut" -- conceivably by 50 percent or more -- will be necessary to transform Greece's prospects.
However, legal experts who have studied past restructurings and the Greek case believe European authorities would need to take big losses themselves in the event of a haircut.
That decreases the chances of them going down this path now, or even in subsequent years when their exposure to Greek sovereign debt will have risen.
"If we get to the point where Greece has to do haircuts, the only way it will work is if the official sector is willing not only to take the pain but to lead the way," said Mitu Gulati, a law professor at Duke University in the United States who co-authored a recent paper exploring the options for policymakers in the Greek case.
"This is the nightmare scenario for them. If they have to take significiant losses it would make it very difficult for them to go into rescue mode in the future."
The crucial difference between Greece and the Latin American default cases of the 1980s is that by bailing out Athens, official creditors in Europe are effectively taking on debt that would otherwise be held by the private sector. This complicates the calculus and increases the number of players that would take a hit in any restructuring.
Because of the bond-buying programme which the ECB reluctantly put in place last year, it now has exposure to Greek sovereign debt of an estimated 40 billion euros, not including bonds it has accepted as collateral in its lending operations.
Eurozone governments have made direct emergency loans to Greece of 38.4 billion euros so far, and that figure is due to rise to 80 billion euros in 2013, when the rescue package they launched with the International Monetary Fund expires. By then, official creditors will own roughly half of Greece's total debt.
Pari passu
While the IMF enjoys preferred creditor status in all its loans and would probably be shielded from any haircut, the ECB and European governments would have difficulty claiming any seniority.
European governments have insisted on preferred status in plans for their future crisis fund, the European Stability Mechanism (ESM), but their loan deal with Greece was done on a "pari passu" or equal-ranking basis.
The ECB's exposure, meanwhile, resulted from purchases of Greek bonds on the open market, which would not normally offer any special protection. From a strictly legal point of view, the ECB and governments would have to swallow the same losses as commercial banks, pension funds and other private entities.
Those losses would be limited by the fact that the ECB bought its bonds from the market at discounted prices, but they would still have dangerous implications for the central bank and its role in future crises. By paying for the spendthrift behaviour of a euro zone government, the ECB could be accused of violating basic principles of sound monetary management.
The ECB could dip into its reserves to help pay for such losses, but many analysts believe it might again have to go cap in hand to euro zone governments for fresh capital. Just last December, it announced a 5billion euro increase in its subscribed capital to 10.76 billion euros, saying it needed to cope with increased market volatility and credit risk.
"Central banks everywhere have an interest in not seeing the ECB take a haircut on the Greek bonds it holds," said Anna Gelpern, a law professor at American University in Washington.
"No central bank would want to cross that bridge and you would expect the political authorities to be of the same mind. Restructuring on the books of the ECB would be even worse than doing it on the books of the IMF."
Complicating the situation is the fact that outgoing ECB President Jean-Claude Trichet pushed through last year's decision to buy Greek bonds over the objections of other central bank policymakers, notably Bundesbank chief Axel Weber.
Taking losses on those bonds would raise new questions about Trichet's decision, which was taken under intense political pressure, and could tarnish his legacy.
In recent weeks, ECB policymakers have vehemently opposed the idea of a Greek debt restructuring on the grounds that it would hurt European banks and could spark panic in markets by fuelling speculation about possible Irish and Portuguese restructurings down the road.
But the impact on the ECB's own finances and credibility are probably equally important factors behind its position.
Lesser evil
For European governments, the prospect of a haircut on Greek bonds may be just as unpalatable. If private investors in Greek bonds are asked to take losses, there will be intense pressure on donor governments to accept haircuts on their emergency loans as well, to spread the financial burden.
Politically this could be very damaging for European leaders, who have justified the eurozone bailouts by telling their taxpayers that they can expect eventually to recover the emergency loans in full.
The alternative -- trying to convince their taxpayers to throw more money at Athens in 2012, 2013 and beyond, to keep Greece afloat without a default -- is also deeply unattractive, but may be seen as the lesser of two evils.
David Skeel, a professor at the University of Pennsylvania law school who has written about Argentina's debt default, says a messy, drawn-out solution like this may be the only acceptable path for all concerned, given the role of European authorities as major holders of Greek debt.
"The ECB and European governments intertwining themselves with the private creditors has increased the variables at play exponentially," he said.
"Longstanding assumptions about the creditor pecking order have been thrown out the window with Greece. And that means there is no silver bullet solution."
REUTERS
