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Saturday
Sep222012

Draghi's Coup d'Etat: Backdoor Eurobonds, Fiscal Policy By ECB Fiat, And A Hidden Banking License

Contributed by Blankfiend, of Fibs and Waves.

According to Mario Draghi, OMT, or Outright Monetary Transactions, is a program of conditional bond buying targeted at specific countries to restore the perception of the euro's "irreversibility" and "stability," and "repair a broken monetary policy transmission mechanism."  Once launched, OMT has no ex ante limits, it is within the ECB's price stability mandate, and it can be halted or interrupted based on achievement of its objectives or non-compliance with conditions imposed upon the targeted national government.

I would posit that OMT is much more than what the party line states.  Here are some alternative interpretations for your consideration.  I challenge you to refute the logic of any of them.

OMT is a Eurobond equivalent, targeted toward specific countries.  Given that ECB holdings are joint and several backed by all of the National Central banks (NCB's) that make up the European System of Central Banks (ESCB), any losses on these bond purchases would be distributed among the NCB's according to their capital key.  OMT would be a peculiar type of Eurobond, with some parallels to the discard red vs. blue Eurobond schema.  Instead of being differentiated by levels of debt-to-GDP (greater or less than 60%), these bonds would be differentiated by country of issue.  For example, if Spain enters this program, its bonds would now have the backing of the ECB, while Italy's would not.  Now, the red vs. blue idea was discarded precisely because it would have established a market preference for the blue bonds (joint and severally backed Eurobonds) versus the red bonds, which would have only had the backing of the issuing sovereign.  Is it so difficult to imagine that the market would quickly develop a preference for the bonds of countries on OMT life support, to the detriment of those NOT on it?

OMT is a banking license for the ESM.  Once the ESM buys the debt of a target country on the primary market, the ECB will follow with potentially unlimited purchases on the secondary market.  This obviously allows the resources of the ESM to be greatly extended without a formal banking license or leverage scheme.  At the same time, it completely bypasses any safeguards countries may think they have in place to limit their bailout related losses.  This is, of course, due to the joint and several liabilities of the NCB's that comprise the ESCB.  Ironically, an official banking license for the ESM has been declared clearly in violation of Article 123(1) of the TFEU by no less than the ECB itself.  The OMT is an obvious scheme to bypass that "technical inconvenience."

OMT is a sham.  While I have no doubt that our beloved Italian central banker will be more than willing to purchase the bonds of program countries, I do not believe for one minute that he would have the resolve to either permanently halt or reverse those purchases if a large target country backslides on its commitments.  I am sure that the markets - and the beneficiary national governments - recognize this as an empty threat as well.  If Draghi carried through on his threat in any meaningful way, he would be abandoning the goals of monetary transmission and euro irreversibility he claims to be striving for.  This is particularly true for big countries like Spain and Italy, sort of like mutually assured destruction.  Once countries like this are on the OMT methadone program, there will be no discharging them for abuse.

OMT is fiscal policy by Central Bank fiat.  Eurobonds, ESM banking licenses, and ESM leverage schemes have all been previously rejected by various European political leaders, most notably Angela Merkel and the Finns, but also Nicholas Sarkozy.  OMT is a clever way to skirt all of those objections and concerns in order to restore confidence in sovereign European debt markets.  At the same time, it is a backdoor method of committing national fiscal authorities to backstopping potential extra-national losses far in excess of what those fiscal authorities were ever willing to commit their taxpayers.  OMT is a full-scale abandonment of the concept that a supra-national central bank should not be able to undertake measures which could subsequently force the hand of national fiscal authorities.  OMT embarks us upon the treacherous path of fiscal policy by unelected, unaccountable central bank bureaucrats.

OMT is a Credit Facility.  Let's see....  We have an unlimited program specifically designed to support the sovereign debt of targeted countries.  We have implausible revocability, dubious terms for enforceability, open-endedness regarding both time and quantity of support provided, and, supposedly, no recourse by the lender.  Furthermore, the provider of this credit is specifically willing to buy even if no one else will.  Admittedly, the credit provider will not buy on the primary market.  However, when you examine the TFEU, there are two distinct restrictions in this regard.  The commonly cited one obviously forbids the ECB from primary market sovereign debt purchases.  But the one that Draghi wants us to ignore forbids ECB credit facilities in favor of national governments.  "In favor of" is clearly broader in scope than the primary market restriction.

OMT is ILLEGAL.  Here I am beating a dead horse, as I have made this argument several times before.  But, one more time for effect: 

OMT IS ILLEGAL AS IT VIOLATES ARTICLE 123 (1) OF THE TFEU, WHICH CLEARLY PROHIBITS THE ECB FROM ESTABLISHING A "CREDIT FACILITY ... IN FAVOR OF NATIONAL GOVERNMENTS."

Reading:  Finns Veto ESM Boost (WSJ)  Seriously?  Is this just keeping up appearances for you electorate, or just plain stupidity?  IF OMT goes through, you're screwed no matter what.

Cross-posted from Fibs and Waves.

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Reader Comments (1)

The ECB can be either a reserve bank or a commercial lender but not both.

If it becomes a commercial lender w/ impaired securities as collateral for leveraged loans it is insolvent.

Even if the securities it takes on represent performing loans leveraging them under the present straitened circumstances renders the central bank insolvent. If Draghi doesn't realize this he is unfit for his job.

There are some circles that cannot be squared: no wonder there are massive runs out of countries (not banks, countries!) By pretending to be the lender of last resort Draghi annihilates the ECB as lender of last resort.
September 22, 2012 | Unregistered Commentersteve from virginia

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