The Dumpster for Toxic Euro Sovereign Debt

dumpster 300x241 The Dumpster for Toxic Euro Sovereign DebtSome might be wondering why the euro zone rescue focus turned to saving banks as opposed to saving governments.  The reasons are illuminating. Consider the following: When a government has a debt bulge, the debt must be held as someone else’s asset. The designated chump to hold a large portion of it has been the banking system, as its portfolio of assets is easily manipulated by bank regulators. This is how it works.

Banks are incented by regulators to hold “safe” assets as a way of making them less vulnerable to failure. But—and you’ve probably already guessed it—regulators designated euro government bonds and even subprime residential mortgage securities as the banking system’s “safe” assets. As a result, the banks load up with the safe asset, which has the effect of over-financing that sector of the economy. This sets banks up for a debt crash down the road when there is more debt than income available to service that category of debt.

To make the regulatory system more convoluted, the incentive for banks to finance the safe asset—even when it is manifestly clear that the safe asset is no longer safe—is the regulatory rule that allows banks to hold less bank capital (preferred and common stock) on the right hand side of their balance sheets. Since bank capital is depleted as a result of the 2008 subprime mortgage write offs, there is a greater need for regulatory capital today.  This has caused Europe’s banks to load up with toxic sovereigns with its  banks holding 25 percent of their assets in government bonds as compared to 10 percent in the U. S.

These incentives to hold the designated safe asset allow greater bank leverage, which translates to a lower ratio of capital to assets. One might ask why banks are strong-armed by government to maintain bank capital. The objective reason is because bank capital in the form of bank equity serves as a protection for depositors when the bank’s assets depreciate because bank equity is in the first loss position in case of an asset write down. Bank capital is also important to governments because of their guarantee (whether explicit or implicit) to restore bank capital in the event the bank is unable to. Without bank equity, depositors lose when banks write off assets; when a bank goes down, its depositors lose their wealth, which causes them to vote in great numbers against the government in power.

Thus, incenting banks to hold “safe” assets systemically makes the system unsafe: it becomes more leveraged, with banks holding a concentration of assets made riskier. The “safe” designation led to decreased market discipline by governments issuing debt, which allowed them to sell too much of it at unsustainably low rates. The ultimate regulatory convolution is when over-financed sovereign defaults take the banks down—but the sovereign maintains the responsibility to save the bank depositors.

Hence, the essence of the great euro debt-saving operation is maintaining and expanding the buying capacity of stressed euro sovereign debt—but not just the previously issued debt but the new debt yet to come. Bank buying power is necessary for euro governments to maintain the market value of their existing bloated debt, which is especially critical at times when the existing debt reaches maturity and needs to be refinanced in the market. Just imagine the challenges of maintaining market values of the yet to be issued debt to cover baby boomer entitlement over the next few decades! This will require expanding the banks’ balance sheet, which is the convenient dumpster for government debt in excess of what the market will absorb.

The problem with maintaining the capacity of the dumpster is based on banks’ ability to recapitalize (sell equity) to meet regulatory minimums. Banks have few good options in that regard—if they did there would be no euro sovereign or bank crisis.

Private equity does not gravitate to banks that have more bad assets than the banks or the government stress tests will admit. Unwary investors take a fall when the truth about the bank’s asset quality comes to light or when governments decide that banks will “voluntarily” take 50 percent haircuts on their sovereign debt holdings.

Ironically, banks don’t want to be recapitalized because it dilutes existing stockholders’ interests and lowers the rate of return on capital. Instead they prefer a capital handout from the government, which has a growing need for “dumpster” capacity for increasing government toxic debt. Government recapitalization of banks usually takes the form of non-voting preferred stock so as not to water down the returns to the common stockholders.

In the U.S., the Toxic Asset Relief Program (TARP) was a government fiscal operation that provided banks with near-costless government bridge financing that didn’t significantly dilute their common stockholders. But in Europe, the government debt financed multi-country funding source, the European Financial Stability Facility (EFSF), is capable (when and if it is funded) of covering only a very small portion of sovereigns and banks bailouts. How to backstop both sovereign debt and the dumpster banks has been center stage now for about a year and a half without resolution.

Written between the lines of last week’s sparse announcement of the “final” solution is a very tentative plan that still needs the approval of the German Bundestag, the last remaining “Rich Uncle of Europe” willing to bailout anyone. If Germany should balk at directly funding other governments or banks themselves or disallow changes in the treaty that would enable the European Central Bank (ECB) to do the same, where would the bailout funding come from?

Rather than relying on direct ECB support, the answer may lie in indirect ECB support through a newly created “Special Purpose Vehicle” (SPV). This legal financial entity looks a little like a bank in that the vehicle funds are used to purchase the assets the euros want off the table, and it is funded by a combination of debt and equity sources with the ECB being a primary contributor.

To give the SPV credibility, the equity portion will be the scant remaining 235 billion euros left in the EFSF (if and when fully funded). Using the bank model of leveraging, the scant capital is projected to expand the balance sheet a multiple of 4 or 5 times if there are takers of the SPV’s debt. This would create a much larger dumpster capacity to purchase toxic sovereign debt that no one else wants and perhaps even bank equity that no one is lining up for just now.

Does this sound familiar? It is the same model employed by Citibank to hide subprime mortgages offshore in an SPV or Enron’s partnerships used for the same purpose. How the government learns financial cover-up tricks from the private sector!

With the equity claims in the SPV held by the EFSF, the question is who will purchase debt claims in the SPV to leverage up the new debt dumpster in order to achieve the hoped for 4 to 5 times expansion of the SPV capacity to purchase bailout assets? Officials are traveling to China and Japan this week and will entertain other private debt investors in the SPV and make it juicer with as yet unclear government guarantees on a portion of losses of the debt investor’s losses in the SPV debt.

Hence, the SPV has a decidedly bank model flavor to it—except it is not subject to regulation and its transparency will be even worse than banks. At this point I believe it would be a heroic success to con individuals to do what bank depositors have become unwilling to do: continue depositing at banks whose assets contain bad government debt and whose deposits are “guaranteed” by the same insolvent governments.

Why would one think that the market will more likely invest in SPV debt than a euro bank deposit whose depositors are fleeing the banks with their money. If the SPV is the same dangerously leveraged model as the banks, with the same assets and the same guarantor, can you expect a different result?

What makes it seem possible is the (intentionally) still hidden role of the ECB. Since Germany will veto ECB participation in direct investments in the underwater sovereign assets, the SPV is a multi-government owned and controlled camouflaged bank that provides the indirect route for the ECB to uplift purchasing power in the toxic European sovereign debt market by purchasing SPV debt with printing press money. This designated role for the SPV in conjunction with the ECB keeps Germany’s hands clean, so to speak.

The ECB printing press provides the leverage for the SPV to increase the capacity of the dumpster. The SPV is also not banned from purchasing bank equity to maintain bank dumpster capacity if banks are unable to be recapitalized by the market, which is likely.

While the plan is a little convoluted, it offers governments the deniability of engaging in what some would call throwing good money (the EFSF funds) after bad (the Greek debt). Since the ECB provides unlimited debt expansion capacity for both the SPV and banks, one wonders why the euro zone heads of state became so caught up with creating the SPV functioning in parallel with the banks. Perhaps it was merely their political sense that the combined governments had to do something. They do, after all, run for re-election, and committing government fiscal resources to banks is not a popular thing to do.

But if the plan works, it will provide added SPV dumpster capacity alongside banks’ increased dumpster capacity, with neither German financial support nor direct ECB support.

The implication of monetizing the financing capacity of the SPV is no different than directly monetizing banks or governments. It supports the ability to have an expanded capability to purchase assets, keep them out of view (do you really expect transparency?), stop the debt unwind, possibly revive the economy with yet more new money, create an asset bubble and have inflation as a side effect. All of which seems better than an instantaneous euro zone unwinding and a debt deflation. Such are the machinations of colluding desperate governments who want to do something that appears on the surface to be helpful. How else can you run for re-election?

Folks, I can’t make this up. What might seem puzzling was the stock market rally late last week, both in anticipation of and following the long-awaited announcement. I can only presume the market was celebrating the fact that banks and the economy were not being deposited in the dumpster immediately, and an indirect vehicle to bring the printing press to bear has been created to increase the sovereign debt holding capacity.

Instead of imminent falling dominos, it is dominos re-inflating.

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