ECB: The end of the last resort

On a crisp November morning, the atmosphere in the Frankfurt conference room is becoming heated. One of the speakers, in front of a large crowd gathered to hear the debate on the role of the European Central Bank in the crisis engulfing European sovereign bond markets, appeals for moderation inside the packed room and beyond. "The mood in Europe is getting less and less amiable and more and more confrontational, and the risk is that this poisons the European debate." The main speakers have been Antonio Sáinz de Vicuña, general counsel of the ECB, and professor Markus Kerber, from the Technical University of Berlin. Kerber has accused the ECB of over-stepping the treaty limits imposed on it to prevent bailouts of sovereign states by undertaking large-scale purchases of troubled eurozone government bonds. The Securities Markets Programme (SMP) has been running since May 2010, when the ECB began buying Greek government bonds. It has been expanded rapidly in recent weeks in an effort to bring down yields on Spanish and Italian government bonds ahead of auctions of new securities to a shrinking and risk-averse investor base. 

Sáinz de Vicuña refers his accuser to former ECB president Jean-Claude Trichet’s speech in May 2010, setting out the case that emerging and dramatic divergences in sovereign spreads were impeding the even transmission of ECB monetary policy across the eurozone. This provided then, and still provides today – so the ECB general counsel claims – legal justification for limited and temporary ECB buying to correct dysfunction in the secondary market for eurozone government bonds.

Kerber fires back that a programme running for 18 months seems to be testing the definitions of temporary and of limited. By the end of last month, analysts suggest that the ECB was holding on the eurosystem balance sheet over €200 billion of mainly Italian, Spanish and Greek government bonds, while also having advanced even larger sums of liquidity to banks from those countries supplying government bonds to the ECB as collateral at more modest haircuts than might be demanded by other counterparts, such as the London Clearing House.

Kerber also suggests that far from failing, bond markets are functioning perfectly well, thank you, in demanding high spreads to fund spendthrift sovereigns. And in any case, by making its purchases of Italian government bonds conditional on the swift implementation of fiscal reform – a link made explicit in an August letter from Trichet and his successor at the ECB, Mario Draghi, to the then prime minister of Italy, Silvio Berlusconi – the ECB has stepped into the forbidden territory of national budgetary policy.

This is not, says Kerber, the economic and monetary union that Germany signed up to. 

The debate is hosted by Open Europe, a think-tank whose chief economist Raoul Ruparel has suggested that the mounting risks on the ECB’s balance sheet – up to €590 billion of exposure to Portugal, Italy, Ireland, Greece and Spain by early November – have not been properly appreciated. These exposures raise a serious risk, Ruparel argues, of losses in the event of sovereign haircuts of a magnitude "that would effectively leave the ECB insolvent and in need of recapitalization".

Amid such wild-sounding notions that the ECB’s balance sheet is so full of rotten assets that it might itself be insolvent, it’s hardly surprising that temperatures are rising on this cool autumn Friday.

Staging a public debate between Sáinz de Vicuña and Kerber is all the more remarkable given that Kerber is taking his case against the ECB to the General Court in Luxembourg.

In the days after the debate in Frankfurt, Derk-Jan Eppink, a member of the European Parliament, joined Kerber in his legal action, claiming that: "By continuously purchasing government bonds of doubtful credit standing, the ECB has gone beyond its mandate. From my perspective, there is no alternative but to judicially review the ECB’s illegal actions."

Observers of the edgy arguments between Kerber and Sáinz de Vicuña, while trying to keep their own heads cool, might have reflected on this: although the two men appear to be adversaries in the great debate over the role of the ECB as a lender of last resort to eurozone governments, these two agree much more than they differ.

They are essentially on the same side and represent, in fact, merely two different wings of the same faction in a wider debate. This faction opposes a much larger role for the ECB in bailing out European governments. Kerber expresses outrage at what the ECB has already done. Public comments from ECB senior officials show their own reluctance to do much more.

Draghi, in his first press conference as president of the ECB last month, rounded on a questioner who dared to ask if he was prepared to commit the ECB to doing whatever might be necessary, including becoming a lender of last resort to governments, to keep the euro area in one piece. "I have a question for you," Draghi shot back. "What makes you think that the ECB becoming the lender of last resort for governments is what is needed to keep the euro area together? No, I do not think that this is really within the remit of the ECB. The remit of the ECB is maintaining price stability over the medium term."

Draghi repeated the three key characteristics of the ECB’s bond-buying programme: that it is intended only to restore monetary policy transmission channels, is temporary and is limited.

Unfortunately, most financial market participants add another description to the ECB’s government bond buying programme – if it is both temporary and limited, it is therefore useless. "From a market perspective, you don’t want this begrudging approach," Dario Perkins, economist at Lombard Street Research, tells Euromoney. "Aside from the strictures of the treaty, the ECB has a deep innate reluctance to buy government bonds. When the market knows that the buyer of last resort is reluctant and that its buying is limited, the market will continually test that limit. To be effective in driving down yields on Italian debt to sustainable levels, the ECB would have to announce it is buying without limit."

This is the last thing the ECB wants to do. At the debate in Frankfurt, Euromoney points out to an adviser to the executive board of the ECB that, for all its buying, spreads have continued to diverge on European government bonds. This is presumably further impeding transmission of monetary policy. So how much more buying will the ECB undertake to repair the broken transmission mechanism? "You are essentially asking when this crisis will end," says the ECB adviser. "We have to presume this crisis will be overcome. We have never seen a crisis that is unending."

However, he doesn’t suggest how it will be overcome and it’s obvious to everyone that this is no answer. The notion persists that the ECB’s apparent reluctance to step in as the lender of last resort will ultimately prove to be a negotiating tactic: a way of forcing governments to shoulder some responsibility of their own to restore order to their finances by reducing entitlement spending, increasing tax revenue and, for the longer term, reforming their economies to boost competitiveness.

The problem, of course, is that such reforms will take months and years to bear fruit, will entail short-term costs and that, meanwhile, the eurozone government bond markets are collapsing right now, right in front of us.

Gilles Moec, co-head of economic research at Deutsche Bank, tells Euromoney: "It would be outright illegal for the ECB to buy government bonds on the primary market, but massive intervention could be justified on the secondary market to repair the monetary policy transmission mechanism, which is clearly broken.

"To justify massive intervention, the ECB would need to show that governments are also taking all steps, including enforceable rules on economic governance to prevent getting into this same mess again. But we might be getting close. Remember that when the SMP started, transmission mechanisms were broken only in small sub-regions of the eurozone. What we have today is contagion across the region."

As November drew to a close, spreads to Germany had been widening on the government bonds of core eurozone countries such as France, Austria and even the Netherlands, which most sovereign analysts say has better credit fundamentals than Germany. Political pressure was growing on the ECB to step up its bond buying massively. Those politicians still in office who have failed to address lenders’ concerns over their creditworthiness all agree that the time has come for a deus ex machina to save them.

Perkins notes: "Despite believing – at various points over the past two years – they were on the brink of something truly nasty, European politicians still haven’t delivered any kind of permanent fiscal solution.

"[French president Nicolas] Sarkozy recently came up with an alternative cunning plan. If governments can’t or won’t pay, they can just force the ECB to. Apparently, the Germans have rejected this idea, but with the crisis escalating and a plethora of commentators arguing Sarkozy’s plan is worth a try, this is not something we can rule out."

The ECB, attacked on one side by those such as Kerber claiming it has bought too many government bonds, is under even more sustained attack on the other from those saying it has done too little. No wonder then that Draghi boiled over in a speech to the European Banking Congress in Frankfurt on November 18.

That governments have failed to convince the markets over fiscal and structural reform is not the fault of the ECB. It has busily delivered its primary mandate of maintaining price stability and its credibility on this score is borne out in indications that inflation expectations remain firmly anchored. In any case, the ECB shouldn’t be cast in the role of buyer of last resort, because the European Financial Stability Facility was supposed to be up and running by now to do this.

Draghi fulminated: "We are more than one-and-a-half years after the summit that launched the EFSF as part of a financial support package amounting to €750 billion or $1 trillion; we are four months after the summit that decided to make the full EFSF guarantee volume available; and we are four weeks after the summit that agreed on leveraging of the resources by a factor of up to four or five, that declared the EFSF would be fully operational and that all its tools will be used in an effective way to ensure financial stability in the euro area.

"Where is the implementation of these long-standing decisions?"

Potential investors from outside the eurozone have all but laughed out of court plans to leverage the EFSF through the creation of a special purpose investment vehicle – a CDO of concentrated exposures among various sovereign borrowers struggling to service their debts at burdensome rates. The guarantees of a few struggling but solvent government borrowers are no great incentive to buy the bonds of those close to insolvency, it seems.

The EFSF has even struggled to sell its own bonds, delaying a €3 billion issue due to finance Ireland amid turbulent conditions in the run-up to the G20 meetings at the start of last month. When it finally got the 10-year deal away a week later, the EFSF had to offer 104 basis points over mid-swaps and bonds cheapened in the aftermarket. The breakdown of buyers by geography and type shows that the main investor interest that allowed the deal just to be covered came from Europe and from central banks.

Bankers close to the borrower talk optimistically about extending a 30% first-loss guarantee to entice asset managers desperate for yield back into Italian government bonds. But the more they talk, the more it sounds as if the EFSF is floundering.

The pressure will not ease on the ECB to step up. Rather, as government bond markets collapse and fall into genuine dysfunction as more traditional buyers – asset managers, banks – abandon them, it will grow.

Stephen King, chief economist at HSBC, spoke for many in the market in a briefing distributed as Kerber and Sáinz de Vicuña shadow-boxed over the proper limits on ECB bond buying. King notes: "At this stage, there is only one way of stabilizing this crisis. The ECB has to expand its balance sheet. It has to become the lender of last resort on a much larger scale and, when required, print money."

King evidently sympathizes with the reservations of ECB governing council members such as Yves Mersch, who has suggested the ECB should consider stopping buying government bonds of Italy if it backslides on reform. However, King says: "The ECB has to find a way to put all of its understandable reservations to one side and bite the bullet. There are now insufficient private-sector creditors to keep Italy solvent and there are too few taxpayers prepared to stump up the necessary funds. The alternative is to create funds from nothing.

"For now, the ECB can continue with the sterilized intervention of the SMP purchases that it mops up on the other side of the balance sheet by taking fixed deposits and could start to issue ECB bills. But it must also stand ready to go further."

George Magnus, senior economic adviser to UBS, explains why the ECB’s insistence that creditor governments consolidate their finances to regain market confidence might be misguided: "European leaders haven’t got to grips with this crisis because, fundamentally, it is a problem of imbalances." He suggests that the conventional economic thinking that rebalancing must come through a deflationary adjustment in debtor countries shows a misunderstanding of the problem.

The alternative is reflation in Germany, a policy that almost every other European government has spent the past 10 years quietly urging on the leaders of Europe’s largest economy with no success. Even while German exporters have benefited from the single currency and unemployment has stayed low, partly thanks to temporary and part-time work contracts, German consumers have lacked the confidence or inclination to spend in ways that might help exporters in the rest of Europe.

In such circumstances, Magnus says: "If there is no new money on the table either from creditor governments or the ECB to help debtor countries roll over their liabilities, and no let-up on this obsession with deflationary adjustment by debtor nations, then there is a rising probability of eurozone break-up."

However, he suggests this might not be the eventual outcome: "More likely is that, faced with the imminent prospect of the abyss, Germany will capitulate and there will be a change of policy at the ECB, which will expand its balance sheet and print money."

That now remote-seeming prospect would require the corralling of abundant political cover for such ECB action across the eurozone, including within Germany itself, where for now all the talk about Europe is focused on economic governance, which translates to enforceable procedures to make sure spendthrift nations reduce their debts or accept punishments if they don’t. The biggest punishment of all, being cast out of the eurozone, was presented to Greece and that risk now hangs over other countries’ sovereign bonds as well.

Even if the ECB could be persuaded to expand its balance sheet and buy enough government bonds in the struggling countries, essentially Italy, to prevent the further contagious spread of downgrade and even default risk being priced into French government bonds, that still raises two nagging questions – would the ECB have the capacity to buy enough bonds to contain the crisis, and is it too late to avoid some awful combination of serial and possibly disorderly government defaults and a fracturing of the eurozone?

After months of top-level crisis meetings, the sense still seems to prevail that there is time and that Europe has not yet faced the final catastrophe that will unleash a sufficiently forceful response. "The ECB will form part of the solution, but only when it sees eurozone governments taking big enough steps themselves," suggests Justin Knight, rates strategist at UBS. However, this takes us back to the mistaken insistence on deflationary adjustment by debtors and the dangerous focus on austerity rather than growth.

Euromoney wonders what might finally trigger an about-turn at the ECB: an abysmal Italian, Spanish or French auction, when larger issuance and refinancing needs kick in next year, a large eurozone bank failure, perhaps, or a French sovereign downgrade, maybe bloody resistance on the streets to the Lucas Papademos or Mario Monti governments? Presumably, it would have to be something that seriously threatens either German government bond markets or German banks directly. "Even then, I’m personally unsure if Germany would agree to give the ECB the licence to print money," Magnus tells Euromoney. "Logic says they should. History, values and psychology say they might well not – or only temporarily in exceptional circumstances."

Late last month, German chancellor Angela Merkel was quoted as saying: "If politicians believe the ECB can solve the problem of the euro’s weakness, then they’re trying to convince themselves of something that won’t happen." She also reiterated her opposition to Eurobonds – bonds issued and guaranteed jointly by eurozone governments – as these would remove the incentive for governments to put their fiscal position in order.

Jim Reid, strategist at Deutsche Bank, told clients: "If you don’t think Merkel’s tone will change, then our investment advice is to dig a hole in the ground and hide. It’s difficult to see any other scenario than wide-scale sovereign defaults without an aggressive ECB."

It could be too late anyway.

Talking to government bond traders about the successful Italian bond auctions in the second and third weeks of last month provided surprisingly little comfort. "Most of the buying has been from investors in Europe, including banks, with a strong interest in the success of those auctions," says one. "That raises the question of whether that is evidence of real end-investor demand. Without the ECB buying under the SMP and those motivated investors around auctions, I don’t see much support for Italian bonds south of 8% or 9%. And its debt service is probably unsustainable at 7%, especially with GDP growth of zero, or more likely negative in 2012. So Italy needs external help now."

Investors were hoping at various times in 2011 that ECB buying would stabilize Italian yields at 5.5%, then at 6%, then at 7%, but it only does so for a short while. Yields have periodically dipped for a short while in response to ECB intervention but then resumed their relentless rise. At his first press conference as ECB president, Draghi admitted: "It is pointless to think that sovereign bond rates could be stably brought down for a protracted period of time by external interventions."

One credit strategist says: "What worries me most is the irreversibility of all this. We probably passed the tipping point on Italy a while ago, maybe in July. Will any of the banks that were priding themselves during the third-quarter earnings announcements on having worked down their exposures to Italy really start buying again? I’m not sure they will unless there is a move to full fiscal union in Europe." That would imply a stabilization mechanism of at least €2 trillion or maybe €3 trillion to underwrite the solvency of heavily indebted European sovereigns and provide enough liquidity to see them past the withdrawal of private-market investors.

Just as investors in bank equity are seeking assurance from bank executives that they are working down exposure to Italy, investing clients will be seeking the same assurances from asset managers, unless yields even on very short-dated debt are so high that they compensate fully for likely haircuts of 50% or so in the event of default.

The third-biggest government bond market in the world now trades on risk of default. That means the mechanics of the market will be further disrupted as counterparties demand higher cash collateral to finance positions, market makers become nervous of hedging short-term Italian exposures, liquidity evaporates, bid-offer spreads widen and markets gap up and down.

The chief economist at one US bank picks up the damaging impact all this has had on primary market access: "Italy is beyond the point of no return in being able to fund itself on any scale in the market, so must fund itself on supported terms either through the EFSF, which is itself only €0.5 trillion, or eventually through loans from the IMF. The market won’t supply funding on sustainable terms until it sees significant progress on fiscal reform and structural reforms to enhance growth prospects. Italy will be cut off from the market for a couple of years and maybe longer."

If Italy is shut out, can Spain be far behind, and then what happens to France? Bond investors have picked up on a plan being discussed between European governments for a limited common Eurobond offering just for the triple-A rated sovereigns. This might protect France from contagion under the shield of Germany’s credit rating. The prospect of borrowing in such a form at low cost might even be a further incentive to other sovereigns to enhance their credit fundamentals and ratings to get in under the umbrella of this core group. Equally, such a plan might cast them out from the lists of acceptable investments of a growing proportion of bond investors.

Even if the ECB could be persuaded, after seeing politicians attempt to implement the right policies, to buy government bonds on a much bigger scale, how much would it need to buy to contain the crisis and would the ECB have the capacity to do it?

Speaking in mid November, Nick Matthews, senior European economist at RBS, says: "Just a few weeks ago, market participants were talking about €2 trillion being needed to restore confidence, but now even that much firepower might not be sufficient."

Some market participants have quietly begun to question the capacity of the ECB to bear credit losses on much bigger holdings of government bonds, without raising new capital from the national central banks and so, ultimately, from the taxpayers of those same indebted eurozone governments.

The extent of such losses is unknown. One thing is clear though: bonds don’t stay forever at the levels where the ECB has recently been buying them. Italian 10-year bonds traded in late November around 85% of face value, and Spanish bonds in the low to mid 90s. Either questions over sustainability will be resolved and those bonds will go back to 100, in which case the ECB will book a profit on its bond buying, or they will collapse to price in loss given default at 50% of face value and possibly worse. Greek 10-year bonds were quoted at 28% of face value last month.

In June, even before the ECB stepped up buying of Italian and Spanish government bonds, Open Europe’s Ruparel suggested that a 50% haircut on directly owned Greek government bonds and also Greek government bond collateral – then representing a combined €190 billion of assets on the eurosystem balance sheet – would leave it facing losses of between €44 billion and €66 billion.

Since then, the ECB’s risk exposures have grown substantially. Last month, it reported an aggregate eurosystem balance sheet – that is across the central banks of the eurozone countries – with just €81.4 billion of capital and reserves supporting €2.34 trillion of assets. It is close to 29 times levered. On the eve of the financial system crisis in 2007, the eurosystem aggregate balance sheet had been half that size and was only 18 times levered.

In theory, a central bank can print money and earn a return on it, so its financial capacity is notionally limitless. Willem Buiter, chief economist at Citi, tells Euromoney: "Yes, the ECB would fail the EBA stress test miserably but this is a complete nonsense issue. It is irrelevant to subject a central bank to a form of stress testing that is used for corporations and financial institutions, as the ECB’s loss-absorption capacity, its economic capital, bears no relationship to conventional forms of regulatory capital or equity."

The ECB can print money, but given that ECB governing council members cling to one supreme justification for all that they have done and not done – an 11-year track record of delivering price stability that rivals even the Bundesbank’s and is reflected in restrained inflation expectations – presumably they would not print money beyond the point where it threatened to unleash inflation that destroyed this hard-won credibility once and for all.

Will we reach this point? Questioned on concerns over the ECB’s balance sheet, Draghi said last month: "Our balance sheet is not at risk and many things have been decided at the last European Council that made the Greek debt and the Greek counterparties compliant with our requirements. There have been measures to recapitalize the banks, there have been measures of credit enhancement, and there have been measures giving guarantees for term funding. And there have been other measures that are reassuring as far as the ECB balance sheet is concerned."

Even if this proves to be wishful thinking and the ECB eventually takes such heavy losses, both from buying government bonds and taking them as collateral for loans to insolvent European banks to bail out their insolvent governments, that it ate through its capital and reserves, the ECB, or rather the eurosystem, has other resources. Its loss-absorbing capacity is backed up by €383 billion in revaluation accounts, much of that coming from unrealized gains in the value of eurozone central banks’ gold holdings.

That might sound like funny money to anyone used to analyzing conventional bank balance sheets and accounts. It smacks rather of the small stock brokerage trying to reassure worried clients that it is well capitalized because the partners have just revalued their wine cellar.

But central banks are not constrained by the same metrics as private banks. They can refuse to recognize the losses that accountants require conventional banks to disclose – as the ECB seems set to refuse to recognize the same losses banks must bear from private-sector involvement on Greek government bond holdings. And, even if the ECB does take losses, some economists look for other sources of loss absorption.

Buiter adds into the ECB’s economic capital the net present value of its seigniorage – the ECB’s revenues from base money issuance consistent with maintaining 2% inflation. These are earnings it would normally redistribute as dividends to the national central banks in the eurosystem. So national taxpayers, instead of having to recapitalize the ECB and the eurosystem at a moment when they are most financially constrained themselves, could instead forgo this future income.

Buiter tells Euromoney: "Even the ECB’s non-inflationary loss-absorption capacity is massive – it could easily reach €3 trillion or more. Even if the ECB were to incur €1 trillion-worth of losses from Greek sovereign default, it would carry on and live to see another day, meeting all its financial obligations and not having to print money on a scale that would threaten undesirable inflation."

Are concerns about the ECB’s capacity to extend its balance sheet simply misguided then? It is intriguing that murmurs about this issue surfaced in May 2010 with the start of the SMP. By extraordinary coincidence, the ECB published that month an occasional paper on the main drivers of its accounts and financial strength.

This ECB paper points out that even though central banks have been able to operate effectively with negative equity – the Czech Republic and Chile are often cited as examples – perceptions of their financial strength have an impact on their credibility, not least as potential lenders of last resort to banks. If a central bank depends on government transfers, it risks, at the very least, a perception of loss of independence.

Was this the ECB pointing out in May 2010 the obstacles on a road – towards large-scale buying of government bonds bringing attendant credit risks on to its balance sheet – down which it did not wish to tread?

Uncertainty around the ECB’s willingness to buy more government bonds must be resolved. There are now even growing worries that by refusing to participate in the banks’ PSI losses on Greek government bonds, the ECB might effectively subordinate bonds of troubled governments held by private investors, so speeding up their withdrawal from funding eurozone governments rather than incentivizing them to continue supporting them.

The ECB is caught. Jacques Cailloux, RBS’s chief European economist, notes: "The ECB’s de facto senior status might result in unintended consequences, leaving market participants with the perception that the more the ECB buys bonds the larger the haircut might be on the bonds left in the market."

No one thinks Greece is unique anymore. What happens on its government bonds might set the pattern others will follow. The ECB could remove fears of structural subordination of remaining holders by participating in the Greek PSI. "However, this would not come without consequences, including the fact that this would imply additional taxpayer money contributing to the Greek bailout," notes Cailloux.

Eventually, investors will require a resolution on the eurozone one way or another: full monetary union or a break up of the currency bloc. Since the crisis began in 2007 and 2008, European politicians have been trying to fudge this choice and they want the ECB to help them maintain this fudge.

Back in the conference room at the Haus am Dom in Frankfurt, an elderly German gentleman wishes to make a point. He turns out to be a veteran of Bundesbank negotiations over the Latin American debt crisis more than a quarter of a century ago. He recounts: "One of the hardest things we had to fight was to get central banks out of the vicious cycle of financing governments."

However, the pressure on the ECB to do that is going to become relentless. For now, the powerful German voices on the governing council, along with the Dutch and Luxembourg, are saying the ECB will not be a lender of last resort to government. However, the ECB is independent and flexible, and on the governing council it is one person, one vote. German control does not reflect its economic power. In theory, the ECB could turn on a pin and change its policy.

Perkins, at Lombard Street Research, says: "There might come a point, if it doesn’t, when there’s not much of a eurozone economy left to be the central bank of."