Next on the ECB’s Collateral List: Goats, Wine, and Cheese Wheels?

Are there any limits to monetary policy? It sure doesn’t seem like it. But in the real world there is a limit: The amount of available collateral to lend against. And the European Central Bank (ECB) is quickly running out of it.

I once said in a webinar that sooner or later the ECB’s collateral requirements for loans will include goats, wine, and cheese wheels.

They’re getting close …

Here is the statement from the ECB on Thursday as it announced its new and improved “conditionally unlimited” bond-buying program [my emphasis]:

“On 6 September 2012 the Governing Council of the European Central Bank (ECB) decided on additional measures to preserve collateral availability for counterparties in order to maintain their access to the Eurosystem’s liquidity-providing operations.

“Change in eligibility for central government assets: The Governing Council of the ECB has decided to suspend the application of the minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the central government, and credit claims granted to or guaranteed by the central government, of countries that are eligible for Outright Monetary Transactions or are under an EU-IMF programme and comply with the attached conditionality as assessed by the Governing Council.

” … Expansion of the list of assets eligible to be used as collateral: The Governing Council of the ECB has also decided that marketable debt instruments denominated in currencies other than the euro, namely the US dollar, the pound sterling and the Japanese yen, and issued and held in the euro area, are eligible to be used as collateral in Eurosystem credit operations until further notice. This measure reintroduces a similar decision that was applicable between October 2008 and December 2010, with appropriate valuation markdowns.”

Any way you choose to slice or dice this, it means the ECB is taking on more credit risk as it significantly expands its own balance sheet. The chart below is a look at the ECB balance sheet before any of the newly announced lending (bond buying) comes into effect.

Click the chart for a larger view.

Notice the ramp up in 2012? That was the result of the ECB’s Long Term Refinancing Operations (LTRO), which was designed to provide liquidity to the banking system and put concerns about the viability of the euro behind us.

At the time, the German Bundesbank criticized it because it would add more credit risk to the ECB balance sheet. And this exposure flows indirectly into the Bundesbank balance sheet. This should help you understand why Germany is so keen on controlling budgets of the other countries it is effectively exposing itself to.

So fast forward to today and imagine how unsettled the Bundesbank is given the newly watered down collateral standards instituted to allow for the new and improved “conditionally unlimited” bond-buying program by the ECB?

Now let’s look at Spain and Italy. Particularly Spain … where all the plans and financial engineering gymnastics may come crashing down.

Click the chart for a larger view.

The chart above clearly shows just how exposed the ECB is to Spain and Italy, while the chart below shows why the ECB is lending them so much.

Click the chart for a larger view.

The ECB is the lender of last resort for Spain and Italy because others are taking their money and stampeding out as fast as they can! Incredibly, on a three-month rolling basis, outflows represent 15 percent of Italy’s GDP. And currently they represent about 50 percent of Spain’s GDP, according to the Financial Times.

The same article goes on to define what it calls “the three main pillars of capital flight” for the latest quarter:

First, foreigners are big sellers of Spanish securities. This generated an outflow of 19.4 percent of GDP.

Second, Spanish residents are pulling out large amounts. The outflow by this source was 16.7 percent of GDP.

Third, foreigners are liquidating Spanish bank debt at the rate of 15.3 percent of GDP.

The ECB is gearing up to lend as much as possible to keep Spain solvent. But this is where the conditions come into play. In order for the ECB, under the implicit approval of Germany, to lend all this new money the Spaniards have to play ball by committing to austerity measures effectively outlined in Berlin, by Germany.

So far Spain is not playing ball as its political class is not keen on handing over sovereignty to Germany. But they may have no choice.

Let’s say Spain goes along with the German/Troika austerity regime and gains access to this unlimited ECB bond-buying. But as the dark days of grinding recession roll along, what happens if the country concludes it can no longer abide by the formerly agreed upon austerity measures?

That would leave the ECB with the tough choice of:

1. Stop buying Spanish bonds ensuring a future default, or
2. Keep buying the bonds and lose every shred of credibility it once had as a responsible, hard-money institution.

Path number one would effectively kill the single-currency regime. Path number two would keep the single-currency regime alive and kicking. But the consequences could be far worse than a break-up — it could mean the Lira-ization of the euro and farmers lining up at ECB headquarters with their goats, wine, and cheese wheels.

Best wishes,

Jack