Friday, December 23, 2011

The European Central Bank Loses Its Virginity

And it means more than is apparent.
This post is adapted from analysis which appeared in The Strategic Planning Group.
Mario, relax . . .
So yesterday, the European Central Bank (ECB) doled out €489 ($639) billion in loans to the European banking sector.

Why’d they do it? ‘Cause Europe’s banks are broke: That is, if all the crap they collectively hold on their books were marked to market, their liabilities would be greater than their assets. American banks shouldn’t smirk: The only reason they aren’t declared bankrupt for the same reason is because of the suspension of FASB 157 back in March 2009.

The ECB lent out the €489 billion against any and all collateral the European banks would put up. In exchange for this collateral—no matter how damaged—the banks got 1% loans, which is not merely free money but essentially subsidized money: Eurozone inflation is around 3%, and except for German and Dutch debt, all sovereign bonds are yielding more than 3%. Thus a 1%-interest loan from the ECB is like being paid to take out a loan—and who wouldn’t want that deal?

Ordinarily, no bank wants to be seen to be taking money from the central bank, because it makes the bank look weak, and therefore hurts its reputation on the markets. But in this case, 523 banks—count ‘em, 523—took the ECB money: Which proves both how fragile the situation really is, and how generalized that fragility really is. European banks no longer care what it looks like, as survival has trumped appearances.

Be that as it may, the banks took the money. And like their American counterparts, who took the Federal Reserve’s $7.7 trillion of free money and used it to buy Treasury bonds, the European banks are likely to plow this ECB largesse into sovereign debt: Thus they will make risk-free profits. And what bank doesn’t want that.

This was a major move, by the way: The ECB—after protesting for months that it was not and would never be the lender of last resort—has become . . . the lender of last resort: It has finally lost its virginity. Not only that, the ECB—like every recently deflowered naïf—will find it next to impossible to say “No” the next time the European banks come looking for nookie.

There are three aspects to this situation that I want to look at here:

The first—the least financially important, but an aspect which explains why Americans are so blissfully unaware of the seriousness of the situation—is the reaction of the financial press on either side of the Atlantic. I think the reporting gives a window on the biases of mainstream financial reporting in America, and why it cannot be trusted to give an accurate view of the historic events taking place—and how in fact it is blinded.

The second issue I want to look at is how this money will not go into every European sovereign bond in equal measure: Rather, some countries will benefit from the banks’ bond-buying spree, while some other countries will be hurt precisely because their bonds will be shunned. And this analysis of sovereign debt winners and losers will not be a financial calculation, but rather a political one.

The third issue is, I’m going to look at the effects of this initial ECB free-money program, and how it augurs the break-up of the Eurozone. Closely tied into the second item of sovereign bond winners and losers, this free money’s effects on the European sovereign debt markets will determine both who will be able to keep on getting financing, and which countries will inexorably be forced out of the eurozone.

A Tale of Two Analyses

This is what Floyd Norris, the chief financial correspondent of the New York Times, wrote yesterday about the ECB lending program:
In recent weeks, the new [ECB] president [Mario Draghi] publicly insisted the central bank would never do any of the things that Germany opposed. The bank would not drastically step up its purchases of Spanish and Italian government bonds. It would not directly finance European governments. It would not backstop European rescue funds or print money that the International Monetary Fund could use to bail out governments.

It would do only what central banks normally do. It would lend to banks.

It turns out that may be enough to stem the European crisis for at least a few years, and go a long way to recapitalizing banks in the process.
[emphasis added]
Compare that to what Louise Armitstead, the chief business correspondent of the London Telegraph, wrote yesterday as well:
The record half-trillion euro take-up – which was far greater than the market had expected – initially triggered a “sugar rush” of euphoria as the move was hailed as a decisive “game changer”. But stock markets fell as economists and financiers recognised that while the imminent danger of another credit crunch had been averted, the threat of sovereign defaults had not.
In short, per the NY Times: “Everything is wonderful! Europe is saved!”

And per the London Telegraph: “The patient got morphine to dull the deathbed misery.”

Ordinarily, Floyd Norris is someone whose judgment I find to be sound—but in this case, he’s dreaming: To think that this will “stem the European crisis at least a few years” is frankly ridiculous—

—but it reflects a peculiarly American trend of burying-in-the-sand Ostrich Think, so prevalent among mainstream publications: An unwillingness—bordering on inability—to look at financial news in a cold light, and see what it actually means, rather than what we hope and pray it might be.

Now of course, happy news sells more than depressing news: The kid with cerebral palsy raising a 4-H cow sells more newspapers and gets more ratings than the story about the dozen Afghani schoolchildren killed by a drone strike.

However, the consistent underplaying of the badness of the financial news—and Norris’ piece is a prime example—creates a false sense of okay-ness among the people, the sense that, “Oh yes, the situation is being handled—no need to worry.” And this false sense of okay-ness leads to shocks, when there’s inevitably a financial disaster.

It also leads—simultaneously—to both complacency and panic: Complacency, because it foments the notion that everything is wonderful, so there’s no need to clean house in the financial markets, and really apply a decent, hard-headed regulatory framework to curb against the excesses of the banksters. Panic, because when all hell breaks loose, ordinary people feel that the crisis came like a bolt out of the blue, and don’t realize that it was actually a long time in coming.

The Telegraph and the Times are equally serious, equally reaching to the educated, upper-middle class demographic—but the Telegraph’s readers will be aware of what’s going on, and thus prepared for when the shit hits the fan in Europe—while the Times’ readers will not: For them, it will be like a lightning strike.

Loves Me, Loves Me Not

The second point I want to make is how the ECB’s free money will affect each eurozone country differently—specifically, it will affect their sovereign debts differently.

Which eurozone country will squeeze its people through the austerity wringer (and therefore be a good sovereign bond bet), and which will not squeeze its people (and thus be a terrible sovereign bond buying bet) is a political determination, by the respective governments of those nations—not a financial one. And this political decision—not the relative economic health and welfare of a country—will determine which nation gets additional funding through the bond markets, and which does not.

And therefore, which eurozone bonds are a good bet, and which are dogs.

We all know how the European bond markets are doing: German, Dutch and Finnish debt is doing great (10-years yielding <2.5%), French and Austrian debt not so great (+3%), Belgian debt a little worse (+4%), Spanish and Italian debt in the worry zone (+5.5% and +6.5% respectively), Irish debt in the red zone (+8%), Portugues debt really in the red zone (double digits), and Greek debt a total basket case (+35%).

European banks receiving the ECB free money will of course plow it into safe bets—the euro-banksters will turn a profit off the ECB’s free money at the minimum of risk, so as to bulk up those tasty year-end bonuses. (What, you think banksters are just an American phenomenon?)

Euro-denominated safe bets will of course be eurozone sovereign bonds—but not all European sovereign debts are equal: Some of them are more equal than others. Some give a tasty yield—for instance Ireland, Portugal, Greece—while others give a crap-yield—for instance Germany.

Question: Where would you invest a couple of billion in free euros?

Answer: The sovereign debt that yields the most—but which has the lowest risk of default or haircuts.

Question: Which countries have the lowest risk of default or haircuts?

Answer: Ireland and Italy.

Over the last year, five countries have ushered in “austerity” governments: Ireland, Portugal, Greece, Italy and Spain—surprise-surprise, they are all of the PIIGS.

However, which of these countries is the most likely to stick to austerity measures through thick and thin?

Ireland and Italy.

See, at this time, though all of the PIIGS are in the austerity camp, only Ireland and Italy will see it through: They will squeeze their people mercilessly—and allow their GDP to contract—so as to not run afoul of the eurocratic establishment. Everything they have done and said in the last year proves this: The Irish essentially taking over their insolvent banks and guaranteeing all the loan, the Italians with their recent show of austerity measures.

Portugal, Greece and Spain? Yeah sure, they’re doing the Austerity Jig now—but they are all on the knife-edge of saying “Fuckit”.

The reason is political: The governments of Portugal, Greece and Spain don’t have the political muscle to stay the course. There are enough opposition elements in those countries to present the people with a viable alternative—default. Hell, the opposition in Portugal is already calling for this, and rather vocally at that. And Greece—well, really, what’s there left to say about Greece, anything?

But Spain is the real worry: Spain’s economy has been suffering for too long—unemployment has been hovering at 20% for too long—youth unemployment especially has been stuck at 50% for too long.

Politically, Spain cannot afford austerity: Therefore, Spain’s debt—which is yielding 5.38, over 150 basis points under Italian debt, and a full 5% under Irish debt—is a lot riskier than Italian or Irish bonds, precisely because Italy and Ireland have the political will to stick with austerity, while Spain does not.

So as banks take the ECB’s €489 billion and begin to decide where to allocate this free cash, they will recognize that Italy and Ireland will pay up—while Spain, Portugal and Greece will likely not. So the ECB largesse will flow to Irish and Italian debt, while Spanish, Portuguese and Greek debt yields will begin to rise—drastically.

The UK will not get a bump up on their sovereign debt—after all, it’s priced in pounds. so the UK is on its own.

But Irish and Italian debt will begin to rise—sharply—even as Portuguese, Spanish and Greek falls—sharply.

The Fate of the Euro

As Irish and Italian debt is bouyed by this ECB free money, Spain’s, Portugal’s and Greece’s debt will begin to collapse—

—and thus the rising yields will make the debt situation in Spain, Portugal and Greece a self-fulfilling prophecy: As the markets ignore their bonds in favor of Irish and Italian bonds, their costs of financing will continue to rise, until they can no longer finance themselves on the debt markets—

—and this is the dividing line between the countries that will remain in the eurozone, and those that will exit it: Italy and Ireland will stay, while first Greece, then Portugal, then finally Spain exit the eurozone.

At SPG, we have already discussed (in fairly exhaustive detail) the shape of a eurozone break-up—both a complete break up, and a partial one, and the financial effects of each of the variables.

If the European Central Bank continues with this massive lending program—and there is absolutely no reason to think that they won’t—then it is inevitable that funds will flow to Ireland, Italy and France, driving down the yields on those sovereign bonds, while Portuguese, Spanish and Greek debt yields will begin to rise.

Thus Portugal, Greece and especially Spain will find it impossible to continue funding themselves.

Thus these three are the ones that will exit the eurozone.

At this time, Spanish debt seems a better bet than Italian debt—but the future considerations of sovereign credit-worthiness will no longer depend on financial reasons, and begin to depend on political ones, specifically one question: How hard are the governments of Italy and Spain willing to squeeze their people in order to keep the eurocrats happy?

The Italian political class has collectively signalled that they will squeeze–but Spaniards are clearly reaching the end of their tether.

This is the effect of the ECB’s lending program: It has brought us in sight of the day of reckoning.
If you’re interested, check out the SPG preview page.


  1. Sounds like you don't know a whole lot of Italians, Gonzalo. They're about as likely to persevere in austerity for 10 years as flies to stop buzzing.

  2. It's not going to go to sov debt. Most likely will be used to roll over the banks own debt. So this isn't going to be a quick fix for rising sov yields.

    Maybe look for another round next year.

  3. SPG. Spain, Portugal, Greece? A little close for comfort?


  5. All this has been planned a long time ago.
    Be prepared for the coming collapse and WWIII

  6. OT, I love the new wallpaper.

  7. Spain has an 'elected' government with a decent majority. It may have a year of 'goodwill' to do what it wants. Italy has a 'troika' imposed government who is being 'told' to implement 'structural' reforms. Italy has a history of killing politicians who intefere with the customary way of life.

    I'd bet on Italy falling apart before Spain. Their bond yield problem almost guarantee it. Spain can kick immigrants out or cut them off as a 'relief valve'. God knows Zapatero let enought of them move in.

  8. I live in Europe. My friends hate to go to Sweden, Norway and UK due to the exchange rates. You think having diverse currencies is a good thing? Think again. Most of my friends vacationed in Greece on the islands of Santorini, Crete, ecc. thanks to Ryanair. The Greek banks are now in Bulgaria and doing quite well. There are only two in Athens and they need to be nationalized but my friends have their money where you yoodle and could care less.
    Italy is recovering from many years of crony capitalism and now many of the industries have headquaters outside of government control. The banks will be given dollars with which to purchase Italian Sovererign bonds, and the IMF will give SDR's to the US in order for the US Treasury to short the USD. The Euro will not break up in fact it may very easily appreciate against the dollar, and the ECB will resemble the FED.The price to pay will be high unemployment rates. Everyone knows austerity is not the answer, but it makes politicians look god to their constituencies and allows the ECB to print.

  9. So how does one do business with a country that defaults on its debts? Cash only?

  10. I take exception to your statement about happy news selling more than bad news although the heart warming tale is more "palatable" the bad news is what has been selling news papers for a quite a while.

  11. Personnally I wouldn`buy italian or irish state bonds now since both countries could exit from the eurozone and play the card of a cheap national currency to boost their exports ( by the way tourism is too a kind of export) in case their economy continue to fall apart. However, regarding the yields, hungarian bonds could be a good bargain since Hungary is already out of the eurozone but of course there is always a risk of non-payment in the end.

    Janos from Hungary

  12. I doubt that Ireland will be in the Euro Zone much longer. Sooner or later the ECB and/or EU will be forced to go to all the member's governments to approve some of the ongoing centralization. Nothing will pass an Irish referendum. They will tell the Irish to revote and to get it right the 2nd time, or get out. That will be it.

  13. Hey GL...compliments of the season to you sir.
    I want to clarify a critical point (been bugging me for an eternity).
    Central Banks (all of them) have been created as a backstop to the banking system...THE BANKS. They may give the impression that they act in favour of the economy as a whole...but no my dear friend...NO. They will act when required to save the Banks in times of financial stress. They look after their own brethren. They operate under enacted power to print unlimited quantities of money. If the banks are "critical" to the banking system and they have representatives (elected) to their respective CB, then mark my words ....when the SHTF they will not fail.

    NOW....given that Central Banks were only created as a safeguard to the BANKS, they therefore cannot be relied upon to save those holding sovereign debt from sovereign default (other than the BANKS). Ultimately what one needs to consider is whether there is a Country BIG enough (and willing enough and capable enough)to come along and absorb the bad debts of potential sovereign default nations. Which country is capable of being the "backstop"
    for those PIIGS that you so cold bloodily put a bullet into their heads and dispatched like a fart in the wind. That scenario is impossible to accept. If any or all of them fail ..the whole system does too. Your kidding if you think Italy, Ireland , France , Germany and UK can survive if Viva la Spana Pork&cheese and the Home of the Kalamata are forced into oblivion ie pushed out of the EURO.

    Lets get it clear once and for all...CB's are evil bureaucratic empires. Main stream media should not be quoted on this blog. Who controls the BANKS controls the MEDIA ...controls the GOVTS. Shame on you GL for using their black and white jargon. You...of all...should know better than to use the words of selected financial media writers as basis for argument and support.

    There is one area I would tend to agree with you on....that is the ultimate demise of the EURO. However I dont see a "Collapse" per se. CHAOS is not written into the RULE BOOK. To have CHAOS is to have utter disorder and that is just too hard to accept as a reality. What we more than likely will see is a lengthy period of adjustment with a new monetary system devised and agreed upon in an somewhat orderly fashion.

    Liquid Motion

  14. ....Greek debt a total basket case...

    no, mr GL, the real basket case is somewhere else.

    ...And Greece—well, really, what’s there left to say about Greece, anything?...

    you are right there, there has been a ton of bullshit from people that know shit. well, by the way, what do you, really, know about Greece?? not what you think you know -by surfing the net and reading the telegraph- but what you r e a l l y know?

    the same question applies, of course, to your understanding of the EU, the global banking system and, well, the future.

    ps. By the way, and what did the big shot bankers and journalists and various other gurus know about Greece, not so long ago, lets say between 2000-2007????

  15. "Portugal, Greece and Spain? Yeah sure, they’re doing the Austerity Jig now—but they are all on the knife-edge of saying “Fuckit”."

    The USA is singing a similar tune.
    Happy New Year to all from Kansas.

  16. Hello,

    GL makes a bold, yet interesting, prediction. And it may turn out that way in the end. Who knows?

    Question, what would happen to the European and American banks if three countries, including Spain, defaulted? How much money would Draghi and Bernanke have to print for the banks in that case? And would printing that much money be politically possible? What would Germany do?

    Lots of known unknowns.

    As for Ireland and Italy: As we all know these countries are famously composed of non emotional, cooperative, sober minded, essentially peaceful people - in some alternate universe maybe - who have little to no history of political violence.
    Chaos sometimes takes its time. Wait for the austerity to really bite in Italy and Ireland like it is in Greece. Question: is violent political disorder good for a country's bond prices?

    Another thought: what will the Irish and Italians likely do, suffering in poverty under the yoke of the bankers, while the country next door that defaulted has a growing economy and is slowly putting back in place its health, education, and social services systems? Maybe the Irish and Italians will just grin and bear it. Sure. And maybe Italian men will start going to church again just like good little boys with their mothers. But it's not a bet I'd be willing to take.

    Then there is the issue of future elections. The Irish fell into the trap of the, sort of, two party system where the incumbent party sold them out to the banks - including British banks no less - and the main opposition party got elected only to confirm the sellout. The current "technocratic" banker governments depend on the current parliamentary configuration, but that can change.

    So what happens when a third party, populist of the left or right, runs on an explicit program of default? Will TPTB suspend elections in Italy and Ireland? That's when you pass into the midnight landscape of the full moon, where people chase illusions, emotions run wild,and anything is possible including things that can be extremely unpleasant.

    To paraphrase a well known Italian movie gangster, "Collecting money for foreign bankers is a dirty business." It can also be a dangerous business. Herr Draghi, now in his post Goldman, German incarnation, along with all the rest of the out of country bill collectors, should watch the movie.



  17. Hello GL,

    I didn't quite agree with the line of argument towards the end of your otherwise superb article. You said(Quote):

    "[...]Portugal and Greece a self-fulfilling prophecy: As the markets ignore their bonds in favor of Irish and Italian bonds, their costs of financing will continue to rise, until they can no longer finance themselves on the debt markets"

    But haven't Ireland, Greece and Portugal already benn shut out of the bond market? After all, they all have two-three digits yields, and it would be utter madness to finance oneself under such market conditions. I was under the impression that all three were currently living on bailout loans from the EU and the IMF? In that way they could ignore the bond market while using that time to get their own house in order.
    I thought Ireland intended to return to the bond market next year if everything goes according to plan, which now turns out to be wildly optimistic as they have fallen back into recession again.

  18. Good article. I dont' see why bids for e.g spainish bonds would be "withdrawn" by an additional 500 B EUR entering on the bid-side for sovereign debt.

    If I was a conspiracy theorist I'd save all my postings, because, hopefully, a few years down the road they will make for a really entertaining reading.

    If being "evil etc." would increase bank profits, they would (and should) be evil. But, a minor detail- banks make most money when we all make a lot of money. It's called capitalism, an awesome force. By maximizing your personal profit, you contribute maximally to the wealth of your society.

  19. Ordinarily, no bank wants to be seen to be taking money from the central bank, because it makes the bank look weak, and therefore hurts its reputation on the markets. But in this case, 523 banks—count ‘em, 523—took the ECB money: Which proves both how fragile the situation really is, and how generalized that fragility really is. European banks no longer care what it looks like, as survival has trumped appearances


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