A "Conditional Bazooka": European Top Court Finds ECB's OMT "May Be Legal" But Must Meet Conditions

Almost a year ago, the German top court found that ECB's OMT is "illegal", then promptly washed its hands of the final decision, kicking the ball in the court of the European Court of Justice. Moments ago, the Advocate General Pedro Cruz Villalon of the EU Court of Justice in Luxembourg delivered the non-binding opinion on issue of Mario Draghi's "unconditional" OMT.

The full opinion can be found here. Below are the details from Reuters and Bloomberg:


The conditions:


Basically, the court has allowed the ECB to drive down borrowing costs using the OMT but it can't fund bailouts. How the two will be "separated" in a world of fungible money is unclear and will likely be the basis for another court appeal. 

The conditionality clause from the Press Release:



A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.


The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.


Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.



Here is the full Default Risk section:

Default risk


The BVerfG also points out that a purchase of government bonds with a, to some extent foreseeably, low credit rating exposes the ECB to an excessive default risk and is therefore incompatible with Article 123(1) TFEU. Although the referring court itself recognises that the assumption of risk is inherent to the activity of a central bank, it considers that the Treaties do not authorise exposure to losses of a significant amount.


Once again, I refer to the reasoning set out in points 193 to 198 of this Opinion, in which I dealt in some detail with the assumption of risks by the ECB. To my mind, that reasoning may perfectly well be applied to the present aspect of the case, since, as has been observed above, the fact that there is a possibility — which purely on principle cannot be discounted — of the ECB’s insolvency or a Member State’s default does not convert the risk, on that ground alone, into a certainty. The fact that a programme for the purchase of government bonds exposes the ECB to a risk is, as one might expect, inherent in this kind of operation and, consequently, doubts as to legality need arise only when the technical conditions of the programme, or its subsequent specific implementation, confirm that the ECB is clearly faced with a default scenario.


In fact, the technical features of the OMT programme do not suggest that the ECB is exposed, with any degree of foreseeability, to a scenario like the one depicted by the BVerfG. It should be recalled that the central objective of the OMT programme is to stabilise the interest rates applicable to certain government bonds with the ultimate aim of restoring the instruments of monetary policy. However, the immediate objective (the reduction of the financing costs of the State concerned) itself contributes to that State recovering its ability to meet its obligations in the medium and long term. The framework in which the OMT programme would be accorded is intended to eliminate or at least reduce such a risk. As I have already pointed out in point 197 of this Opinion, the fact that, considered as a whole, the transactions announced in the OMT programme confirm the ECB’s intention of guarding against or preventing more or less irrational processes which generate or significantly increase risks, tends to establish that a measure such as that at issue does not entail circumvention of the prohibition in Article 123 TFEU.


I consider, in short, that that intention on the part of the ECB has been sufficiently established for it to be concluded that a purchase of government bonds — even ones with a low credit rating — which may expose the ECB to a degree of risk of default, is not as such contrary, in the circumstances described, to the prohibition of monetary financing laid down in Article 123(1) TFEU.

So the ECB does not "take on risk" - did this guy miss the whole part about how the ECB became one of the world's biggest hedge funds in recent years with its record direct and indirect holdings of European peripheral bonds? Apparently all it took was a few phone calls from Goldman and the ECB to make sure he did.

On Pari Passu status:

Creditor treatment


The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

And this is how Article 123 was just squashed:

Waiver of rights and pari passu status


The full or partial waiver of claims securitised in government bonds of the State subject to the OMT programme is the first feature which, according to the BVerfG, could render the programme contrary to Article 123(1) TFEU. In the referring court’s view, as in that of a number of the applicants in the main proceedings, the fact that the ECB and the central banks do not have the status of preferential creditor but rank pari passu and may be obliged to accept a full or partial waiver in the context of a restructuring agreement, (92) makes the measure into an indirect means of financing the debtor State.


I do not find that argument convincing. In the first place, it must be borne in mind that the risk of a full or partial waiver relates only to a future and hypothetical situation entailing the restructuring of the debtor State’s debt and is not, so to speak, an intrinsic component of the OMT programme. As I have already explained in points 193 and 194 of this Opinion, the assumption of risk is inherent in a central bank’s activity, so that an event such as that described by the referring court cannot become, merely because it might conceivably occur, a necessary consequence of implementation of the programme.


Moreover, the ECB has stated in its written observations that, in the context of a restructuring subject to CACs, it will always vote against a full or partial waiver of its claims. In other words, the ECB will not actively contribute to bringing about a restructuring but will seek to recover in full the claim securitised on the bond. The fact that the ECB acts with a view to preserving its claim in full confirms that the aim of its conduct is not to grant a financial advantage to the debtor State but to ensure that the latter meets the obligation it has entered into.


Finally, I think that the point should also be made that a purchase by the ECB, as a non-preferential creditor, of the debt securities of a Member State will inevitably involve a degree of distortion of the market, which appears to me, however, to be tolerable from the point of view of the prohibition in Article 123(1) TFEU. By contrast, as has been explained in point 183 of this Opinion, purchases made with the status of preferential creditor deter other investors, since they send out the message that a significant creditor, in this case a central bank, will be given preference over other creditors in the recovery, with the impact that that will have on demand for bonds. Accordingly, I take the view that pari passu clauses may be regarded as a means that seeks to ensure that the ECB disrupts the normal functioning of the market as little as possible, which, ultimately, involves a further guarantee of compliance with Article 123(1) TFEU.


I therefore consider that the fact that the ECB might be obliged — in the hypothetical event of a restructuring of a Member State’s debt — to waive, in full or in part, its claims securitised in government bonds, as a result of the OMT programme being activated, does not mean that the programme amounts to a monetary financing measure contrary to Article 123(1) TFEU.

And then some more goalseeked humor to validate the breach of Article 123:

Holding the bonds until maturity


The BVerfG also asserts that holding government bonds until maturity may conflict with Article 123(1) TFEU, since it reduces the number of bonds circulating on the secondary market, thereby disrupting the normal development of market prices.


It is true, as the BVerfG has argued, that if the ECB were to purchase government bonds under an obligation to hold them until maturity, that would give rise to a significant distortion on the secondary market for government securities. The secondary government bond market would have to reckon with the presence of an investor — the ECB — holding a substantial portfolio of government bonds which would not circulate on that market, regardless of the way in which their market price developed.


The ECB has, in response, emphasised that at no point in the press release of 6 September 2012 is it stated that government bonds purchased under the OMT programme will be held until maturity

Bottom line: Draghi's "unconditional" bazooka just became conditional, but it is still a bazooka, albeit one that will never actually be used since well over two years after it was revealed following Draghi's famous "whatever it takes" speech, it still has no legal termsheet or basis, and no definition on its pari passu or burden-sharing status. And it never will: after all it was merely meant as a precautionary device designed to scare away the bond vigilantes, and never to be actually implemented.

Some more from the FT:

Mr Villalón said in a statement that the ECB' should have "broad discretion" in framing and implementing the eurozone's monetary policy", and argued that legal courts therefore "must exercise a considerable degree of caution when reviewing the ECB's activity, since they lack the expertise and experience which the ECB has in this area".


Therefore, in Advocate General Cruz Villalón's view, the OMT programme decided upon by the ECB, as it results from the technical features described in the press release, does not infringe the principle of proportionality and may be considered lawful, provided that, in the event of the programme being implemented, the obligation to state reasons and the requirements deriving from the principle of proportionality are strictly complied with.


However, the advocate general did say that the OMT programme constituted an "unconventional monetary policy measure", which must comply with certain legal provisions.


Thus, in the event of the OMT programme being implemented, the ECB must, if the programme is to retain its character of a monetary policy measure, refrain from any direct involvement in the financial assistance programme that applies to the State concerned.


The Advocate General considers that the ECB must give a proper account of the reasons for adopting an unconventional measure such as the OMT programme, identifying clearly and precisely the extraordinary circumstances that justify the measure. Given that no such justification is to be found in the press release of 6 September 2012, if the programme is put into practice, both the legal act which gives it form, and its implementation, will have to satisfy those requirements relating to reasons.

So what does this mean, and how will Germany react? Here is a useful primer from SocGen which we posted several days ago explaining the next steps,and whose outcome we now know:

Where are we now? It appears the answer, absent additional details, is the red "baseline" scenario, which as SocGen noted "would undermine Draghi's promise of "whatever it takes" and leave the region more vulnerable to an eventual ressurgence of risk."

Finally some other observations via the social networks: