LONDON—European banks, increasingly concerned about their ability to access funding, are devising complex and potentially risky new deals that enable them to continue borrowing from the European Central Bank.
The banks’ moves, which include behind-the-scenes swapping of assets among financial institutions, could heighten risk across Europe’s already fragile financial system, say some senior industry officials and regulators.
They also are a sign that struggling banks across Europe are preparing for a period of prolonged reliance on financial lifelines from the ECB. The Continent’s intensifying financial crisis has made it difficult for many banks to obtain funding from customary market sources.
Specifically, traditional sources of bank funding in Europe, such as institutional investors and other banks, are getting cautious as fears grow about the need for sovereign debt restructurings. As liquidity dries up, the only reliable source of funding is often the ECB.
But the ECB only accepts certain types of assets as collateral for loans, and some banks are running out of those assets.
So they’re turning to investment banks and other “counter-parties” that have them. And they’re entering into “swap” agreements in which they exchange their assets for the counter-parties’ assets and then stock-pile the latter assets for use as collateral.
And that’s a fine plan… until the music stops and one big “counter-party” fails.
When one big counter-party fails, it could set off a chain reaction in which every bank and trading partner on the Continent (and elsewhere) immediately starts scrambling to recover cash and more liquid assets. And then Europe will be right where the U.S. was in the fall of 2008.
What could stop the slide? The ECB could step in and start accepting different types of assets as collateral. Or step in and buy enough Euro-country bonds to drive interest rates down to sustainable levels.
At this point, a wide range of economists agree that any plan to avert a breakup of the euro zone will have to involve the European Central Bank stepping up and pledging to backstop the debt of countries like Italy and Spain. Those calls have only grown louder this week, as the bond market went haywire and the contagion spread to once-safe countries like France.
And yet… European officials keep insisting that the ECB isn’t legally allowed to play savior. On Tuesday, the head of Germany’s Bundesbank called it a violation of European law. The Wall Street Journal argued Wednesday that the European Union’s founding treaty would need to be revamped before the ECB could act as a lender of last resort to countries like Italy. So is this true? Could Europe really melt down because of a few legal niceties?
Not really, say experts. It’s true that the Treaty of Lisbon expressly forbids the European Central Bank from buying up debt instruments directly from countries like Italy and Spain. But, says Richard Portes of the London Business School, there’s nothing to prevent the central bank from buying up Italian and Spanish bonds on the secondary market from other investors.
“If that’s illegal, then officials should already be in jail,” says Portes. “Because they’ve been doing it sporadically since May of 2010.” The problem is that the bank’s current erratic purchases only seem to be creating more uncertainty in the market. “Right now,” says Portes, “nobody’s buying in that market except the ECB.”
Instead, what many experts want the European Central Bank to do is to pledge, loudly and clearly, that it will buy up bonds on the secondary market until, say, Italy’s borrowing costs come down to manageable levels. In theory, says Portes, the central bank wouldn’t even have to make many purchases after that, because expectations would shift and become self-fulfilling. In the near term, investors would stop worrying about whether they’d be repaid for loaning money to countries like Italy, and Italy’s borrowing costs would drop — giving it room to figure out its debt woes.
If you haven’t read the partial transcript of Citi economist Willem Buiter on Bloomberg TV today, you ought to.
The key part, which he said with some anger rising in his voice, was this:
On why the ECB hasn’t acted yet:
“Because after the error of the Bundesbank, they consider central banks purchasing sovereign debt outright to be like swearing in church. It’s just not done. This has been in fact to a certain extent embedded in the treaty which forbids the ECB from lending directly to governments or buying stuff in the primary market. But there is no restriction at all on them buying any amount of sovereign debt at any time in the secondary market, so they can do it.”
“This crisis is the result of the failure to provide the minimal institutional underpinning for a monetary union in the euro area and also a result of the ECB unfortunately being the heir of the Bundesbank and therefore not understanding and rejecting the role of central bank as lenders’ last resort to sovereigns. They certainly are a central bank. They just are a central bank that prefers to fight with both hands behind their back. If they just let go of one hand, that would be enough.”
It’s not just that the ECB could immediately push Italian yields down to 4% if it wanted to… it’s that this role that the ECB is being asked to play is not even extraordinary by modern economic standards. Every other major economy in the world: Japan, the UK, the US, China, etc. has a central bank that funds the government. Only Europe doesn’t have that, and that’s why, with debt-to-GDP ratios high around the world (Japan has a 200% debt-to-GDP remember), it’s just Europe that’s in crisis.
But there is this problem with the ECB being the descendant of the Bundesbank, and, well, the Germans are really not into anything that looks like debt monetization.
PARIS—The gap between France and Germany’s benchmark 10-year bond yields widened to a euro-era record Wednesday, as the crisis of confidence in European sovereign debt threatened the region’s second-largest economy and one of two key pillars of the euro zone.
The rise in borrowing costs is fueling a dangerous trend for France, lifting the burden of servicing its debt—set to be the single largest budget expenditure in 2012—and weighing on already weak economic growth.
By contrast, Switzerland – the safe haven of choice for nervous investors at present – sold six-month bonds at an interest rate of -0.3%. Investors, in other words, were paying the Swiss government for the privilege of being allowed to lend money to a country seen as rock solid. This is simply a posh way of hiding money under the mattress.
The financial markets understand just how critical the situation is, even if the pfennig has yet to drop in Berlin.
Dhaval Joshi, at BCA Research, delved into the world of physics to explain Europe’s predicament. “Approaching a black hole, cosmologists define the event horizon as the point beyond which it is impossible to escape a guaranteed ultimate annihilation,” Joshi said. “The fascinating thing is you can cross this point of no return without realizing that your doom is certain. So the question is: has the euro area unwittingly crossed its own event horizon? We believe not, although it is getting dangerously close.”
Economics:
- Spain and France will try to sell you some bonds.
- At 8:30 a.m. ET the Labor Department releases weekly jobless claims. Economists think claims edged up to 395,000 from 390,000 a week earlier.
- Also at 8:30 a.m., the Commerce Department releases housing starts data for October. Economists think starts fell to an annualized pace of 610,000 from 658,000 a month earlier.
- At 10:00 a.m., the Philadelphia Fed releases its business outlook index for November. Economists think it rose to 9.3 from 8.7 in October.
- At 12:30 p.m., Cleveland Fed Presideant Sandra Pianalto speaks.
- At 12:50 p.m., New York Fed President William Dudley speaks.
Earnings:
- Before the opening bell we get results from Sears Holdings and J.M. Smucker.
- At some point during the day we hear from GameStop and Helmerich & Payne.
- After the close we get results from Salesforce.com, Intuit and Gap.