• Edward Harrison

LTRO operation is pushing Spanish banking system closer to collapse


I thought I’d point out that the already severely undercapitalised Spanish banking system is being crushed by the spike in Spanish sovereign yields.

If you recall, last November when the euro crisis last flared, my argument was that questioning Italy’s solvency leads inevitably to monetisation because Italy was too big to bail. At the time, I also argued the end result of that monetisation would be investors piling in once the ECB figured out how to deliver. Here’s the key paragraph from my November monetisation article to focus on in the Spanish context (emphasis in original quote):

If a central bank guarantees investors credibly that they can invest in certain debt instruments and not suffer principal or interest repayment risk, but only currency and inflation risk, some investors are almost definitely going to buy the debt instruments with the greatest yield pick up. Put another way, the only reason not to buy Italian debt at 2 or 300 basis points over Bunds, or Greek debt at 3 or 400 basis points over Bunds is because those governments are not credibly backstopped by the ECB.

The ECB offered up an implicit backstop in the LTRO (hint, hint, wink, wink). Investors jumped at the chance to get higher yielding ‘risk-free’ government bond investments on the back of this. This has all gone pear-shaped though – because the backstop has lost credibility. A quote from Bloomberg economist David Powell gets at both the magnitude of the bet on Spanish bonds and the magnitude of capital losses so far (hat tip to Warren Mosler).

Banks in Spain have been saddled with losses of about 1.6 billion euros as a result of the liquidity operation conducted in December, according to Bloomberg Brief estimates. Spanish lenders purchased 45.7 billion euros of government bonds during the months of December, January and February, according to monthly data from the ECB, and the average of the current prices of two-, six- and 10-year government bonds of Spain is 3.5 percent below the average of the average of those prices from Dec. 22 to March 1.

Make no mistake, the easy LTRO money that Portuguese, Italian, Irish and Spanish banks are all addicted to is monetisation pure and simple despite what officials might claim.

Here’s the thing though. The Europeans don’t want to see the ECB writing the check. Supporters of a hard currency euro know that Italy and Spain would have no reason to make reforms or move to fiscal consolidation without the sovereign insolvency stick and so they are using that stick as much as they can reasonably do. The problem with this approach is it will subject the euro zone to crisis again and again because austerity is a debt deflationary policy response. There is zero chance these countries are getting out of this without continual monetisation. Eventually, in every case in the periphery we will get what I said in 2010 are the only three options for the euro zone: monetisation, default, or break-up.

Now, looking at the specific scenario for Italy and Spain, in December I put it this way:

In sum, Europe is certainly a problem that will flare because the longer-term solution is a combination of credit writedowns, more bank capital, a lender of last resort and economic growth. Right now, the solution is no credit writedowns, maybe some bank capital eventually, some monetisation and economic anti-growth. Big difference.

So I expect Europe to continue the extend and pretend approach, creating volatility and crisis. And the question again and again will be: does the ECB write the check. I believe they will.

Looking at what’s happening now with Spain, you can see extend and pretend is going down the same route it has done in Greece , Portugal and Ireland. But, of course, Spain is too big for any of the EU’s bail out funds. It will all boil down to whether the ECB writes the check.

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