The preferred, puzzling, ESM | FT Alphaville

The preferred, puzzling, ESM

Eurozone states signed the final version of the treaty establishing the European Stabilisation Mechanism on February 2.

(Click the image for the full document)

The ESM treaty now heads for ratification by 17 states, ready for it to enter into force by July 2012. So much, so dull, so… deja vu. An earlier version was signed in summer 2011 but was never ratified as first Greece then Italy sent markets into a panic in July and December, shunting eurozone politicos into changes to what the ESM can do to bail out sovereigns and how it’s funded. (Full list of changes in this handy factsheet.)

Though we reckon this long-controversial portion of the treaty is worth reminding people about now that it’s finally close to becoming a reality…

(13) Like the IMF, the ESM will provide stability support to an ESM Member when its regular access to market financing is impaired or is at risk of being impaired. Reflecting this, Heads of State or Government have stated that the ESM loans will enjoy preferred creditor status in a similar fashion to those of the IMF, while accepting preferred creditor status of the IMF over the ESM. This status will be effective as of the date of entry into force of this Treaty. In the event of ESM financial assistance in the form of ESM loans following a European financial assistance programme existing at the time of the signature of this Treaty, the ESM will enjoy the same seniority as all other loans and obligations of the beneficiary ESM Member, with the exception of the IMF loans.

(14) The euro area Member States will support equivalent creditor status of the ESM and that of other States lending bilaterally in coordination with the ESM

So, yeah — this summer in Europe, sovereign debt investor subordination officially gets just that little bit worse if any sovereign needs a new bailout.

Though it’s been pointed out to us that it’s what the treaty says about the IMF that might be just as interesting. The Fund’s preferred creditor status is widely acknowledged and respected in the market, and it has been for decades. It’s de facto but not de jure. The IMF’s own Articles of Agreement refer to “adequate safeguards” which cover the preferred creditor status (PCS) but there’s no treaty making it totally explicit. PCS lets the Fund fulfil the “public good” role of lending to a sovereign which is restructuring its debt or in default with its private creditors. Ergo, the private creditors usually pragmatically accept PCS as a buttress to aiding recovery on their holdings. Always de facto though. Explicit de jure seniority might involve taking a risk with (for example) credit default swap triggers, acceleration event clauses in sovereign debt, pari passu clauses, etc. Whether it’d really be a serious risk of all these legal claims flying, we don’t know, but as it is the issue is shut off.

This de facto nature is one reason why a 2011 bid to have Ireland’s IMF loans declared a CDS credit event was unsurprisingly foiled by Isda’s determinations committee.

Right, so — how do the ESM treaty’s claims about seniority square with all that? It’s already pretty bonkers, with the ESM somehow being preferred, but not too preferred as it’s still junior to the IMF, and thus somehow eligible to take losses. It’s compounded in that the ESM offers its PCS to any country that makes bilateral loans alongside the ESM. Further down in the treaty, in its actual articles, there is a provision that (Art. 16[3]):

The financial terms and conditions of each ESM loan shall be specified in a financial assistance facility agreement, to be signed by the Managing Director

So — maybe — who knows until a loan agreement is signed. But the preamble bit above makes clear that the ESM’s status is effectively immediately on ratification. We are confused. One for the lawyers, perhaps? Although that’s the whole reason we want to raise this: IMF lending has never had this confusion. The ESM isn’t operational yet and it’s already confusing.



And if you want another little demonstration of the euro-guff lying around this actual, proper international treaty…

(12) In accordance with IMF practice, in exceptional cases an adequate and proportionate form of private sector involvement shall be considered in cases where stability support is provided accompanied by conditionality in the form of a macro-economic adjustment programme.

That’s a new bit added since the last signing, and we’ve always said it was guff. The IMF doesn’t organise or set rules for PSI, it only lays out red lines on debt sustainability. ‘Only’ but that can involve swingeing PSI if deemed necessary by the sovereign or its other creditors.

Which is exactly what’s happening in Greece.

Related link:
IMF takes tougher stance over Greek debt – FT