09.07.2012 0

Europe’s circular bailout continues

European Circular BailoutsBy Robert Romano — Spain looks to be the next on the bailout block. It is seeking a €300 billion rescue package from the European Union on top of the €100 billion bank bailout it already got.

Since Aug. 2010, the European Central Bank (ECB) has purchased about €140 billion of Spanish and Italian government bonds on the secondary market.

But before a deal can be made on more purchases, Germany, speaking through the ECB, has some tough conditions that Spain has thus far not proven receptive to. For the temporary aid, German chancellor Angela Merkel wants assurances that Spain will not just need another bailout next year — which would require real reforms not yet undertaken.

It would also require Spain to formally apply for European Financial Stability Facility (EFSF) funding. Thus far, Spanish interest rates have been held down by the ECB’s informal second-hand purchases, but there have not been any strings attached.

Now it appears Germany is using ECB support of Spain as leverage to get the country into its reform program. The message is that there will be no more free rides.

Thus far, Spain has benefited just on the margins from the ECB bond purchase program through slightly lower interest rates.

But were Spanish and Italian banks even the primary beneficiaries of the previous bond-buying program?

If so, that would be very similar to the circular bailout that has been occurring in Greece, wherein the ECB lent money to its regional branch in Greece, in turn lending that money to Greek banks, which used it to purchase refinanced Greek sovereign debt. Greece then takes the money and pays it right back to ECB, which was the original bondholder.

But then again, maybe not.

Since the crisis began, Spanish and Italian banks have loaded up on their own countries’ debts, increasing their holdings, while French and German banks have decreased their holdings of Spanish and Italian debt. If the Spanish and Italian banks were unloading their bonds on the ECB, wouldn’t their holdings be decreasing?

It is hard to say, as the ECB has not disclosed who specifically they were buying the government bonds from, or which bonds they were purchasing. But perhaps it was the French and German banks then, which were the ones selling their bonds to the ECB.

If so, that could mean the ECB is attempting to quarantine the sovereign debt crisis to the debtor nations themselves. This would, in principle, shield core nations from the fallout should Spain or Italy default on their obligations — since their own financial systems would be left holding the bag.

We’ll know soon enough what the ECB is holding, as the bank has promised that “Publication of the average duration of Outright Monetary Transaction holdings and the breakdown by country will take place on a monthly basis.”

However, further complicating matters, all the while the ECB has been accepting Spanish and Italian debt as collateral from Spanish and Italian banks to make further loans to Spanish and Italian banks — presumably to buy even more Spanish and Italian debt.

Since the beginning of 2011, Spanish (€325.8 billion) and Italian (€235.8 billion) banks have increased borrowing from the ECB by a combined €561.6 billion, according to data published by the Banks of Spain and Italy.

So, a Spanish or Italian default would also be quite harmful to the ECB itself, as it is accumulating risk in two ways: through the purchase of government bonds on the secondary market, and by accepting government bonds as collateral in its long-term refinancing operations.

In summary, these banks are using government bonds as collateral to borrow money from the ECB just to purchase more government bonds. And at the same time they are also selling many of these same bonds back to the ECB because nobody else wants them. Hard to imagine this ending well.

If this seems confusing, imagine if a credit card company continually issued credit cards to a debtor to pay off their previous credit card bills, charging them interest along the way, and never collecting on the underlying principal.

Welcome to Modern Finance 101, which gives debt “collection” a whole new meaning.

Robert Romano is the Senior Editor of Americans for Limited Government.

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