Throwing a Hypothetical Out There

Months ago I went on one of my rants; the issue? The European Central Bank creating a 2-3 tiered bond market.

When Greece needed to swap its debt for shiny new debt that would see Greek bondholders lose 50+% on the transaction (after all getting paid 50% is better than a default and getting zip-unfortuantely Greece probably won't be able to service the new debt either and that is why at last check it was trading at 20% of par) the ECB quickly and as quietly as possible exchanged their Greek debt for new Greek debt without the 50% haircut. Now I understand that the ECB by its own charter cannot finance sovereign deficits, and therefore if they got the same deal as everyone else they would have broken the rules of their charter, but that may have been a better solution. Why?

The ECB, much like the F_E_D, cannot participate in primary auctions, meaning they can't go to Spain's auction tomorrow and scoop up al the debt being auctioned, they can however buy the debt in the secondary market to try to support the yields and keep them from rising to 6+%, a level of interest that no country can afford to pay. In doing so, the ECB can acquire a majority or near majority position in any one EU country's sovereign debt. Greece could not afford to repay the debt they had outstanding so they negotiated (or strong armed is more appropriate) a write-down on their debt. Being the ECB didn't participate in those losses, they did enormous damage to the bond market and killed the decades old concept of equal and fair treatment of bondholders, thereby creating a senior and subordinated class of debt, senior if you are the ECB, subordinated if you are anyone else.

Knowing that  Italy, Ireland and Portugal will likely seek fair and equal treatment-the same deal the Greeks got, it created a situation that I said back during my rant would comeback to bite the ECB in the rear end.

Now bondholders or potential bond buyers know that the more debt the ECB holds of any one country, when it comes time to restructure to get their debt loads down to 120% of GDP, the only debt that will be written down will be the subordinated debt and not the ECB. So if for instance the debt load needs to be reduced by half and the ECB owns half of the outstanding debt, the losses the bondholders will take will be proportionately bigger according to how much debt the ECB holds as only the subordinated debt will be written down, not the ECB's. Would you want to be a buyer of debt knowing there are no more protections, knowing that when that particular country goes for a debt restructuring, you will lose more money and only your debt will take the losses needed to get that country to 120% debt to GDP?

Probably not.

There fore the French/Germans and ECB thought they could fix the situation by giving banks a 3 year 1% loan and fully expected the banks to take these LTRO loans and buy debt with them, the problem is, the banks in the EU are already undercapitalized, this 1% money is exactly what they needed to shoe up their balance sheets and they knew they'd ultimately get screwed when the next country approached a default and had to restructure debt. As a result, the ECB saw record inflows of deposits from banks that would rather pay the ECB to keep the money safe than to try to go out and make some money buying sovereign debt. The plan backfired, but several shorter dated debt auctions like yesterday's in Spain have gone through ok as some banks know that they have a 3 year loan and if the debt matures before the 3 year loan, they "should be safe". Anything longer than the 3 year loan and they are on their own, this is why tomorrow's Spanish 10 year debt auction is such a big deal, it could fail miserably sending Spanish yields way past 6% and putting Spain in the position of needing a bailout, one that the EU cannot afford. Spain literally could be the last domino standing.

So here's what could happen and while we'll never know for sure, the results of tomorrow's auction should give us a pretty good idea. When Italian yields were moving to 6 and even 7%, somehow mysteriously they conducted a primary debt auction that had a yield lower than that of what was seen in the secondary market. Manipulation was suspected, being the ECB can't directly participate in the auction, it has been thought that the ECB may have transferred money to several banks and had the banks buy the Italian debt on the ECB's behalf, of course without telling anyone as that certainly is at best a very grey area and would defeat the purpose of a successful auction if everyone knew the ECB was behind it.

The Spanish auction tomorrow may arguably be one of the most important auctions the ECB has seen, should it fail, yields will rise, Spain will not be able to repay their debt, they will not be able to go to market to issue new debt and they may be in danger of a default, one the Euro-zone can't afford to pay for, unlike their smaller neighbors in Greece, Ireland and Portugal.

So the pressure is on, should the ECB do what I laid out above (what many already suspect they did with Italy), then the auction should come in fairly strong. Should they leave it to the market alone, the auction will likely fail. In fact, not that I have heard this, but it wouldn't surprise me if the auction was cancelled at the last minute as the results could be catastrophic for the entire Euro-zone.

It never seems to fail, every EU fix creates a bigger problem. This is the one problem they can't afford. You can see how this could have consequences for the US markets as many of our financial institutions have branches in Europe, not to mention the chaos it would create in the world economy.

I almost want to stay up late and see how this goes down, I probably won't bother though because since I said the EU will be back in the spotlight about a month ago, the trends there have deteriorated rapidly. Yes, they will kick the can for as long as possible, but it doesn't take a genius to see how this will ultimately end.