Firstly this debt exchange story is still that, just a story, and just doesn’t read right. It feels like either the reporter didn’t understand the source, or the source had some key detail wrong, but let’s pretend it’s true.
Well, early this week I tried to put some ideas down on what Greece should be doing. The key is ensuring that they have financing in place after a default. An operating central bank would be helpful and the ECB was on the list of groups that Greece needs to deal with. The exchange seems very favorable to the ECB. No notional reduction – which frankly seems greedy – why not just take a notional amount equal to the cost basis. Most importantly, it looks like the ECB is trying to segregate its holdings from the “private sector” bonds. This step would make it easy for Greece to default on old bonds and remain current on new bonds. Maybe that encourages greater participation, maybe it won’t. Why would Greece cut a special deal with the ECB that is so favorable to the ECB? Did they negotiate continued ECB support for its bonds as part of the exchange deal? I really don’t understand the exuberance over the story (which really does seem to be off).
On the other hand, maybe the problem is solved. Italy issued a 100 billion 30 year bonds with a 1% coupon. Banks buy these at 50 on the auction (since the ECB can’t participate in auctions). The banks then sell the bonds to the ECB for 55 . The banks build equity capital quickly since 5 points on a 100 billion adds up quickly. The ECB then exchanges these bonds for new bonds with a 1.1% coupon. It distributes the 45 points of “profit” to the Italian central bank. Italy would owe 1.1% on 100 billion of debt due in 30 years. Italy would have received 115 billion from the sale of the original bonds and their share of the ECB profits based on the exchange. The banks will have made 5 billion on a single trade. Repeat this as often as necessary. Does this sound stupid? If so, how is it so much different than the bond swap story the market is so excited about?