OMT? OMG! The bad bank to end all bad banks

September 10, 2012 | Capital markets, Central bankers, Democracy, Euro, Global news, Grexit

By:David A. Smith

 

In their commitment to save the conceptual Euro at all costs, the European Central Bank has done something that is both breathtakingly imprudent and completely undemocratic: they’ve made the ECB into the bad bank to end all bad banks.  Today’s post will cover the bad bank idea, using a New York Times (September 7, 2012); tomorrow’s, using the Wall Street Journal (September 6) (blue font), will bid auf wiedersehen to German national sovereignty unless the ECB’s authority is overturned.

 

 

The new ECB program, called Outright Monetary Transactions, or OMT, will purchase government bonds and focus on maturities from one to three years.

 

It would be simpler to call it One More Trick. 

 

Speaking in Frankfurt on Thursday, the ECB’s president, Mario Draghi, outlined a new program to lower borrowing costs of countries like Spain and Italy that have been forced to pay rates which most analysts believe would be sustainable [sic; the Times means ‘unsustainable’ – Ed.] in the medium term.

 

While obviously the cost of capital impacts a nation’s ability to repay, rates have never been the Eurozone’s problem: the weak nations cannot repay their principal, and the capital markets are pushing up the interest rates in the expectation of an eventual default and rescheduling. 

 

Markets like it when dodgy paper is guaranteed by the man who prints the money

 

Called Outright Monetary Transactions, the program will focus on purchasing government bonds with maturities from one to three years. The ECB will not set a limit on how much it buys –

 

We will save for tomorrow the national-sovereignty implications of granting unelected administrators authority over a nation’s checkbook – for today the more important howler is what follows:

 

Hey, this is serious now

 

– and will not insist on senior creditor status, which means being paid ahead of others in the event of a restructuring. Such status worries other investors who fear they would face disproportionate losses.

 

Only the New York Times could write an explanatory sentence as credulously backwards as that.  We have already seen that in a previous bailout round, Europe’s governments totally shafted private bondholders to give preference to public bondholders, and got away with it, and this particular breach of contract followed only a few months after a previous total betrayal of principle, that itself worked only for a short while:

 

This marks the third attempt by the ECB to get a handle on Europe’s debt crisis that began in Greece nearly three years ago. The central bank started buying Greek, Spanish and Portuguese bonds in May 2010, spending €16.5 billion in the first week.

 

But the effort was hampered from the beginning. The ECB created the program just four days after then-President Jean-Claude Trichet said the idea wasn’t even discussed at a monthly board meeting, a blow to the bank’s credibility.

 

Do I look like a spur-of-the-moment guy?  I do?  Well, then I guess I am!

 

It was a panic move, as evidenced by the lack of discussion and lack of consensus:

 

More critically, Germany’s top central banker at the time, former Bundesbank President Axel Weber, announced his opposition to the plan just hours after it was unveiled.

 

Do I look like I support panic moves?

 

Naturally, it didn’t work:

 

The program continued in fits and starts in late 2010 and into 2011, providing little relief. Faced with contagion that was sweeping southern Europe and threatening larger economies, the ECB expanded its program—after a four-month hiatus—to include Spanish and Italian bonds in August 2011.

 

How’s that workin’ out for ya?

 

The ghost of Lyndon Johnson would call this ‘economic Vietnam.’

 

More bad news, huh?

 

But the purchases quickly waned after then-Italian Prime Minister Silvio Berlusconi started to backtrack on pension-reform promises.

 

Backtrack?  Is that like foreplay?

 

The experience with Italy last year scarred ECB officials, making them wary of buying bonds without airtight commitments.

 

Of course the markets’ immediate reaction was gleeful, as the mark with the biggest wallet has just bought in for more chips:

 

London — Borrowing costs for Spain and Italy were down Friday.

 

That’s what happened each previous time.  Why will this one be different?

 

But countries wanting help will have to ask for it and will then need to meet strict conditions.

 

Unlike those other bailouts, which had no conditions attached.  Oh, wait …

 

That presents a crucial problem for Spain, which is at the heart of the crisis and whose government worries that such a formal request would constitute a political humiliation.

 

Political ‘humiliation’ is the least of Spain’s problems.

 

It’s not so humiliating we can’t demand more benefits

 

And difficult discussions lie ahead about Greece’s bailout, with international lenders due to arrive in Athens this weekend. The government there is asking for more time to hit its targets, but euro zone nations are reluctant to fill yet another gaping hole in Greek financial plans.

 

Greece has yet to hit a single one of any of its targets, and the more Europe keeps bailing out the Greeks for ‘trying hard’ the less the Greeks will bother to achieve.  Then too, as I’ve said many times, one does not solve a solvency problem with finance: government spending has to go down, and this amidst a severe contraction in the Greek and Spanish economies. 

 

The euro zone’s gross domestic product shrank 0.7%, at an annualized rate, in the second quarter. ECB staff shaved their forecasts to show a 0.4% contraction this year and barely any growth in 2013.

 

All these billions of Euros being thrown into the maw buy time, but then the time bought is wasted.

 

A failure of those talks could still lead to a Greek exit from the single currency, with huge consequences for the rest of the euro zone.

 

By moves like this, the ECB completely undermines national spending discipline in profligate countries.  The ECB’s only recourse, after having bought all this Greek paper, would be to cut off further credit and expel Greece for the Euro, and this the ECB has stated it will never do.  To me this is unbelievably dumb:

 

How dumb can you be and still ride in a limo?

 

While the ECB’s announcement has undoubtedly bought time for the single currency area, analysts said it needed to use that time to build more credible structures in order to restore market confidence, including ambitious plans to construct a banking union.

 

Guaranteeing all their short-term paper will do exactly just the opposite – make it easy for Club Med countries to keep spending. 

 

The experience of the euro zone crisis so far is that, whenever pressure from the financial markets is reduced, politicians postpone difficult decisions.

 

All they have to do is promise fiscal discipline, and then renege later.

 

Paradoxically, that could mean that the ECB’s intervention will make agreement on crucial changes seem less urgent.

 

No shit, Sherlock.

 

They see but they do not observe, Watson

 

Regardless, it is far from clear that the plan will work. Europe’s economy remains in the doldrums and its economic picture is dimming. Without any tangible prospect for short-term growth, vulnerable countries’ fiscal positions will likely worsen, further undermining investor confidence in their prospects.

 

We have already seen European banks talking their paper down and buying it up at a discount.  Anyone who believes their promises is a mug.

 

“You’re a mug”

 

Mujtaba Rahman, an analyst for Europe at the Eurasia Group, said in e-mailed comments that the ECB’s announcement should prove important in stabilizing sentiment in the near term, but that “many serious challenges exist regarding the execution and implementation of the bank’s new Outright Monetary Transactions in practice.”

 

He singled out the “new, more important role” of the ECB Governing Council in signing off on governments’ compliance with their reform programs –

 

We have given ourselves a new, more important role

 

There are the same folks who winked at all the fudging about budget deficits needed to get Greece, Italy, and half a dozen more countries into the Euro initially.

 

They believed I could fly

 

– the implications for beneficiary countries, and the “disincentivizing impact” that “diminished market pressure could have on euro zone institution-building.”

 

Translation: More free money means less fiscal discipline.

 

But Jorg Asmussen, a close ally of Ms. Merkel who sits on the bank’s executive board and who split with Mr. Weidmann over the bond program, sought to reassure Germans that it would not lead to increased inflation.

 

“It will only be able to happen when a country agrees to strict reform measures,” Mr. Asmussen said in an interview with Berlin’s public radio on Friday. “That is a mandatory, a necessary requirement for our deal.”

 

When I say ‘strict,’ I mean it in the German sense of the word, not the Greek sense

 

So, they will agree – and then they will ignore their agreements, and where will you be then, Mr. Draghi?

 

A worry is that the ECB is placing enormous risk on its books, leaving taxpayers to foot the bill if the plan goes awry and a country receiving the assistance were to default.

 

To be precise, the taxpayers in creditor countries will be on the hook. 

 

Germans have long been skeptical of handing control of the euro to a central banker from Italy, given the country’s pre-euro history of high inflation and volatile currency swings.

 

What could possibly go wrong?

What, don’t you trust me?

 

To counter criticism that the program may fuel inflation, the ECB said any purchases will be “fully sterilized”—meaning an equivalent amount of funds would be drained from the banking system in an effort to keep the money supply stable.

 

When we started this, we thought only one of you would die: now the odds have doubled!

 

Thus European banks, whether they like it or not, will have capital sucked out of them that the ECB will then use to buy subordinate southern-zone paper likely to lose money. 

 

To make it easier for countries to take advantage of the bond-market intervention, the ECB said it would suspend its minimum collateral requirements for bonds issued or guaranteed by governments eligible for the new program.

 

This charade is a variant of zero-down-payment lending, and it’ll fail as did the earlier attempts to pretend there is no risk.

 

Commercial banks use those bonds as collateral with the ECB in return for short-term loans. Europe’s affected countries rely on the continued flow of that credit to keep their financial systems functioning.

 

The banks, in other words, are no longer masters of their own destiny; they are now effectively controlled by the ECB.

 

Banks can still borrow as much as they want from the ECB assuming they have the collateral—which can include the deposits they park at the ECB.

 

Thus the claimed fiscal discipline is all bilge, just a giant shell game to obscure the reality; the European Central bank will just print whatever it needs.  The Europeans will have no choice but to buy the paper:

 

The ECB reserved the right to withdraw any bond help if countries backtrack on their promises.

 

Ooo, scare me again.

 

You’re so funny when you’re trying to be threatening

 

Yet some observers warn that the central bank will have difficulty making good on that threat because withdrawing the support could trigger a market panic.

 

Yes – I’ll quit drugs tomorrow.  Just one more fix …

 

 

“We have this conditionality element, that’s the most important difference” from the previous program, Mr. Draghi said, and “leads us to think it will actually work.”

 

This one will actually work!

 

Ready to fly?

 

“We want this to be perceived as a fully effective backstop” that removes extreme risks for the bloc, ECB President Mario Draghi told reporters after the ECB’s monthly meeting, at which it also left its main policy rate unchanged at 0.75%, a record low.

 

The ECB has thus willingly set itself up as the ultimate bad bank – it will buy bad assets from southern-zone banks, and it will collect the cash to buy these bad assets by printing what had heretofore been good Euro notes.  This is blinking nuts. 

 

Frank Schaffler, an expert for financial affairs for the Free Democrats [Ms. Merkel’s German government coalition partners – Ed.], said in an interview Friday with Deutschlandradio for Berlin, “The ECB has not become the bad bank of all worthless papers in Europe.”

 

Unfortunately, as he well knows, it has.

 

And why?  For what practical reason?

 

“The euro is irreversible.”

 

Chisel that in granite, along with the other great predictions:

 

A severe depression is outside the range of probability. 

– Harvard Economic Society, November 16, 1929

 

Don’t worry, it’ll blow over

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