Banks, companies and investors are preparing themselves for a collapse of the euro. Cross-border bank lending is falling, asset managers are shunning Europe and money is flowing into German real estate and bonds. The euro remains stable against the dollar because America has debt problems too. But unlike the euro, the dollar’s structure isn’t in doubt.08/13/2012 By Martin Hesse
Otmar Issing is looking a bit tired. The former chief economist at the European Central Bank (ECB) is sitting on a barstool in a room adjoining the Frankfurt Stock Exchange. He resembles a father whose troubled teenager has fallen in with the wrong crowd. Issing is just about to explain again all the things that have gone wrong with the euro, and why the current, as yet unsuccessful efforts to save the European common currency are cause for grave concern.
He begins with an anecdote. “Dear Otmar, congratulations on an impossible job.” That’s what the late Nobel Prize-winning American economist Milton Friedman wrote to him when Issing became a member of the ECB Executive Board. Right from the start, Friedman didn’t believe that the new currency would survive. Issing at the time saw the euro as an “experiment” that was nevertheless worth fighting for.
Fourteen years later, Issing is still fighting long after he’s gone into retirement. But just next door on the stock exchange floor, and in other financial centers around the world, apparently a great many people believe that Friedman’s prophecy will soon be fulfilled.
Banks, investors and companies are bracing themselves for the possibility that the euro will break up — and are thus increasing the likelihood that precisely this will happen.
There is increasing anxiety, particularly because politicians have not managed to solve the problems. Despite all their efforts, the situation in Greece appears hopeless. Spain is in trouble and, to make matters worse, Germany’s Constitutional Court will decide in September whether the European Stability Mechanism (ESM) is even compatible with the German constitution.
There’s a growing sense of resentment in both lending and borrowing countries — and in the nations that could soon join their ranks. German politicians such as Bavarian Finance Minister Markus Söder of the conservative Christian Social Union (CSU) are openly calling for Greece to be thrown out of the euro zone. Meanwhile the the leader of Germany’s opposition center-left Social Democrats (SPD), Sigmar Gabriel, is urging the euro countries to share liability for the debts.
On the financial markets, the political wrangling over the right way to resolve the crisis has accomplished primarily one thing: it has fueled fears of a collapse of the euro.
Cross-Border Bank Lending Down
Banks are particularly worried. “Banks and companies are starting to finance their operations locally,” says Thomas Mayer who until recently was the chief economist at Deutsche Bank, which, along with other financial institutions, has been reducing its risks in crisis-ridden countries for months now. The flow of money across borders has dried up because the banks are afraid of suffering losses.
According to the ECB, cross-border lending among euro-zone banks is steadily declining, especially since the summer of 2011. In June, these interbank transactions reached their lowest level since the outbreak of the financial crisis in 2007.
In addition to scaling back their loans to companies and financial institutions in other European countries, banks are even severing connections to their own subsidiaries abroad. Germany’s Commerzbank and Deutsche Bank apparently prefer to see their branches in Spain and Italy tap into ECB funds, rather than finance them themselves. At the same time, these banks are parking excess capital reserves at the central bank. They are preparing themselves for the eventuality that southern European countries will reintroduce their national currencies and drastically devalue them.
“Even the watchdogs don’t like to see banks take cross-border risks, although in an absurd way this runs contrary to the concept of the monetary union,” says Mayer.
Since the height of the financial crisis in 2008, the EU Commission has been pressuring European banks to reduce their business, primarily abroad, in a bid to strengthen their capital base. Furthermore, the watchdogs have introduced strict limitations on the flow of money within financial institutions. Regulators require that banks in each country independently finance themselves. For instance, Germany’s Federal Financial Supervisory Authority (BaFin) insists that HypoVereinsbank keeps its money in Germany. When the parent bank, Unicredit in Milan, asks for an excessive amount of money to be transferred from the German subsidiary to Italy, BaFin intervenes.
Unicredit is an ideal example of how banks are turning back the clocks in Europe: The bank, which always prided itself as a truly pan-European institution, now grants many liberties to its regional subsidiaries, while benefiting less from the actual advantages of a European bank. High-ranking bank managers admit that, if push came to shove, this would make it possible to quickly sell off individual parts of the financial group.
In effect, the bankers are sketching predetermined breaking points on the European map. “Since private capital is no longer flowing, the central bankers are stepping into the breach,” explains Mayer. The economist goes on to explain that the risk of a breakup has been transferred to taxpayers. “Over the long term, the monetary union can’t be maintained without private investors,” he argues, “because it would only be artificially kept alive.”
The fear of a collapse is not limited to banks. Early last week, Shell startled the markets. “There’s been a shift in our willingness to take credit risk in Europe,” said CFO Simon Henry.
He said that the oil giant, which has cash reserves of over $17 billion (€13.8 billion), would rather invest this money in US government bonds or deposit it on US bank accounts than risk it in Europe. “Many companies are now taking the route that US money market funds already took a year ago: They are no longer so willing to park their reserves in European banks,” says Uwe Burkert, head of credit analysis at the Landesbank Baden-Württemberg, a publicly-owned regional bank based in the southern German state of Baden-Württemberg.
And the anonymous mass of investors, ranging from German small investors to insurance companies and American hedge funds, is looking for ways to protect themselves from the collapse of the currency — or even to benefit from it. This is reflected in the flows of capital between southern and northern Europe, rapidly rising real estate prices in Germany and zero interest rates for German sovereign bonds.
‘Euro Experiment is Increasingly Viewed as a Failure’
One person who has long expected the euro to break up is Philipp Vorndran, 50, chief strategist at Flossbach von Storch, a company that deals in asset management. Vorndran’s signature mustache may be somewhat out of step with the times, but his views aren’t. “On the financial markets, the euro experiment is increasingly viewed as a failure,” says the investment strategist, who once studied under euro architect Issing and now shares his skepticism. For the past three years, Vorndran has been preparing his clients for major changes in the composition of the monetary union.
They are now primarily investing their money in tangible assets such as real estate. The stock market rally of the past weeks can also be explained by this flight of capital into real assets. After a long decline in the number of private investors, the German Equities Institute (DAI) has registered a significant rise in the number of shareholders in Germany.
Particularly large amounts of money have recently flowed into German sovereign bonds, although with short maturity periods they now generate no interest whatsoever. “The low interest rates for German government bonds reflect the fear that the euro will break apart,” says interest-rate expert Burkert. Investors are searching for a safe haven. “At the same time, they are speculating that these bonds would gain value if the euro were actually to break apart.”
The most radical option to protect oneself against a collapse of the euro is to completely withdraw from the monetary zone. The current trend doesn’t yet amount to a large-scale capital flight from the euro zone. In May, (the ECB does not publish more current figures) more direct investments and securities investments actually flowed into Europe than out again. Nonetheless, this fell far short of balancing out the capital outflows during the troubled winter quarters, which amounted to over €140 billion.
The exchange rate of the euro only partially reflects the concerns that investors harbor about the currency. So far, the losses have remained within limits. But the explanation for this doesn’t provide much consolation: The main alternative, the US dollar, appears relatively unappealing for major investors from Asia and other regions. “Everyone is looking for the lesser of two evils,” says a Frankfurt investment banker, as he laconically sums up the situation. Yet there’s growing skepticism about the euro, not least because, in contrast to America and Asia, Europe is headed for a recession. Mayer, the former economist at Deutsche Bank, says that he expects the exchange rates to soon fall below 1.20 dollars.
“We notice that it’s becoming increasingly difficult to sell Asians and Americans on investments in Europe,” says asset manager Vorndran, although the US, Japan and the UK have massive debt problems and “are all lying in the same hospital ward,” as he puts it. “But it’s still better to invest in a weak currency than in one whose structure is jeopardized.”
Hedge Fund Gurus Give Euro Thumbs Down
Indeed, investors are increasingly speculating directly against the euro. The amount of open financial betting against the common currency — known as short positioning — has rapidly risen over the past 12 months. When ECB President Mario Draghi said three weeks ago that there was no point in wagering against the euro, anti-euro warriors grew a bit more anxious.
One of these warriors is John Paulson. The hedge fund manager once made billions by betting on a collapse of the American real estate market. Not surprisingly, the financial world sat up and took notice when Paulson, who is now widely despised in America as a crisis profiteer, announced in the spring that he would bet on a collapse of the euro.
Paulson is not the only one. Investor legend George Soros, who no longer personally manages his Quantum Funds, said in an interview in April that — if he were still active — he would bet against the euro if Europe’s politicians failed to adopt a new course. The investor war against the common currency is particularly delicate because it’s additionally fueled by major investors from the euro zone. German insurers and managers of large family fortunes have reportedly invested with Paulson and other hedge funds. “They’re sawing at the limb that they’re sitting on,” says an insider.
So far, the wager by the hedge funds has not paid off, and Paulson recently suffered major losses.
But the deciding match still has to be played.
Translated from the German by Paul Cohen
- DER SPIEGEL: Investors Prepare for Euro Collapse (investmentwatchblog.com)
- Spiegel: Investors Prepare For Euro Collapse | ZeroHedge (underinformation.wordpress.com)
- Spanish Banks’ ECB Loans Rise as Rajoy Mulls Second Bailout Call – Bloomberg (bloomberg.com)
- Stop Fooling Yourself… NO Entity On Earth Can Stop This (zerohedge.com)
- Things Are Going To Collapse Again In Europe ( Bank of America and AMP) (ampgoldportfolio.com)
- Merkel Returns to Crisis as Leaders Squabble Over Bond Purchases (bloomberg.com)
- Hedge Funds Capitulate on European Shorts Fastest Since 2009 (bloomberg.com)
- The Market Oracle – DK Matai – European Bankers And Top Politicians Fear Collapse Of The Euro – 12 August 2012 (lucas2012infos.wordpress.com)
Euro zone leaders agreed in principle on June 29 to establish a joint banking supervisor for the 17-nation single currency area, based on the European Central Bank, although most of the crucial details remain to be worked out.
The proposal was a tentative first step towards a European banking union that could eventually feature a joint deposit guarantee and a bank resolution fund, to prevent bank runs or collapses sending shock waves around the continent.
The leaders agreed that the euro zone’s permanent bailout fund, the 500 billion euro ($620 billion) European Stability Mechanism, would be able to inject capital directly into banks on strict conditions once the joint supervisor is established.
But the rush to put first elements of such a system in place by next year may come too late.
Deposit flight from Spanish banks has been gaining pace and it is not clear a euro zone agreement to lend Madrid up to 100 billion euros in rescue funds will reverse the flows if investors fear Spain may face a full sovereign bailout.
Many banks are reorganizing, or being forced to reorganize, along national lines, accentuating a deepening north-south divide within the currency bloc.
An invisible financial wall, potentially as dangerous as the Iron Curtain that once divided eastern and western Europe, is slowly going up inside the euro area.
The interest rate gap between north European creditor countries such as Germany and the Netherlands, whose borrowing costs are at an all-time low, and southern debtor countries like Spain and Italy, where bond yields have risen to near pre-euro levels, threatens to entrench a lasting divergence.
Since government credit ratings and bond yields effectively set a floor for the borrowing costs of banks and businesses in their jurisdiction, the best-managed Spanish or Italian banks or companies have to pay far more for loans, if they can get them, than their worst-managed German or Dutch peers.
The longer that situation goes on, the less chance there is of a recovery in southern Europe and the bigger will grow the wealth gap between north and south.
With ever-higher unemployment and poverty levels in southern countries, a political backlash, already fierce in Greece and seething in Spain and Italy, seems inexorable.
European Central Bank President Mario Draghi acknowledged as he cut interest rates last week that the north-south disconnect was making it more difficult to run a single monetary policy.
Two huge injections of cheap three-year loans into the euro zone banking system this year, amounting to 1 trillion euros, bought only a few months’ respite.
“It is not clear that there are measures that can be effective in a highly fragmented area,” Draghi told journalists.
Conservative German economists led by Hans-Werner Sinn, head of the Ifo institute, are warning of dire consequences for Germany from ballooning claims via the ECB’s system for settling payments among national central banks, known as TARGET2.
If a southern country were to default or leave the euro, they contend, Germany would be left with an astronomical bill, far beyond its theoretical limit of 211 billion euros liability for euro zone bailout funds.
As long as European monetary union is permanent and irreversible, such cross-border claims and capital flows within the currency area should not matter any more than money moving between Texas and California does.
But even the faintest prospect of a Day of Reckoning changes that calculus radically.
In that case, money would flood into German assets considered “safe” and out of securities and deposits in countries seen as at risk of leaving the monetary union. Some pessimists reckon we are already witnessing the early signs of such a process.
Any event that makes a euro exit by Greece – the most heavily indebted member state, which is off track on its second bailout program and in the fifth year of a recession – look more likely seems bound to accelerate those flows, despite repeated statements by EU leaders that Greece is a unique case.
“If it does occur, a crisis will propagate itself through the TARGET payments system of the European System of Central Banks,” U.S. economist Peter Garber, now a global strategist with Deutsche Bank, wrote in a prophetic 1999 research paper.
Either member governments would always be willing to let their national central banks give unlimited credit to each other, in which case a collapse would be impossible, or they might be unwilling to provide boundless credit, “and this will set the parameters for the dynamics of collapse”, Garber warned.
“The problem is that at the time of a sovereign debt crisis, large portions of a national balance sheet may suddenly flee to the ECB’s books, possibly overwhelming the capacity of a bailout fund to absorb the entire hit,” he wrote in 2010, after the start of the Greek crisis, in a report for Deutsche Bank.
European officials tend to roll their eyes at such theories, insisting the euro is forever, so the issue does not arise.
In practice, national regulators in some EU countries are moving quietly to try to reduce their home banks’ exposure to such an eventuality. The ECB itself last week set a limit on the amount of state-backed bank bonds that banks could use as collateral in its lending operations.
In one high-profile case, Germany’s financial regulator Bafin ordered HypoVereinsbank (HVB), the German subsidiary of UniCredit (CRDI.MI), to curb transfers to its parent bank in Italy last year, people familiar with the case said.
Such restrictions are legal, since bank supervision is at national level, but they run counter to the principle of the free movement of capital in the European Union’s single market and to an integrated currency union.
Whether a single euro zone banking supervisor would be able to overrule those curbs is one of the many uncertainties left by the summit deal. In any case, common supervision without joint deposit insurance may be insufficient to reverse capital flight.
German Chancellor Angela Merkel, keen to shield her grumpy taxpayers, has so far rejected any sharing of liability for guaranteeing bank deposits or winding up failed banks.
Veteran EU watchers say political determination to make the single currency irreversible will drive euro zone leaders to give birth to a full banking union, and the decision to create a joint supervisor effectively got them pregnant.
But for now, Europe’s financial disintegration seems to be moving faster than the forces of financial integration.
(Editing by David Holmes)
- Most-Accurate Forecasters See Euro Bottom at Odds With Options – Bloomberg (bloomberg.com)
- German president tells Angela Merkel to come clean on EU debt deal (independent.ie)
- Marsh on Monday: German anti-euro backlash gathers pace (marketwatch.com)
Having finished his “damage control” PR campaign (for now) Ben Bernanke decided to discuss… Europe, urging the Big Banks to help prop up the system over there.
Exclusive: Bernanke breaks bread with top bankers
After completing a series of public lectures in Washington, D.C. last week, Federal Reserve Chairman Ben Bernanke quietly slipped into New York City for a private luncheon on Friday with Wall Street executives.
Fortune has learned that attendees included Jamie Dimon (J.P. Morgan), Bob Diamond (Barclays), Brady Dougan (Credit Suisse), Larry Fink (Blackrock), Gerald Hassell (Bank of New York Mellon), Glenn Hutchins (Silver Lake), Colm Kelleher (Morgan Stanley), Brian Moynihan (Bank of America), Steve Schwarzman (Blackstone Group) and David Vinar (Goldman Sachs).
Sources say Bernanke spoke at length about monetary policy, in an apparent effort to persuade attendees that they needed to take a more active role in helping to deal with the European debt crisis. He spent virtually no time discussing regulation, although that mantle got taken up by both Dimon (domestic regulation) and Schwarzman (global regulation).
The lunch was held at the New York Fed, and hosted by NY Fed president William Dudley. Before leaving New York, Bernanke separately addressed NY Fed staffers.
This is an interesting progression from the last time Fed officials went to New York:
Fed met with major financial firms to discuss Volcker Rule impact
Documents released by the Federal Reserve on Monday show that its officials met with some of Wall Street’s major financial firms earlier this month to discuss Volcker Rule implications.
The Fed met with representatives from Goldman Sachs, JPMorgan Chase and Morgan Stanley on Nov. 8, according to Bloomberg.com. Bank lawyers H. Rodgin Cohen and Michael Wiseman from Sullivan & Cromwell were also present during the meeting.
According to the documents, the meeting entailed a discussion on “possible unintended consequences of the rule.”
Notice that during discussions of regulations, it was “Fed officials” who attended these meetings, NOT Bernanke himself (at least he’s not mentioned anywhere). So why is Bernanke, the head of the Fed wanting to meet with bankers to discuss Europe instead of Regulation?
You guessed it: Bernanke realizes Europe is totally and completely bust… and that the coming fall-out will be disastrous for the global banking system.
After all, the ECB spent over $1 trillion trying to prop up the system over there. And already the effects of LTRO 2 (which was worth $712 billion) have been wiped out. If you don’t think this sent a chill up Bernanke’s spine, you’re not thinking clearly.
Consider the following facts which I guarantee you Bernanke is well aware of:
- 1) According to the IMF, European banks as a whole are leveraged at 26 to 1 (this data point is based on reported loans… the real leverage levels are likely much, much higher.) These are a Lehman Brothers leverage levels.
- 2) The European Banking system is over $46 trillion in size (nearly 3X total EU GDP).
- 3) The European Central Bank’s (ECB) balance sheet is now nearly $4 trillion in size (larger than Germany’s economy and roughly 1/3 the size of the ENTIRE EU’s GDP). Aside from the inflationary and systemic risks this poses (the ECB is now leveraged at over 36 to 1).
- 4) Over a quarter of the ECB’s balance sheet is PIIGS debt which the ECB will dump any and all losses from onto national Central Banks (read: Germany)
So we’re talking about a banking system that is nearly four times that of the US ($46 trillion vs. $12 trillion) with at least twice the amount of leverage (26 to 1 for the EU vs. 13 to 1 for the US), and a Central Bank (the ECB) that has stuffed its balance sheet with loads of garbage debts, giving it a leverage level of 36 to 1.
I guarantee you Bernanke knows about all of the above. He also knows the ECB’s used up all of its ammunition fighting the Crisis over there. And lastly, he knows that the Fed cannot move to help Europe without risking his job. After all, even the Dollar swap move the Fed made in November 2011 saw severe public outrage and that didn’t even include actual money printing or more QE!
Moreover, Bernanke knows that the IMF can’t step up to help Europe. The IMF is, after all, a US-backed entity. How many times has it requested more money to help Europe? Maybe a dozen? And the answer from the US has always been the same: “No.”
Finally, the G20 countries have made it clear they don’t want to spend more money on Europe either. They keep dangling a bailout carrot in front of the EU claiming they’ll cough up more dough if the EU can get its monetary house in order… knowing full well that they actually cannot provide more funds (otherwise they’d have already done it).
This leaves the private banks as Bernanke’s last resort for a “backdoor” prop for Europe. If private meeting with the TBTFs that focuses on Europe doesn’t scream of desperation, I don’t know what does.
And do you think the big banks, which have all depleted their capital to make their earnings look better, actually have the money to help Europe? No chance.
Which means that Europe is going to collapse. Literally no one has the firepower or the political support to stop it.
Remember, we’re talking about banking system that’s a $46 trillion sewer of toxic PIIGS debt that is leveraged at more than 26 to 1 (Lehman was leveraged at 30 to 1 when it went under).
Again, NO ONE has the capital to prop the EU up much longer. And the collapse is coming.
If you’re not already taking steps to prepare for the coming collapse, you need to do so now.
- Bernanke Just Admitted the Fed Failed… Not That More QE Is Coming (zerohedge.com)
- Exclusive: Bernanke breaks bread with top bankers (finance.fortune.cnn.com)
- Revisited: Three Data Points That Prove Europe Cannot Be Saved (zerohedge.com)
- We Are Nearing the End Game For Central Bank Intervention (zerohedge.com)
AP | Jan. 18, 2012, 4:44 AM
It’s a sign of stress in the banking system. The high deposits in the ECB’s safe haven indicate banks are unwilling to lend to each other because they are afraid they might not be paid back.
The Tuesday deposits were reported Wednesday. They broke the old record of euro501.9 billion from Monday.
The eurozone debt crisis is pressuring banks because they hold government bonds issued by countries with shaky finances, and could suffer losses on those bonds if the countries do not pay or the bonds fall in value.
Banks took euro489 billion in emergency loans from the ECB last month, leaving the system awash with cash.
They argue that one euro will fall to just $1.20 within the next four months, compared to a current value around $1.34. What’s more, they think this estimate has downside risks.
Their analysis is predicated on a baseline scenario that EU leaders will put stop-gap measures in place in the near-term but will ultimately have to adopt large-scale QE to stave of the crisis in the medium term.
From their investor note:
In our central case, in which the ECB will be forced into a delayed and reactive large-scale QE, risk assets could trade better over time (assuming that the QE amount is sufficient). But it is likely to be seen as a change in the ECB reaction function, and hence we think EUR/USD would trade lower in the medium term. AUD, CAD and EM FX should perform quite well in this scenario.
We also expect ECB QE and although the immediate effect upon announcement of such measures may well be EUR bullish, large-scale monetization is likely to weigh negatively on the EUR in the medium term, hence providing an offsetting force to any USD negativity related to Fed QE3.
- NOMURA: The Euro Is Going To See A MASSIVE Drop In Value In The Next Four Months (businessinsider.com)
- Analysis: ECB’s Failure To Sterilize Bond Buys – Is It QE? (forexlive.com)
- The Pound rallied from a low just above 1.56 against the US Dollar Exchange Rate (torfx.com)
- Complete Summary Of What To Expect From Europe This Week (zerohedge.com)
- ForexLive European wrap: Euro shows a bit of backbone after S&P’s announcement…… (forexlive.com)
- S&P Threatens To Downgrade Euro Rescue Fund Amid Crisis Of ‘Governance’ In Euro Area (businessinsider.com)
By Harald Uhlig
Oct. 21 (Bloomberg) — The euro area is burning and policy makers seem increasingly powerless to douse the flames. Meanwhile, we can only stand by and watch this nerve-wracking spectacle.
Yet the situation may not be utterly hopeless. In the last month or so, researchers have floated proposals for the creation of synthetic euro bonds that may offer a way out. The idea rests on three principles: No cross-subsidization between countries; safety; and the replacement of risky sovereign debt by synthetic bonds in European Central Bank repurchases.
I know what you are thinking: Are these people out of their minds? Collateralized debt obligations? Synthetic securities? That is what got us into this mess in the first place.
Let’s take a closer look. The proposals all start with some version of an open-ended mutual fund that would hold euro-area bonds. Ideally, the fund would hold these assets in proportion to the gross domestic product of each member country. It would then issue certificates that would be fully backed by these bonds. If there is a partial or full default on one of the securities (Greek 10-year bonds, say), then the mutual-fund certificates would lose some value.
In the case of a small country or a partial default, the losses would be small. So, the certificates would be reasonably safe.
The most important aspect, however, is that there would no mutual bailout guarantees, no cross-subsidization between countries and no need for high-level political brinkmanship. This is the core of the proposal I put forth with my colleagues Thorsten Beck and Wolf Wagner, of Tilburg University in the Netherlands.
We recognize that many people will say that reasonably safe isn’t safe enough when it comes to synthetic securities. We believe they could be made safer. Markus Brunnermeier and his fellow members of the Euro-nomics group propose to divide the mutual-fund certificates into tranches. The junior tranche would be hit first in case of a default. The senior tranche would be most protected and could be called “European safe bonds” or “ESBies.” Both tranches would be traded on markets.
This would slice a slightly risky investment into several parts, one of which is safe. It would be an important feature if the ECB can’t be persuaded to use the raw mutual-fund certificates directly for repurchasing transactions, or if the original certificates are still considered too risky on bank balance sheets.
The biggest disadvantage of this idea is that it is too reminiscent of the infamous alchemy of 2008. I think it can work if properly implemented.
Another proposal by two Italian economists, Angelo Baglioni and Umberto Cherubini would create the original mutual fund, but it would only buy senior debt from governments, which would be required to post cash collateral. That is less appealing because it would require too much political maneuvering, would too easily allow cross-subsidization, and would entail restructuring of current government debt to create securities of appropriate seniority.
But the main point is this: It would be feasible to fine- tune any proposal to ease particular concerns of participants regarding seniority and safety, as long as the three principles I outlined above are obeyed.
The last of the three principles may be the most critical: These certificates must replace risky sovereign debt in ECB repurchasing transactions. One objection to this is that there is no particular reason now, for, say, a Greek bank to hold Greek debt or for a Spanish bank to hold Spanish debt, when they could all hold much safer German bonds.
‘Hold to Maturity’
The banks that can still afford to mark their sovereign debt to market, rather than “hold to maturity” and pretend all is well, can do this now. They can ensure their safety by selling the debt of Portugal, Ireland, Italy, Greece and Spain, and buying German bonds.
The trouble with that scenario is that if all banks were to act this way, the prices of those bonds might plummet. That would mean far deeper trouble for Portugal, Ireland, Italy, Greece and Spain the next time they try to issue new debt. It would cause problems for the banks, too, as they would get even less than what they currently think the bonds are worth.
The ECB has danced around this issue by repurchasing risky sovereign debt, buying it outright in the open market, supporting these prices through intervention, and trying to unwind again. The ECB is ultimately backed by the euro area’s taxpayers, who either get more inflation or a depreciation of their currency, if things turn south.
In addition, the central bank’s actions have had the unintended effect of encouraging private banks to hold the risky assets, rather than discouraging them from doing so. This makes sense: These bonds get higher returns, are still usable as collateral with the ECB, and are implicitly guaranteed by government bailouts if things go wrong. The real loser is the taxpayer.
The mutual-fund construction removes much of this moral hazard. It can buy a sizeable fraction of the risky debt, taking it off the books of the ECB and the commercial banks. Yes, it may still need to buy German, Dutch and Finnish bonds on the market, but the banks, in turn, would buy these certificates. And, importantly, the ECB uses the mutual-fund certificates or their ESB-safe versions for its repo- and open-market transactions, while gradually phasing out its support of individual risky sovereign debt.
Who can create these certificates? A savvy market participant could probably pull this off in a few days. But it would be better to have a public institution do it instead. Competition among several such funds may even be better, with the ECB deciding which ones to accept and which ones to phase out. In any case, this can be done quickly, if decision makers in government and the financial-market institutions can be persuaded to act.
This isn’t a glamorous, magic solution. Nor is it a sexy proposal for politicians to sell in speeches. This is a simple step forward that wouldn’t cost much, but is easy and effective. Most of all, it is what the euro area needs right now.
(Harald Uhlig is chairman of the economics department at the University of Chicago and a contributor to Business Class. The opinions expressed are his own.)
- The Eurozone Crisis For Dummies (businessinsider.com)
- Franco-German deadlock over ECB’s role in rescue fund (jhaines6.wordpress.com)
- Italy Picks Surprise Central Bank Chief (online.wsj.com)
- EU Said to Consider Wielding $1.3 Trillion to Break Impasse (businessweek.com)