Friday, March 09, 2012

How the ECB Kicks the Can Down the Road

How the ECB Kicks the Can Down the Road
By Bengt Saelensminde, Contributing Editor, MoneyWeek (UK) 

I get really interested when I think that I'm getting conned. 

Take this con that I'm going to tell you about today... 


Fancy Some Free Money?

The ECB has just lent half a trillion euros to European banks.

Mario Draghi, the ECB's new head, has come in with all guns blazing. In December practically the first thing he did was launch an initiative to try to tackle the ever-escalating euro crisis. You've probably heard about the LTRO (Long Term Refinancing Operation). Well, here's how it works:

First the ECB asks a load of banks "Do you want some free money?"... Well, not exactly free. They'll have to pay 1% interest and give the money back in three years' time.

So now a load of shrewd bankers consider their options. Do they take the money and pump it into some investments where they hope to get more than 1%? Or do they say, "Aaah, thanks but no thanks. I don't reckon I'm clever enough to find anywhere to put your cash and make more than 1%."

Well - let's see what they did...

When the offer was first made back in December, 523 banks took the ECB up on their generosity. This time round it was nearer 800!


Super Mario and His Great Big Bazooka

The question is: why is Mario Draghi so eager to give money away so cheap? Well, because he's up to his neck in it.

As I see it, Draghi's ECB has got two problems. First, they're the central bank and are ultimately responsible for ensuring European banks are stable. But of course many aren't. Some of Europe's finest are cash-strapped.

And the second problem he's got is that the markets have been shunning the bonds of many eurozone nations. And they are his employer!

This is not a good situation for Mario. And it's not good for the financial system he's supposed to protect.

But Mario's a clever fellow. He was vice-chairman of Goldman Sachs after all. He reckons his LTRO remedy is just the cure that Europe needs. And with just one pump of the bazooka!

Simply lend the money to the banks - at 1% remember - then let the banks buy up the miserable looking bonds and earn themselves say 5, 6, or 7% (even more on the really dodgy stuff) on their brilliantly masterminded carry trade.

Hey presto! Suddenly investors aren't shunning dodgy Italian, Spanish (etc, etc) bonds. And weyhey - the banks can earn 5% or more on billions and billions of freshly minted cash. That way they can earn their way out of trouble.

And on the face of it, the ruse seems to have worked. Here's the chart of European sovereign debt yields over the last few years.

chart of European sovereign debt yields over the last few years


Source: Bloomberg.


When yields go over the black dotted line (7%) there's trouble - basically it's an ominous sign that the market is seriously worried about lending to you. As you can see Greece, Portugal and Ireland have been in the danger-zone for ages.

But what was causing the ECB sleepless nights was the fact that Italy and Spain were skirting with the danger-zone.

You see how late last year the red and orange lines were hitting the dreaded black dotted line? Well now look at how yields have come down - not just for Spain and Italy, but for Ireland too. Mario's wonder scheme even seems to have arrested the upward-spiralling Greek and Portuguese yields.

So far so good...

This is When It All Goes Wrong

But I ask you: Have the underlying problems of the peripheral nations been sorted out?

I would say no.

In fact, the ECB's financing initiatives only make the situation worse. I suspect the write-downs Greek bond holders are currently negotiating ('default' in the words of anyone, other than the ECB) will not be the last. I reckon we've got more debt forgiveness negotiations to come with more of the peripherals. The problems haven't been fixed after all. And that means somewhere down the line, the bonds these hopeless banks are currently buying may start to disintegrate.

Remember, these guys are buying the bonds for a carry trade - maybe they make 5% a year. But what good is a 5% profit if the value of your bonds get cut in half (or worse, as has been the case with Greece)?

I mean, you take the weakest banks in the world, then you load them up on debt from the dodgiest countries you can find. And you expect things to turn out rosy!



The Eurozone Has Become a Giant Ponzi Scheme

Like all classic Ponzi schemes, it can only last as long as you keep pumping in new money. The ECB knows this isn't a final solution.

So how do you solve a problem like Mario's?

The answer should be clear. You don't stop the LTRO.... Never!

This Long Term Refinancing Operation is an exercise in can-kicking, the likes of which only a super banker could put together. And you keep on kicking until the can finally disintegrates.

Good luck to all who put their faith in it.

I'm on Tim Price's side with this. This scheme by the ECB is destined for failure. As Tim pointed out a couple of weeks back:

"The ECB creates electronic money. It then uses that money to buy government bonds from eurozone banks. Flush with new money, eurozone banks can then buy more government bonds! If this sounds like a Ponzi scheme designed to rig the market for the prices and yields of eurozone government debt, that's because it is. 

"The wrinkle in this scheme is what happens when a eurozone government is so overborrowed and with such a small chance of growing its economy that it defaults on its debts anyway (which looks increasingly likely for Greece, and possibly Portugal)."


This is one of the biggest threats to your wealth in a generation. So you need to take steps to protect yourself.

Bengt Saelensminde
Contributing Editor, MoneyWeek (UK)


Publisher's Note: This is an edited version of an article that first appeared in MoneyWeek (UK).

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