Europe's Chief Bailout Officer Introduces the ESM to Investors



Klaus Regling, the head of the euro area's bailout facilities held a conference call for investors on Tuesday presenting the soon to be launched ESM. The introduction, including an extensive 'FAQ' type section can be downloaded in full here (pdf). The aim of the conference call was to begin marketing ESM bonds to investors. In order to increase the bailout vehicle's firepower, it will – similar to the EFSF – sell bonds to investors. Since the German constitutional court has recently given its placet to the ratification of the ESM, the new bailout fund is set to become operational on October 8. We were astonished to learn that the staff of the EFSF (which will run the ESM as well) consists of altogether 60 people. We wondering a bit what they are doing all day long as it were. Here are a few noteworthy pieces of information from the conference call (mostly it summarized things that are already known, but here we have it all in one place):

The ESM will have total capital of €700 billion, in the form of €80 billion in paid-in capital and €620 billion in callable capital guarantees. The signatories to the ESM treaty have to cough up their share of capital additions within seven days if they are called upon to do so. Since the fund only has a lending capacity of up to €500 billion, it will be theoretically overcollateralized by 40%.

Should one member nation be unable to come up with the funds to meet a capital call (for instance by dint of being bankrupt), the remaining members must make up for its share on a pro-rata basis. It is hoped that this rule will assuage the concerns of outside bondholders as to the security of their investment. The ESM has not been rated yet, so one assumes that this was also designed with the credit rating in mind. Apart form the €100 billion Spanish bank recap, where the ESM will rank pari passu with other investors, it will have seniority in all additional bailouts it undertakes – with a sole exception: its claims will remain subordinated to the IMF's. The fund will be able to participate in private sector repo markets, but it won't get a banking license and hence won't be able to repo securities with the ECB (issuance of a banking license to the ESM has been deemed illegal both by the ECB's legal counsel and the German constitutional court, so the banking license idea is finally dead as a doornail).

Another Three Card Monte



One might think at this point that ergo, the ESM's operations will be non-inflationary. The devil may be in certain details though. In point 24 of his FAQ list, Regling describes how the Spanish bank recapitalization will be handled (readers may remember that a similar method was employed by the EFSF in Greece in connection with the post PSI bank recapitalization). According to the transcript:

“Q: Will the funding for the Spanish bank recap be done by means of bonds transferred to Spain (i.e., a cashless operation) or by means of capital market funding? A: The funding for the Spanish bank recap will in general take the form of EFSF or ESM bonds provided to FROB (the Spanish bank restructuring agency).”

(emphasis added)

Let's think this through: Spain's FROB gets ESM bonds (or EFSFS bonds, which will later become ESM bonds), which it then presumably hands over to banks that require new capital. A question that was neither asked nor answered was whether the banks concerned could then in turn use these bonds to obtain central bank funding, but we must assume that it is possible. After all, why should the ECB (or the Bank of Spain) refuse to take these high quality bonds, which are guaranteed by 17 different nations of which at most five or six (depending on who you ask) are currently insolvent?

Given a reserve requirement of a mere 1% in the euro system, the banks could in theory then lever up the reserves they receive in return in concert by a ratio of up to 100:1.

We are of course well aware that this is not going to happen in the current economic climate. However, one cannot shake the suspicion that an indirect subsidization of the debt auctions of Spain's government could (and probably will) occur in this manner. After all, if the banks get new reserves in exchange for pledging ESM bonds with the central bank, they could use those to extend credit to the government.

Moreover, if the banks were to create new deposits in favor of the government and got new government bonds in return, they could pledge these bonds to the central bank as well. Since the ECB has dropped even the last bit of pretense regarding the 'quality' of its own balance sheet by more or less dropping all limits to collateral eligibility (ostensibly to 'ease a collateral shortage', which it asserted as recently as mid 2011 did not exist), Spanish government bonds would certainly not be rejected, regardless of their rating.

As an aside to the above, the ECB's LTRO's have vastly increased the ratio of covered to uncovered money substitutes in the euro area's banking system. Prior to the huge increase in central bank credit, the effective demand deposit cover in the euro are was below 5%. At present the euro area's true money supply consists of €871 billion in currency plus money substitutes amounting to €4.097 trillion. Of these money substitutes, a full €882 billion are covered these days (this is to say, they have bank reserves deposited with the ECB behind them), up from a far more paltry €200 billion prior to the LTRO's.

In short, bank reserves held at the ECB exceed required reserves by about €840 billion, or 20.5% of the money substitutes outstanding. Of course the banks that have deposited excess reserves with the ECB are not the same banks that need the 1% reserve requirement to merely scrape by (this was lowered from an already risible 2% last year). Ownership of bank reserves is not exactly evenly distributed. The fact remains though that there is now immense credit expansion potential – even though it is fair to assume that it will remain dormant for now.

Note however that the ECB itself is evidently interested in seeing these reserves mobilized for credit expansion: this is why it lowered the interest rate it pays on excess reserves to zero (and the possibility of introducing a penalty rate has been and presumably continues to be discussed). In extremis the banks could react to the introduction of a penalty rate on reserves by exchanging them for currency and keeping the banknotes in a vault (provided the cost of guarding the money pile does not exceed the penalty rate).

ESM and ECB Tandem



In the event of an aid request from e.g. Spain, the ESM would become a primary market financing vehicle for the government, i.e. it would presumably buy Spanish bonds directly from the treasury. The ECB would buy bonds on the short end of the curve concurrently in the secondary market, so as to manipulate market interest rates.

In short, once a country comes under the bailout program, interest rates on its debt will no longer properly reflect an adequate risk premium. It will be impossible to gauge what interest rates would obtain in a non-manipulated market – in fact, it is already impossible to do so, due to the 'announcement effect'. Since studies exist that show that the risk premium contained in interest rates on government bonds in the euro area is also reflected in rates charged in the loanable funds market in the private sector, this manipulation has potentially wide-ranging economic effects. The ECB wants it that way of course (the monetary bureaucracy falsely holds that manipulation of interest rates by bureaucrats is economically beneficial). According to the ECB, there have to be the same interest rates across the euro area, regardless of the differences in risk and economic circumstances.

We would again note here that the ECB's contention that its planned 'OMT' operations would be non-inflationary must be doubted on the grounds that there is already such a huge amount of excess bank reserves extant.

Say for instance that the ECB were to buy bonds worth €200 billion in the secondary market and then proceeded to 'sterilize' them by issuing a weekly renewable deposit tender at an interest rate high enough to entice the banks to take it up. Where would the funds for this come from? Why would the banks that are currently starved for interest on their excess reserves not simply move some of them over into this new facility? In that case, we might have to consider the sterilization to exist only on paper. The bond buying as such would of course swell both the ECB's and the banking system's deposit liabilities further, so much would would still depend on how the banks dispose of the additional reserves they would garner, i.e. if they would be prepared to pyramid further credit atop them. Moreover, the initial money supply expansion cannot possibly be 'sterilized'. Only the further inflationary expansion of credit atop the new deposit money created can theoretically be curtailed by sequestering bank reserves with deposit tenders.

Imagine the government issuing €200 billion in bonds in order to repay holders of maturing bonds and to spend the remainder. The banks buy these bonds at auction and fob them off to the ECB. Evidently the €200 billion will indeed enter the economy, 'sterilization' or no sterilization. Also, to the extent that the ECB buys bonds from non-banks in the secondary market, additional deposit money will be created directly.

The inflationary potential might never be fully realized, especially as those who are solvent are not eager to spend and many banks are themselves eager to bolster their cash assets at the moment, but it is important to recognize that it exists.

Lastly, Regling shot down the idea that 'money left over' from the €100 billion Spanish bank recap could be used to finance government debt. The exact amount required for the recap exercise will soon be determined (although we are slightly mystified as to how anything but a rough snapshot can be arrived at – after all, this is a moving target, and a fast moving one at that). The official line is now that the entire €100 billion probably won't be required and that the remainder will enhance the €400 billion in ESM lending capacity that is left over. This is a not unimportant detail, due to the fact that the ESM won't enjoy senior creditor status in the bank recap. The fewer bonds it issues to the FROB, the safer it will be for outside investors to buy ESM bonds.







The ESM's capital structure (prior to obtaining funds from the capital markets) and lending capacity, via Der Spiegel – click for better resolution.





Current EFSF/ESM bailout recipients and the size of the bailouts. The ones in dark blue remain in the EFSF program. Note that Slovenia is likely to soon require help for its banks as well – click for better resolution.

Conclusion

In summary, the European Keynesian rescue operation, which consists of saving the balance sheets of the already ruined by viciously impairing the ones of those still (barely) standing in good health, is rolling on full blast.

Bombs away, one might say.

Charts by: Der Spiegel

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