Tuesday, 08 June 2010 11:36

The ECB and the Potential Failure of Quantitative Easing, Euro Edition - In the Spotlight!

From the Bloomberg.com front page:

June 8 (Bloomberg) -- Jean-Claude Trichet used a simple chart to convince European leaders the euro was in grave danger.

It was Friday, May 7. Spanish, Greek, Portuguese and Irish government bonds were plunging, sending shudders through world markets and fueling speculation Europe’s 11-year-old monetary union could collapse. The European Central Bank’s president traveled to an emergency Brussels summit of heads of government armed with graphs to dramatize how bad things were.

“My main message for the governments was: Some of you have behaved very improperly and have created an element of vulnerability for your own country, and by way of consequence for Europe,” Trichet recalls. “Now the situation calls for taking up responsibilities.”

By 3:15 a.m. the following Monday, Europe knew the price of that responsibility: an unprecedented 750 billion-euro ($900 billion) aid package to prevent a debt spiral, backed by a credibility-testing pledge from the ECB to purchase the bonds of distressed governments, all to keep the $11 trillion, 16-nation economic and monetary experiment afloat.

This culminates in a big "I told 'ya so", documented in explicit detail via "The Coming (now arrived) Pan-European (soon to be global) Sovereign Debt Crisis" series.

So Trichet made the biggest gamble of his career, agreeing to buy government debt to halt the surge in yields in the hope politicians will respond by fixing their budgets, allowing the ECB to return to fighting inflation.

The risk is that profligate nations will renege on the deal, expecting stronger euro-area neighbors such as Germany and France to save them just as they rescued Greece.

Critics say the ECB has abandoned a founding principle not to bail out cash-strapped governments and may be left having to buy more debt, which could ultimately undermine its primary price-stability mandate.

Oh, that is a virtual guaranteed event. Do we not lean from our recent history... As excerpted from BoomBustBlog's Smoking Swap Guns Are Beginning to Litter EuroLand, Sovereign Debt Buyer Beware!

There are broad indications hinting that Italy and Greece are not the only countries that have used SWAP agreements to manipulate its budget and deficit figures. France and Portugal may be two other European economies which have resorted to similar manipulations in the past in order to qualify as part of single currency member nations (Euro Zone). Below is a small subset of the research that I have been gathering as I construct a global sovereign default model. This model is very comprehensive and thus far has indicated that quite a few (as in more than two or three) nations of significance have an 90% probability of defaulting on their debt in the near to medium term. More on this later, now let’s dig into what we have found that looks like gross manipulation of the numbers in order to hide debt in several European countries...

Back to the Bloomberg article...

The result is a price-stability record that surpasses even the Bundesbank’s. Inflation in the euro region has averaged 1.98 percent since the ECB took control on Jan. 1, 1999, in line with its self-set target of “below but close to 2 percent.” The ECB’s standing is now in jeopardy. Trichet’s detractors argue the decision to buy bonds breaches a rule that the central bank doesn’t rescue governments, undermining the independence it needs to breed confidence in the euro. They also say that the ECB risks stoking inflation by increasing the money supply. To David Mackie, chief European economist at JPMorgan Chase & Co. in London, the danger is that a lack of follow-through from governments will leave the ECB exposed.

ECB in Danger

“If governments don’t deliver on the fiscal side, will the ECB get sucked into buying more and more amounts of outstanding debt?” asks Mackie, who predicts the central bank won’t raise interest rates on Trichet’s watch again. “The ECB has got itself into a situation where it’s in danger.”

It’s also far from certain that the asset purchases will work. By June 2, Spanish and Italian yield premiums over German bonds had exceeded pre-intervention levels. The Spanish spread was at 203 basis points yesterday, 39 basis points above its May 7 level. The Italian spread was 177 basis points and Portugal’s 264 basis points. That may require the ECB to do even more to ease market strains. Policy makers next meet on June 10 in Frankfurt. David Owen, chief European financial economist at Jefferies Group Inc. in London, says he would not be surprised if the ECB stopped sterilizing its bond purchases at some point, meaning it would effectively be printing new money.

My readers have been thoroughly warned of the risks of such actions. Reference A Comparison of Our Greek Bond Restructuring Analysis to that of Argentina:

Price of the bond that went under restructuring and was exchanged for the Par bond in 2005


Price of the bond that went under restructuring and was exchanged for the Discount bond


With this quick historical primer still fresh in our heads, let’s revisit our Greek, Spanish, and Italian banking analyses (the green sidebar to the right), many of which are trying to push the 400% mark in terms of returns if one purchased OTM options at the time of the research release. It may be worthwhile to review the Sovereign debt exposure of Insurers and Reinsurers as well.

We may very well get a bear market rally or two that may pop prices, but from a fundamental perspective, I do not see how significantly more pain is not to come out of this debt fiasco. The only question is who’s next. We feel we have answered that question is sufficient detail through our Sovereign Contagion Model. Thus far, it has been right on the money for 5 months straight!

Subscribers should either have their positions in, or be in the process of actively setting them up. The Spanish Actionable Intelligence Notes regarding banks have been pushing the 700% return mark, to date. This is the update right before the great ECB QE brigade...

std opt. research time purchase

Since then, the positions have surged significantly in profitability (the last trade printed at $3.75!), showing the stress in the Spanish banking system was far from mitigated despite the precarious position that the ECB has placed itself in. I do not feel the equity markets have fully pried in the fears seen by the Spanish and European banks who are hoarding capital at levels that best even the Lehman collapse days.

Courtesy of Zerohedge:

European banks are hitting the ECB for parking their cash (as opposed to to lending to fellow banks that are killing themselves or are nearly guaranteed suspect counterparties) at a greater rate that at ANY time during the crisis, ANY TIME! Yes! This includes the collapse of Bear Stearns and the bankruptcy of Lehman Brothers - which many considered the harbinger of the apocalypse (of course, we at the BoomBust simply thought it was the bankruptcy of the 2nd smallest of the bulge bracket banks).

Subscribers, please reference the following paid content downloads:

File Icon Spain public finances projections_033010
File Icon Italy public finances projection
File Icon A Review of the Spanish Banks from a Sovereign Risk Perspective – retail.pdf

File Icon A Review of the Spanish Banks from a Sovereign Risk Perspective – professional
File Icon Spanish Banking Macro Discussion Note

File Icon Italian Banking Macro-Fundamental Discussion Note

icon Sovereign Contagion Model - Retail (961.43 kB 2010-05-04 12:32:46)

File Icon Sovereign Contagion Model - Pro & Institutional

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Last modified on Wednesday, 09 June 2010 10:51