June 14, 2011 – The solvency of the European Central Bank is being called into question by some brilliant in-depth research from OpenEurope.org.uk. This independent think tank believes “the EU must now embrace radical reform based on economic liberalisation, a looser and more flexible structure, and greater transparency and accountability” in order for the “EU’s over-loaded institutions, held in low regard by Europe’s citizens” to meet “the pressing challenges of weak economic growth, rising global competition, insecurity and a looming demographic crisis”.
The press release announcing the report, which is entitled “A HOUSE BUILT ON SAND? – The ECB and the hidden cost of saving the euro”, succinctly summarizes several key points which I quote below. My comments in italics are bracketed:
• “In parallel with the IMF’s and EU’s multi-billion euro interventions, the ECB has engaged in its own bail-out operation, providing cheap credit to insolvent banks and propping up struggling eurozone governments, despite this being against its own rules. [emphasis added] The ECB is ultimately underwritten by taxpayers, which means that there is a hidden – and potentially huge – cost of the eurozone crisis to taxpayers buried in the ECB’s books.”
• “As a result, the ECB’s balance sheet is now looking increasingly vulnerable. We estimate that the ECB has exposure to struggling eurozone economies (the so-called PIIGS) of around €444bn – an amount roughly equivalent to the GDP of Finland and Austria combined. Although not all these assets and loans are ‘bad’, many of them could result in serious losses for the ECB should the eurozone crisis continue to deteriorate. Critically, struggling banks in insolvent countries have been allowed to shift risky assets away from their own balance sheets and onto the ECB’s (all the while receiving ECB loans in return). Many of these assets are extremely difficult to value.” [But in all likelihood are worth far less than the carrying value at which they are booked on the ECB’s balance sheet.]
• “Overall, the ECB is now leveraged around 23 to 24 times, with only €82bn in capital and reserves…This means that should the ECB see its assets fall by just 4.25% in value, from booking losses on its loans or purchases of government debt, its entire capital base would be wiped out.” [The ECB is over-leveraged just like the sovereign debtors whose interests it is serving by bailing them out.]
• “Hefty losses for the ECB are no longer a remote risk, with Greece likely to default within the next few years [Open Europe is being exceptionally optimistic; “months” or even “weeks” for a formal default to occur are real possibilities, but for all practical purposes, Greece has already defaulted because it does not have the capacity – nor probably the will – to repay its debts.] – even if it gets a fresh bail-out package from the EU and IMF – which would also bring down the country’s banks. We estimate that the ECB has taken on around €190bn in Greek assets [more than twice the ECB’s capital base] by propping up the Greek state and banks. Should Greece restructure half of its debt – which is needed to bring down the country’s debt to sustainable levels – the ECB is set to face losses of between €44.5bn and €65.8bn on the government bonds it has purchased and the collateral it is holding from Greek banks. This is equal to between 2.35% and 3.47% of assets, meaning it comes close to wiping out the ECB’s capital base.” [Again, Open Europe is being overly generous by assuming only one-half of Greece’s debt is restructured. After all, both halves are equally bad.]
• “A loss of this magnitude would effectively leave the ECB insolvent and in need of recapitalisation. It would then have to either start printing money [The ECB is nothing but a money-printing organization, so in reality, it would need to print more money than it is already printing] to cover the losses or ask eurozone governments to send it more cash (via a capital call to national central banks). [This capital call could be made in terms of euros, which the national central banks would need to borrow or print, but it could also be made in terms of gold, which represents their only real capital. Whether the national central banks would be willing to transfer to the ECB some or all of their remaining gold reserves – for those banks that have any left – remains to be seen.] The first option would lead to inflation, which is unacceptable in Germany [as well of course to people throughout the EU], while the second option amounts to another fully fledged bail-out, with taxpayers facing upfront costs (rather than loan guarantees as in the government eurozone bail-outs).”
• “The ECB’s actions during the financial crisis have not only weighed heavily on its balance sheet, but also its credibility.” [Its credibility has already been largely lost. That happened last May when the ECB bent to the will of politicians ‘solving’ the then brewing Greek crisis and forced the ECB to break its own rules and buy Greek sovereign debt. The ECB has continued down this path to ruin by buying the debt of other over-leveraged sovereigns burdened by their debts.]
For all practical purposes, the ECB is insolvent. Its doors remain open simply because it is using the well-worn accounting trickery of all insolvent banks. Most people cannot recognize when a bank becomes insolvent if it doesn’t write-down its assets to their real value and reports those write-downs in its financial accounts. The bank and its directors thus operate recklessly because the impaired assets are greater than the insolvent bank’s capital. The insolvency only becomes obvious when the bank goes out of business, which is a truism made observable by the collapse of Lehman Brothers. In other words, growing in early 2008 from a few short sellers and those customers who withdrew their money from Lehman, the market increasingly recognized that Lehman was insolvent even though its balance sheet didn’t show it, sending Lehman’s share price into a death spiral as the awareness of its insolvency grew. This report from Open Europe is now causing people to look at the ECB’s balance sheet and available facts, and therefore forcing them to draw conclusions about whether the ECB is solvent. The implications for anyone holding the euro are as ominous as those for anyone who owned the shares of Lehman Brothers.
Lest you come away from reading the above by concluding that the problem is solely Europe’s, ponder the following.
An article in this week’s issue of Barron’s about the Open Europe report says: “The U.S. Federal Reserve sports leverage double the ECB’s, at more than 50 times, but its holdings of U.S. Treasuries are higher-quality than PIIGS debt.” This comment blithely ignores the fact that US Treasury debt instruments comprise only 55% of the Federal Reserve’s assets, and much of the remainder is toxic or illiquid. Further, US Treasury debt is no more likely to be repaid than that of other over-leveraged sovereigns.
Thus, there is only one logical conclusion. Given that repayment is beyond the financial capacity of over-leveraged debtors, much of the debt overhanging the globe will never be repaid. Because a large portion of this debt is the principal asset backing national currencies today, these currencies have been debased. It is debasement just like that instigated by corrupt and autocratic kings and emperors of yore that we read about in monetary history, who cheated the citizenry by mixing lead or other base metals into coins to replace their gold and silver content. But today the debasement of fiat currency arises from the unrepayable loans of over-leveraged sovereigns run by corrupt and autocratic bureaucrats and politicians and of course their hand-maiden, central bankers. This observation succinctly highlights a theme I have made repeatedly. Central banks are a barbarous relic.