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Unintended Consequences of the ECB's Intervention


In an effort to keep the eurozone from breaking up in the midst of a credit crisis, the ECB may have made it easier for it to break up in the future.

Editor's Note: This article was originally published on February 3.

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

– Sigmund Freud

Let me introduce Mauldin's Rule of Thumb Concerning Unintended Consequences:

For every government law hurriedly passed in response to a current or recent crisis, there will be two or more unintended consequences, which will have equal or greater negative effects then the problem it was designed to fix. A corollary is that unelected institutions are at least as bad and possibly worse than elected governments. A further corollary is that laws passed to appease a particular group, whether voters or a particular industry, will have at least three unintended consequences, most of which will eventually have the opposite effect than the intended outcomes and transfer costs to innocent bystanders.

This week we wonder about the consequences of the European Central Bank (ECB) issuing over €1 trillion in short-term loans to try and postpone a banking credit crisis and lower sovereign debt costs for certain peripheral countries in Europe. What if, instead of holding the European Monetary Union (EMU or eurozone) together, that actually makes a breakup more likely? That would certainly fall under the rubric of unintended consequences, and be worth our time to contemplate in this week's letter.

Further, what if the group that oversees credit default swaps declares an actual sovereign debt default not to be a technical default in order to avoid a credit crisis because CDS would have to be paid? Could that actually undermine the ability of smaller countries to borrow money at lower cost, if they could even borrow it at all? Thus making the eventual outcome even worse? We will explore these perplexing questions and more as we once again turn our attention to Europe.

But first, and quickly, we are now ready to take reservations for the 9th Annual Strategic Investment Conference, May 2-4, which this year will be in Carlsbad, California for the first time, at a venue that will allow us to take a few more attendees but still keep that intimate feeling. I host the conference, along with my partner Jon Sundt and his team at Altegris Investments.

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I should note that the best feature of the conference is the attendees themselves. You will make new friends and meet old ones. And the speakers are very accessible. The price goes up considerably on March 15, so register early. We always sell out, and I get calls asking to get in at the last minute, and have no way to help. Don't procrastinate. Register now. We are way ahead of last year on the pace of registrations. Again, it will sell out. Do it now.

Unintended Consequences

The ECB injected (created? printed?) €529.5 billion for an annual cost of 1%, more than the €489 billion they issued just last December. This was called a long-term refinancing operation, or LTRO. The total now is over €1 trillion (around $1.3 trillion), which can only make Federal Reserve Chairman Ben Bernanke jealous. That money was technically issued to the various national central banks, who in turn lent it to their various commercial banks for almost any collateral that still had a pulse. Which banks in turn used it to shore up their balance sheets, and any spare change was used to buy more sovereign debt of their countries, thus financing their own government's deficits. And making a nice juicy spread for the next three years, which can help repair that balance sheet.

I can't find a chart I have permission to use and don't feel like spending three hours to make one just to show that the ECB has simply exploded in the last six months, swelling almost four times in that period, on a time-adjusted basis. Just imagine a slowly rising line that viciously turns north beginning July of last year. As in a "J" curve.

Did we see a rise in loans to commercial establishments? Easy money for all? Hardly.

The markets were quite happy that a credit crisis has once again been put off. So were the various governments. Did we see a rise in loans to commercial establishments? Easy money for all? Hardly. So what did the banks buy with their new money? (Besides the chance to deposit it back at the ECB?) They bought short-term government bonds, which more or less matched the terms of the money they had borrowed.

Which collapsed shorter-term bond yields. In November, Spanish one-year bonds paid about 5% over similar German bonds. Today it is less than 1% more. Still a nice total spread over 1%. Three-year bonds have dropped from around a 5% spread over the corresponding German bonds to slightly under 3%. Italian debt has dropped from a spread (over German yields) of 6% to 1% for one-year bonds and from over 7% to under 4% for three-year bonds. Nine and 10-year bonds are roughly the same for both countries as three months ago.

Sufficient Unto the Day

So what does a country with deficits and growing debt do? It sells lower-current-cost short-term bonds to help its current deficit (more on that later), rather than take on longer-term debt. It can also buy back more expensive longer-term debt sold last year for much lower short-term rates today.

But that means there is more roll-over risk in the very near future, as you have to borrow to replace those bonds when they mature; but why worry about that today? As my Dad was wont to say when he wanted to ignore the problems cropping up in his future, "Sufficient unto the day is the evil thereof."

I saw a table created by those clever people at Bridgewater. They analyzed the nature of the capital of the banks of various European countries. Not much has changed in the last few years, except that foreign capital is still fleeing and that capital is being replaced (almost euro for euro) by ECB debt. Let us make no mistake, without ECB largesse, European banks would either have to sell equity at fire-sale prices or their governments would have to nationalize them. Otherwise they would be insolvent. And that would in all likelihood mean a credit crisis worse than 2008, as hard as that is to imagine.

And while many applaud ECB President Mario Draghi's actions, as they feel he has averted a crisis with his initiation of the LTRO, there are others who are not pleased. This note from yesterday's Financial Times:

The head of Germany's Bundesbank has launched a powerful attack on Mario Draghi, president of the European Central Bank, in a sign of mounting concern in Europe's biggest economy at measures being taken to try to contain the eurozone financial crisis.

Jens Weidmann's warning of increasing risk stemming from some ECB policies highlights fears of potential costs for Germany from its role as the eurozone's biggest creditor nation and may spark fresh doubts about the eurozone's ability to deal with the long-running banking and sovereign debt crisis.

Mr. Weidmann, who has an influential voice on the ECB's governing council, said the central bank risked endangering its reputation and called for a quick return to stricter rules on the collateral that the ECB accepts from banks in return for central bank funds. The criticism in a letter to Mr Draghi was revealed on Wednesday by Germany's Frankfurter Allgemeine Zeitung.

Peter Sands, the head of Standard Chartered (a British commercial bank), warns that the new money runs the risk of "laying the seeds for the next crisis." He wonders what happens in three years' time when all that debt needs to be refinanced. That seems a reasonable question, as finding a spare €1 trillion will not be a lot easier in three years.

Former ECB board member (and fellow Italian) Lorenzo Bini Smaghi added to Mr. Sands' concerns. He said that banks may become "addicted to easy financing," creating a disincentive for them to "stand on their own feet once the crisis is over." (the FT)

The concern is that the ECB is now committed to more than just €1 trillion. As noted above, ECB financing, which amounts to almost 8% of peripheral countries' bank financing, has offset foreign (to the home country) debt that is leaving. Since that exodus is accelerating, the word fleeing may be more appropriate. And foreign investors (mostly banks, as I understand it) have another 14% of funding in peripheral banks.

The concern is that the ECB may have to come up with even larger sums to offset the losses as foreign assets flee. (Foreign in the sense that they are not from in-country sources. As an example, Italian banks have about 6.5% of ECB funding and 12% of foreign – non-Italian – funding.)

There is really no way to know how much will be needed to forestall a further crisis. The ECB has so far signaled it is willing to step up, and the markets seem to see no reason it won't continue to do so.

But therein lies the unintended consequence. In an effort to keep the eurozone from breaking up in the midst of a credit crisis, they may have made it easier for it to break up in the future. To understand why, let's revisit Greece a few years ago.

Was it only three years ago that the market was willing to lend Greece all the money it wanted at rates not far above those of Germany? And then it seemed like, all of a sudden, in the blink of an eye, Greece could no longer sell debt at interest rates that allowed it to credibly have a hope of repaying the debt.

And Europe had to step in and bail them out. But let's be certain of one thing. As I was writing back then, the ONLY reason that Germany, France, et al., were willing to continue to lend Greece money was that their banks had bought so much Greek debt that if they had to write it off all at once it would cost the various governments hundreds of billions. The financing package of €130 million that Greece will get? €100 billion goes right back to private bondholders, mostly banks and institutions (like insurance and pension funds). Just to create the fig leaf that there is no default. So Greek debt actually goes up, even though there is a haircut on current debt. (More on that below.)

If the only banks that held Greek debt had been Greek banks, then Europe would simply have let Greece go under, with its banks. Maybe some token help, but nothing like the amounts that have been funded. Greece would have had no choice but to leave the eurozone and return to the drachma.

I wrote at the time that we would know when German banks had essentially sold their Greek debt, written it down, or were otherwise able to handle a default, because Merkel would no longer be willing to fund Greece. That point was essentially reached a few months ago. Now Europe keeps demanding ever more austerity from Greece, and every time Greece agrees they move the line and ask for more. Greece is now going to have to demonstrate it is willing to cut spending and raise taxes, no matter what.

Greece's economy will experience deflation this year as GDP falls 4.4%, the nation's fifth straight year of recession, according to the European Commission. Greece's economy contracted 6.8% last year and 3.5% in 2010.

As recently as November, the commission forecast the Greek economy would contract just 2.8% this year. But just two weeks ago that estimate was blown away. Fourth-quarter data showed Greece had contracted by almost 7% in 2011. But they had just agreed to massive austerity cuts for the next ten years, totaling as much as their current annual GDP. In an economy where government spending is 40% of GDP. Such cuts will make it even more unlikely they can meet their targets.

Europe will then demand even more cuts when the targets are not reached (or increases in taxes on what's left of the private sector). Everyone realizes the party is over, but no one wants to be the first to leave. It simply will not do for the eurozone to expel a member. The precedent is dangerous. So they make staying in the eurozone so onerous that leaving eventually becomes the best choice (more on that later). "We didn't tell force you to leave; it was your own choice."

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