Analysis - Fitch offers ECB way out of Greece funding corner

A euro sculpture is pictured in front of the headquarter of the European Central Bank (ECB) in Frankfurt, January 15, 2009.

FRANKFURT (Reuters) - Ratings agency Fitch has opened the door to a possible compromise deal on Greece's debt crisis that would allow the European Central Bank to continue accepting Greek bonds as collateral in its funding operations.

The ECB is proving a major stumbling block in agreeing a second rescue plan for Greece as it has threatened to refuse to accept restructured Greek bonds as collateral in its lending operations in the event of a default or a "restricted default."

Such a scenario would cut off funding to much of Greece's financial sector, risking a destabilising chain reaction to banks across the euro zone.

The ECB's stance severely restricts the options for organising private bondholder involvement in a new rescue plan for Greece -- a key consideration for Germany, which is facing domestic pressure to involve the private sector in the cost.

Fitch offered a potential solution on Wednesday, saying that under a Vienna-type initiative for Greece, it would temporarily downgrade Greece's 'Issuer Default Rating' to 'restricted default' but keep the government bonds at 'CCC'.

Under the "Vienna Initiative" for central and eastern Europe, international lenders agreed in 2009 to boost credit to the region and the main commercial banks in turn committed to maintain exposure and roll over credit lines.

'CCC' is a non-investment grade, but this of itself does not necessarily present a barrier to the ECB accepting such bonds as collateral, rather under the current procedure it simply charges an additional 5-percent haircut on the bonds' value.

The problem that ECB policymakers have pointed to is with Greek bonds themselves being rated 'default' or 'restricted default', and maintaining at least one 'CCC' rating could avoid this situation and potentially allow the ECB to continue to accept them as collateral.

"If one of the rating agencies continues to rate Greek debt as eligible for collateral even if some voluntary rollover is done, it would help a lot to sort out their problem," said Berenberg Bank economist Holger Schmieding.

"Then the ECB would not have to bend its own rules -- especially Trichet would not have to take back what he said: namely no selective default."

ECB President Jean-Claude Trichet last week stressed that the bank opposes debt restructuring, which it worries could trigger another Lehman-type crisis in the euro zone, pushing up bond yields for countries such as Spain.

"We exclude all concepts which would not be purely voluntary, without any elements of compulsion. We call for avoiding any credit event and selective default, say. And of course, default," Trichet hold a news conference.

However, another senior ECB policymaker, Lorenzo Bini Smaghi, said on Wednesday the ECB continuously examines the collateral it considers eligible for its lending operations -- a comment that may suggest some room for compromise by the ECB.

"I would like to emphasise that our collateral eligibility and risk control framework is continually reviewed," he said.

BIGGER PROBLEM

While such a compromise deal may allow Greek banks to continue using their sovereign's bonds as collateral, it would not address the bigger problem of the ECB's Greek debt holdings.

The ECB is believed to have bought about 45 billion euros worth of the bonds since last year to try to calm the markets and is keen to avoid having to book losses on them, which could eat into its capital, limiting its ability to operate and might force it to seek new funds from euro zone governments.

"From the Fitch report, it looks like the ECB may well be able to receive Greek bonds as collateral," said Lena Komileva, economist at Brown Brothers Harriman. "It's the ECB's direct exposure to Greece that's the bigger issue here."

The ECB steadfastly opposes extending the maturities on the Greek bonds it holds -- which would hit its own balance sheet -- and as it owns so much of the debt its participation in any rollover could be crucial to any Vienna-style initiative.

Bini Smaghi underlined the ECB's position on Thursday.

"Asking the ECB, as has been the case recently, to extend the maturities of the government bonds it holds or to accept as collateral bonds from a state that is considered to have defaulted ... is a violation of the principle prohibiting the central bank from monetarily financing the treasury," he said.

Komileva believed some sort of a balance sheet transfer of Greek government bonds off the ECB's books may be possible.

"There is nothing like an emerging global capital market crisis to focus politicians' minds and regrettably the situation will probably have to get a lot worse before a political agreement can be reached in the 11th hour," she said.

(Editing by Patrick Graham)