Mario Draghi has achieved the impossible. A recap of yesterday’s momentous developments:
- Mario was able to maintain “Radio-Silence” on the key elements of the plan he unfolded. As a result, he achieved tactical advantage when he unveiled his bold proposals. The global capital markets were both shocked and awed, and responded with unbridled enthusiasm.
- Draghi has presented a well thought out proposal. It addressed all of the issues that the markets and politicians were worrying about:
A) To appease the concerns of the citizens of Germany, Netherlands, Finland etc. the ECB support plan has stiff conditionality. This important step will, no doubt, assuage any concerns those citizens may have that their tax dollars might be at risk.
B) Mario was decisive. He did not fire a bazooka, he did not fire a howitzer. He fired the most powerful weapon known to a Central Banker. He said the “U” word. Unlimited market intervention was promised. With this one word, Draghi has eliminated any uncertainty on the outcome of the Euro and the EU.
C) Draghi boldly addressed the issue of subordination that has vexed the EU bond markets. The issue no longer exists. All sovereign bonds outstanding will now be treated the same in the event of default. There will be no “preference” provided to the bonds Draghi will buy in the market. Clearly, Mr. Draghi’s prior experience with Goldman Sachs has paid off. His knowledge of the capital markets, and the “creativity” that comes from being an ex. Goldman banker, has given him the insight needed to eliminate the subordination issue.
D) Mario changed collateral requirements that will unglue the EU funding markets.
E) In a brilliant move, Draghi placated those old curmudgeons at the Bundesbank who have expressed concern on the inflationary front. Any bond purchases that the ECB makes, will be immediately sterilized. This single step eliminates the possibility of any inflationary consequences.
F) Taken together, the measures initiated by Draghi will allow the ECB to fulfill its promise of eliminating any impediments for monetary policy to be successfully “transmitted” to both Italy and Spain. The low interest rates in Germany will now be available to the citizens of the EU southern countries. The cheap money will fuel a broad based economic recovery.
So, do you like that rundown? That is the way the Draghi presentation is being spun by the media. More importantly, that is the way the market is “reading” the ECB actions. I think it is a complete crock-of-shit.
First off is the fact that absolutely nothing new was announced yesterday. What has been cobbled together by Super Mario is a rehash of of the SMP. Second, is that every detail of the new ECB steps was deliberately leaked to the market before Mario took the stage. How could a program that contains nothing new and and was previously disclosed, have had such a significant consequence to the capital markets? I don’t get it.
A – Yes, there is conditionality to bond purchases. The condition for Spain to get support from the ECB is simple. All they have to do is get down on their knees and and beg. To get the bond market support, they will have to accept the austerity measures that Germany requires. The same measures that are now hated in Athens. It gets worse. Not only would Spain have to accept the austerity conditions from the north, the will be obligated to sign up for a full IMF bailout program.
Folks, this will not happen easily. Spaniards do not want Troika types running their government. They definitely do not want the IMF involved. There will be enormous blow-back in Spain to the draconian steps that will be demanded by the IMF. But that is nothing compared with the outrage that will happen in Italy.
B – Yes Draghi did say the Unlimited word. And yes, that is important. The German citizens should be crapping in their pants over this. Unlimited means unlimited. Draghi can’t back off on this promise, ever. He has dug himself a hole that is measured in the Trillions with this commitment. How can anyone promise “unlimited” action when there are always limits?
There will come a day when Draghi will be tested on his promise. There are two possible outcomes. (1) he lives up to his promise and the ECB absorbs a huge portion of the debts of Italy and Spain or (2) Mario blinks at the critical time, and backs off. Either way, that would be the end of the Euro system.
When Draghi said unlimited he bought the EU some time, but he made an all in bet. The consequences of an EU member leaving has now been raised dramatically. Mario has created an “all or nothing” scenario for the EU. When a member leaves, it will crash the entire system. Systemic risk in Europe has increased as a result of Marios’ efforts. I don’t think the markets (or the politicians) realize how high the stakes have become.
One further note on the “unlimited” issue. Mario clearly said that there is a big “but” to his promise. The obligation to purchase an unlimited amount of debt is conditional on the country involved meeting the “targets” that will be set by a Troika. We have never seen a country live up to the demands of the Troika yet. There is no reason to believe it will happen in the future. What this means is that when things really get tough in Spain, and they are unable to achieve the level of austerity demanded by the North, the ECB will stop its purchases. At that point the entire system will go up in flames. If bondholders believe that this will all work out, they will be disappointed. The bondholders that I know are not stupid. They will see through this obvious flaw.
C – I flat out don’t believe Draghi when he says that any bonds purchased will become parri-passu (equal). He can say what he likes, but when the rubber meets the road, and there is a sovereign default, the restructuring will be done by by Brussels. When that happens (it will), the bond holdings of the ECB will be carved out. Private sector creditors will not be treated the same as the public sector.
As part of any bailout, Mario has insisted that the IMF will be brought in. Let me be very clear on this. The IMF is always Senior to pubic holders of debt. This means that the IMF will be Senior to the ECB as to the right of repayment. Do you get this German citizens? This means that Draghi has put you on the back of the bus!
There is a reason that governments and the IMF have always been treated as senior to other creditors. These types of lenders are not in it for the return, they are forced into lending as a result of a crisis. Tax payer money is at risk when cross-border bailout loans are made. Those types of creditors should have protection over commercial lenders who made a mistake. That has been the tradition in all sovereign bailouts over the past 100 years. Mario has broken new, and very dangerous ground with this step.
D – Collateral requirements have been a sticking point for the ECB. Not any longer. With a wave of his hand, Mario has said he will accept any junk collateral that is out there. Busted mortgage loans, crappy corporate assets and un-payable sovereign debt is now going to be eligible for financing at 100% of par at a dirt cheap price.
In the end, the people in Germany will own this crap. The cost will be staggering. I can’t imagine how the German politicians, the Bundesbank and the German people can allow this to happen. They are getting fleeced by a guy from Goldman who has allegiance to Italy, not Europe.
E – I wait to see if the promise to sterilize all purchases of debt is delivered on. If this is done in small amounts (under E 200Bn), I think that it could be done in a sterilized manner. But there is little chance that it can be done in the Trillions of Euros that will be required. To live up to the promise of “unlimited”, Draghi will have to print money. To think there are no inflationary consequences attached to the Draghi plan is just wishful thinking, or outright lies.
F – I don’t think that the objective of eliminating the impediments that have clogged up the “transmission of monetary policy” has been met with Draghi’s efforts. Quite the contrary.
For the ECB to implement the new measures for a country like Spain, the first condition is that there must be a crisis in the markets that forces the government to go begging. So now we must wait for a crisis to occur. This is the environment that allows for the smooth transmission of monetary policy? I would think not.
I try to never to stand in the way of market sentiment. All of the signs point to the conclusion that the market is satisfied will what Draghi has delivered. The most conclusive evidence comes from the EURCHF market. For the first time in many months, the key cross rate is above the floor set by the Swiss National Bank. So Draghi has succeeded.
Me?, I think he has set the EU, and the rest of the world, up for a very big fall. Nothing he did will change the economics in Spain. More austerity for this country will not fix the problems, it will make the problems worse.
What Draghi did is buy some time. The only question is, “How much time?” My guess is that it will take three months before we are back in crisis mode.
Images: Flickr (licence attribution)
About The Author – Bruce Krasting
I worked on Wall Street for twenty five years. This blog is my take on the financial issues of the day. I was an FX trader during the early days of the ‘snake’ and the EMS. Derivatives on currencies were new then. I was part of that. That was with Citi. Later I worked for Drexel and got to understand a bit about balance sheet structure and corporate bonds from Mike Milken. I was involved with a Macro hedge fund later. That worked out all right, but it is not an easy road. There was one tough week and I thought, “Maybe I should do something else for a year or two.” That was fifteen years ago. I love the markets. How they weave together. For twenty five years I woke up thinking, “What am I going to do today to make some money in the market”. I don’t do that any longer. But I miss it.
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