Sovereign Bond Risks to Increase Significantly

February 21, 2012

If you remember, we were frightened when the U.S. Government threw out two hundred years of settled law when they arbitrarily threw out the superior claims of General Motors' bondholders in favor of the subordinated claims of the shareholders and unions. But, we have since dismissed this incident as being just against one company; and besides it was politically expedient.

However, we did the exact opposite in the financial crisis when we saved the bondholders with public funds. Again, it was politically expedient.

Saturday, the European Central Bank (ECB) did something they may regret later. They exchanged their existing Greek bonds for "New Greek" bonds that are not subject to the "collective action clause" (which allows a supermajority of bondholders to agree to a debt restructuring.) Now, under the new terms, the ECB has first claim to Greek assets over all other bondholders. They did this without the other bondholders consent and without objection from other European nations.

In other words, the ECB can now retroactively change the terms of any bond contract. For example, who has the superior claims against assets, the interest rates, the maturities, etc. at any time it's to their advantage and without bondholder acceptance. No rule of law. No judicial appeal.

Bond buyers will now have to reassess the current value of European bonds for this new risk and then evaluated them against U.S. Treasuries where we have had the rule of law. This increased risk should have an impact on Europe and on our markets.