naked capitalism

By Philip Pilkington, a writer and journalist based in Dublin, Ireland

While I was writing on the unsustainability of the haircut deals yesterday, the peripheral bond markets in Europe rallied. My argument was that when other countries started getting uppity and demanding haircuts, European government bond investors would slowly but surely come to realise that they were the ones on the end of the hook and that politicians didn’t give a damn about them. This would eventually result in their piling out of the bond markets, sending yields into the stratosphere. The ECB would then be forced to step in and buy up bonds in the secondary market – or perhaps do something even more responsible, who knows?

And indeed, as the Greek deal began to solidify, Ireland quickly joined the queue:

Ireland would see any European Central Bank contribution to the restructuring of Greek debt as a precedent that would boost Dublin’s efforts to ease the burden of its own sovereign debt, the country’s finance minister said on Wednesday.

In the meantime, however, the markets for peripheral company and bank debt rallied – and rallied rather hard at that. The FT reports:

For all the uncertainty over Greece, Europe’s bond markets have been rallying strongly. Now the ‘risk on’ sentiment has spilled over into markets for company and bank debt, with investors snapping up a wave of bond issues from Italy, Ireland and Spain.

Of course, this isn’t the European government bond markets; this is just company and bank debt. And we can’t expect investors get nervous until they start seeing governments in countries like Portugal rattle the cage and demand a haircut. But still, some explanation is surely needed.

Is it that these investors are stupid? Well, we should never assume stupidity when easy moneymaking might be involved. And that, of course, is precisely what’s happening here. Per the FT:

Bankers say that the European Central Bank’s €489bn injection of much-needed liquidity through a three-year loan programme into Europe’s financial system not only provided unlimited and cheap funds to the region’s banks but helped to lure cash-rich investors back into the public bond markets, and those of so-called peripheral eurozone nations in particular.

Sorry, what? Let’s hear that again:

Torsten Elling, co-head of the European rates syndicate team at Barclays Capital, says that the ECB’s so-called longer-term refinancing operation has convinced investors to look at higher-yielding assets again. “The door is open for covered and senior unsecured bond issues in the periphery. There’s definitely demand from investors and that’s been driven by the LTRO.”

Aha! Of course! It’s the ECB bailout that is facilitating this bond market rally. Investors grab the LTRO funds and bang them into high-risk assets, while at the same time investors are told that they’re going to get burned in the Greek bond market.

Naked they came from their mothers’ womb, and naked they shall depart. The Troika gave and the Troika has taken away; may the name of the Troika be praised!

Yesterday I claimed that the Eurocrats had not thought their strategy through; I said that they had not considered how bond markets would react when more haircuts became inevitable and began to be demanded by other countries. Was I wrong? Is there indeed a master plan? Is the LTRO the mechanism by which this master plan is launched?

No. I don’t think so. The LTRO bailout fund will not stem the tide in this regard. The key problem is that this is not a liquidity crisis, but a solvency crisis. And it is not a solvency crisis in the typical sense, but a solvency crisis of a group of sovereign states that don’t use their own currencies.

The LTRO cannot make up for the fact that countries such as Ireland and Portugal do not issue their own currency and are being starved for funds by their de facto central bank, the ECB. This is for the simple fact that, as a BCA Research reports said recently (via WSJ blog):

The ECB’s LTROs can solve the banks’ refinancing needs for the next few years if they choose to take advantage. [But] the LTROs’ effect on peripheral sovereign debt is only indirect and is subject to the banks’ fickle appetite for risk.

The LTRO then, has a few functions. The most obvious is to keep the banking system operating while the Eurocrats continue to spit fire on the economies of the periphery and, in doing so, greatly increase the risk on these very banks’ holdings of sovereign debt. Tied to this, the Eurocrats can walk daily into the same room as the bankers and the financiers and not get shouted at for ruining their portfolios. Oh, it’s a wonderful life!

Yet people would be misled if they thought that this was, at heart, a nefarious banker-driven scheme. No, the bankers are being kept wriggling on the hook like everyone else. They’re just being fed rather well.

At heart this is, as it always has been, a political problem. And it must be said that, disgusting and ruthless though it all is, those that are pulling the strings are doing a rather good job at balancing all those political forces – like the bankers and the financiers – that might have the power to actually hold them accountable for their destructive and reckless actions.

But the situation remains a house of cards. And once other peripheral countries, squeezed hard in the vise of austerity, begin to demand the haircuts that are all but inevitable, those same bankers and financiers will look back to Greek default and remember just how important their interests really are relative to the naked political desires of those in power.