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Mar 01 2012

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Europe Takes a Page From Bernanke

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No Lasting Results From Artificial Measures

“Even more bright signs emerged Wednesday. The European Central Bank agreed to provide an additional $700 billion in cheap loans to the continent’s banks.” ~ The Washington Post (3-1-12)

 With a second round of lending to 800 banks yesterday, the European Central Bank (ECB) has now disbursed $1.3 trillion in near zero financing to the continent’s financial institutions in only 90 days.

Even by Obama-Bernanke standards, that’s real money.

But is it good news?

In the immediate short term, probably yes.

Since Angela Merkel and the “austerity-niks” in Berlin have no intention of bailout out failing financial institutions that unwisely gorged themselves on mortgage-backed securities and shaky sovereign debt, the ECB is the last life line to prevent a full fledged credit freeze that could lead to an even more severe recession, with global consequences.

As we have heard, endlessly, with Chairman Bernanke, this easy money policy is intended to keep banks lending, which – de facto – will contribute to economic growth.

But that policy has not worked in practice in the United States – as any consumer who has tried to get a loan here without signing away the rights to their first born as collateral can attest – and it will probably not work in Europe either for the same reasons.

Euro banks, like their US counterparts are likely to use the cheap money to retire maturing, higher priced loans in their portfolio. In addition, the Euro financial institutions will seek to improve their balance sheets by investing the money – wait for it – in higher yielding European sovereign debt.

This serves three, overlapping, short-term purposes.

The EU banks become financially stronger by simply arbitraging the spreads between the ECB loans and the risky sovereign debt. Second, the “at risk” countries with eye-popping national debt, find a ready source of new financing outside of the traditional market that (artificially) lowers borrowing costs in the short-term, without having to pester the Germans and the EFSF for direct loans.  And finally, global financial markets are reassured, allowing equity prices to continue to rise, as huge sums of cheap central bank money in the US and Europe finds its way to stocks for a decent return, creating the impression of a “wealth effect.’  See the DOW at 13000.

Of course, the cohort that is left out here are the consumers and businesses looking for loans.  The actual generators of economic activity.

What incentive does a bank have to accept the risks of a personal or business loan when it can simply tuck the money into a sure thing on sovereign debt?  After all, if there is another “credit event” in another “at risk” country, would the ECB actually allow a write down of its own money?

So the actual catalytic impact of ECB lending – beyond the illusion of greater liquidity – is actually much less than anyone might have anticipated given the size of the ECB program.

And therein lies the real problem.

Growth – real, tangible and durable – is the only mechanism that can truly save the EU; making Europe globally competitive, increasing productivity, and reducing debt. But given the structural impediments to growth throughout the EU, painful reforms in the European social contract will be necessary before that kind of growth is possible.

That is where the ECB program is a long-term inhibitor.

Before the ECB intervention, the market dictated the need for reform.  A failure to attract private market financing for banks, or the soaring rate required to secure financing for sovereigns, were stark drivers pushing for reform.

Tthe ECB has effectively nullified that pressure as an artificial stand in for market forces.  But the breathing room created by the ECB is having the reverse impact on the necessary reform agenda.

According to the Wall Street Journal, “Ominously there already are signs governments are taking advantage of easier financial conditions to backpedal on reform. The Spanish banking sector overhauls…fell far short of the radical plan that had been promised in January; some in Madrid ara now talking of relaxing fiscal targets [as well]….In France, the front-runner inn the presidential elections, Francois Hollande, has been talking of lowering the retirement age to 60 from 62.”

Thus, without continuous pressure for comprehensive reform across the continent, the ECB lending initiative will ultimately prove futile and counter productive; delaying but not stopping a day of reckoning.

You can only charge windmills for so long before you can see them for what they are.

By example, consider that day of reckoning has become real for Greece.

Despite two years of sustained EU effort to save Greece from default by calling it anything but a “default”, the “real world” is going to have its say.

Both Fitch Ratings and Standard and Poors await the final Greek restructuring agreement to assign new ratings for the country – “restricted default” and “selective default”.

And today the International Swaps and Derivatives Association will make a decision on whether the Greek restructuring – including a convoluted Greek provision that compels a “voluntary” write down of Greek bonds – constitutes a “credit event”, triggering “credit-default” insurance contracts taken out on Greek debt.

While the sum of the swaps is relatively small (about $4 billion) a market default judgement on Greece will necessarily have an impact on the EU as a whole, particularly as a destination for investment dollars.

This is further complicated by the fact that the Europeans have effectively created a two-tiered system for repayment. The EU has ruled that Greek debt held by the ECB must be repaid in full, at face value. Private investors though, must take a haircut of up to 75%.

So, with regard to that fresh $1.3 trillion now floating around Europe? If you do a deal with an institution that is significant party to the ECB’s largess, remember that the ECB gets paid before you do in any future credit event.

You only need to consider the dilema; what happens when future write-downs on another EU country are required of private sector financial institutions that used ECB money to invest in sovereign debt?

What a mess.

Who wants to invest in a place like that.

 

 

 

 

 

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