Worse than Sinn

I have told myself to stay out of the Target 2 debate, partly because this pretty much sums it up and I’ll just end up repeating myself and partly because the brave Olaf Storbeck has taken this on himself so many times.

However, this article by Tornell and Westermann is worth bringing up because the appearance of two people who are not Hans Werner Sinn making Sinn-like claims might suggest there is a point here. In fact, this piece has even less to add (and more to subtract, if believed) to the stock of useful knowledge than Sinn’s various pieces. (Unfortunately, its points were repeated on the usually-excellent FT Alphaville.)

Tornell-Westermann (TW) repeat the fallacy that the Bundesbank has loaned money to the so-called GIPS central banks. Their new twist on this story is that “In order to fund these loans, the Bundesbank sold its holdings of German assets.”

They back this up with a table showing information from the Bundesbank balance sheet. A line labelled “Private securities owned by central bank” shows a large decline in recent years.

What does this line correspond to? Well, TW’s line for “Private securities owned by central bank” equals €224 billion in 2009 and €277 billion in 2008.

Let’s go consult the Bundesbank’s own description of its balance sheet for these years (page 148 of this file). It tells us that “Lending to euro-area credit institutions related to monetary policy operations denominated in euro” equalled €223.61 billion in 2009 and €277.425 billion in 2008. I’m going to guess that the resemblance between these figures and those reported by TW is not coincidental and that TW’s figures correspond to the same entries.

Is “Private securities owned by central bank” – as best I can see a terminology invented by TW – a more accurate description than the terminology used by the Bundesbank, which effectively means “loans”?

Well, no. These entries correspond to loans. They are securitised loans, specifically repurchase agreements, so the Bundesbank holds a security as collateral for the (usually short) maturity period of this loan. But the value of the loans are less the value of the corresponding securities (i.e. a haircut is applied to the collateral) so the asset on the Bundesbank’s balance sheet is the value of the loan, not the value of the asset. Also, the asset remains on the balance sheet of the borrowing bank because the bank regains the asset on repayment of the loan and thus the transaction does not correspond to the accounting requirements for “derecognition” of assets.

So, this item – lending by the Bundesbank to German banks – has declined in recent years, from €277.425 billion in 2008 to €37.6 billion in August 2011 (the latest figures I could find – page 111). The reasons for this are not too surprising. There has been enormous capital flight from the periphery into German banks which, as a consequence, have had far less need than previously to borrow funds from the Bundesbank for liquidity purposes.

Note also that Eurosystem policy in recent years has been to supply banks with a full allotment of funds requested in refinancing operations, so the Bundesbank has not made any conscious decision to reduce the amount of lending it has done.

If “the Bundesbank has done less lending because German banks have asked for a smaller amount of loans” sounds different from “the Bundesbank has had to sell off securities to fund loans to peripheral central banks” that’s because it is. The first statement is true and the second isn’t.

The rest of Tornell and Westermann’s article is not much better.

· The presentation of the Bundesbank’s “Other claims within the Eurosystem (net)” (i.e. the Target 2 credit) as some kind of enforced loan to the rest of the system rather than the accounting entry that reflects a transfer from the rest of the system to Germany mirrors Professor Sinn’s ability to make something that is good for Germany appear to be Germans getting ripped off.

· The idea that the Bundesbank is about to “run out of money” – “the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem” – is completely without basis in reality. Still, the stuff about the Bundesbank’s gold holdings and the German public not wanting to sell it will appeal to paranoid goldbugs everywhere.

· The material about Target claims being collateralised by, for example, Greek bonds sounds scary but, in reality, is just false.

· The less said about TARGET being “overwhelmed” because “the ECB has a relatively small capital base” the better.

The crazy thing is that the Euro area is undergoing a real crisis and there is a huge need for an informed public debate on potential solutions. We don’t need academics making up fake crises and stirring intra-European resentments based on a misunderstanding of central bank arcania.

A New Referendum?

My presumption has been that any set of “fiscal union” measures of the type mentioned here will require a referendum. Far more trivial international agreeements have required them, so surely this would too. Eoin reckons it can be avoided via some Lisbon-related maneuver.

I’m not a constitutional expert but some of our readers must be. What do people think? Can we get some concrete cites to the relevant articles or protocols.

Time for a Deal on ELA

Whatever happens, there’s going to be a lot of Euro summitry in the coming months. It seems clear that Germany is pushing for a swift Treaty change to introduce all sorts of legal limits on debt and deficits as the solution to the debt crisis. (You could argue it’s a bit like a flood defense plan that relies on banning rain.) In return for this, the ECB will agree to provide funds to bail out Italy and others, perhaps via turning EFSF into a bank.

Personally, I still think the economics and politics of the “Debt Treaty” approach are terrible. But it’s probably going to happen.

Given that, what should Ireland’s government do? Most likely, with the EU threatening to pull fiscal and bank funding if they don’t co-operate, our leaders will just agree to sign the dotted line at the relevant EU Council meeting and then see if they can get away with not having a referendum. (Unlikely — an Irish referendum will be one of many banana skins the process could encounter).

So here’s one thing that I think they can do. If the ECB is going to move into uncharted territory, then it’s time to ask for a small favour that will barely register as relevant when compared with a huge sovereign bond purchase scheme: Delaying repayment of the IBRC’s ELA debts. While unimportant in the European scheme of things, it would give Enda Kenny a big political win if he could announce the cancellation of the €3.1 billion March 31 promissory note payment.

If you want to read more about this, here‘s a column I’ve written for Business and Finance.

Shares of Public Expenditure

The lead editorial in today’s Sunday Times (not on the web) states

Many in Fine Gael believe it is almost impossible to judiciously — and fairly — cut €2.2 billion from spending if 70% of the total, in the shape of public-sector pay, is protected from further reduction.

Now I know that the Irish government is pretty hopeless at presenting its fiscal accounts but it’s really not too hard to find out the true figures on the shares of expenditure taken up by pay and other elements.

Go to page 49 of this document which we have to send to Brussels on a regular basis and which uses the perfectly sensible approach of reporting all of the government’s spending and revenue, rather than specific sub-components picked out according to some unintelligible criteria. The shares of public expenditure for major categories this year are as follows:

Pay and pensions = 25.5%
Social payments = 37.8%
Intermediate consumption = 11.4%
Interest payments = 8.4%
Capital formation = 6.4%
Other (including subsidies) = 10.5%

So not 70%. Closer to one-third of that figure. And, as I’ve dicussed before, when income taxes paid by public sector workers are factored in, the net cost is significantly less.

I have stated repeatedly that I think further cuts in public sector pay rates are required. However, it is hard to see how any reasonable debate on this issue can be had when so many of our media outlets hopelessly misrepresent the basic facts at hand.

Central Bank Paper on Mortgage Arrears and Negative Equity

The Central Bank have been publishing data on mortgage arrears for some time now.  On Friday, the Bank released some very useful additional analysis in the form of a paper by Anne McGuinness (press release here.) The paper provides new information on the extent of negative equity and also on buy-to-let mortgages, which are not covered in the Bank’s usual quarterly arrears figures.

Daniel Gros on Italian Growth

If Italy is to be the Euro’s last stand, then a huge amount appears to be riding on hopes that “structural reforms” can get Italian growth going.  This paper from Daniel Gros provides reasons to be sceptical.

I think Daniel’s focus on the link between governance failures and growth is a bit speculative. Still, his conclusion that “it will be difficult to organise a sustained effort to combat corruption, foster adherence to the rule of law and improve the efficiency of the administration in general” might be too negative.

If the worsening of governance and control of corruption is associated with the rule of Berlusconi, then Daniel’s arguments would imply that his departure may have greater economic benefits than currently anticipated. Alternatively, a return to short-lived and unstable coalitions may just make things worse.

Anyway, it’s worth reminding our readers that economists don’t have a good track record at explaining differences across countries in long-run growth rates. Those claiming to have the recipe to produce a spurt in Italian growth while simultaneously imposing fiscal austerity are largely relying on guesswork.

Burning Ourselves?

On tonight’s edition of The Frontline on RTE, Gavin Blessing, Head of Bond Research at Collins Stewart made some comments about repayments of ELA liabilities by the IBRC (i.e. Anglo-INBS) that I’d like to elaborate on. Gavin pointed out that IBRC’s major liabilities are to the Central Bank of Ireland. Indeed, I estimate that IBRC now owes about €42 billion in ELA to the Central Bank.

Gavin then followed this up by saying that we would be “burning ourselves” if we cancelled these payments to the Central Bank. This is a complicated business and I fully understand Gavin Blessing expressing the situation in this way. However, I would like to emphasise that it is my understanding that there is no offsetting financial gain to the Irish state from the IBRC’s repayment of Emergency Liquidity Assistance to the Central Bank.

The details are below but I can summarise this issue as follows: Channelling taxpayer funds towards repayment of ELA is equivalent to burning public money.

Let me start by describing the information communicated by a central bank balance sheet, such as this one for the Central Bank of Ireland. Central banks could create money by following Milton Friedman’s analogy and dropping it from a helicopter. However, helicopter drops are neither efficient nor fair. So the long-standing tradition has been for central banks to issue money by acquiring assets via open market operations.

Central bank balance sheets thus show you the assets that a central bank has accumulated via its money issuance. At some point in time, somebody decided it was a good idea to place the money that was issued to acquire these assets on the “liability” side of this balance sheet. I’m not sure this was such a great idea as central bank balance sheets can cause a lot of confusion. Suffice to say, however, these liabilities are somewhat theoretical. If someone brings a banknote to the Central Bank, the only thing they can exchange it for is other banknotes that the cost the Bank almost nothing to print.

That over with, the accounting treatment for Central Bank’s issuance of ELA can be described as follows.

1. The Central Bank provided ELA by crediting, for example, Anglo’s reserve account that it holds with the Central Bank. This was just the Central Bank creating electronic money out of nowhere and this new money was counted as a liability on the Bank’s balance sheet.  In particular, this shows up in “Other Liabilities” on the CBI’s balance sheet.

2. On the other side of the balance sheet, the money that Anglo then owed back to the CBI as a result of the ELA is counted as an interest-bearing asset for the CBI.

Now consider the repayment of part of the ELA by the IBRC. For example, consider repayments funded by IBRC’s annual receipt of €3.1 billion in promissory note payments. One could imagine two possibilities for what happens next.

One possibility is that the following happens. A €3.1 billion repayment gets taken in by the CBI who can then, for example, buy German bonds with it and ultimately use the interest payments on these to pay money back the government when they make profits.  In this case, the amount of money created from the original operation doesn’t change and the Central Bank’s ELA asset gradually turns over time into other, more tangible, financial assets. It is likely that this is what Gavin Blessing thinks is happening.

The alternative possibility is less attractive. The Central Bank takes in the €3.1 billion repayment and then deducts this from the value of its ELA asset. On the liability side it reduces “other liabilities”—the idea is that taking in this €3.1 billion is effectively siphoning off part of the money that was created in the original ELA operation.  In this case, no new securities are purchased by the Bank. The €3.1 billion is effectively being burned.

The available evidence indicates that the latter, less attractive, mechanism is what occurs.

Earlier this year, the Irish government deposited a large amount of money in the Irish banks; this money was later converted from a deposit liability into equity when the banks were recapitalised. When the banks obtained these funds, they reduced their ELA debts to the Central Bank of Ireland.

A quick look at the Central Bank’s balance sheet shows that “other assets”  (which we know is mainly ELA) are down by €17 billion since February. Other liabilities are also down by €19 billion. There is no sign of any jump in the Central Bank’s holdings of other securities as a result of the ELA repayments. There is no hidden positive story at the end of the ELA rainbow.

So why repay it at all? Well, if we don’t repay this money, the Central Bank’s ELA operation will have been equivalent to flying a helicopter over the IBRC, dropping €40 billion and not asking for it back. A jolly good wheeze for the bondholders and depositors who got paid back but possibly not a good precedent for the Euro area. If every Euro area country could do that with their troubled banks, there would be no banking problems but there would probably be a decent amount of inflation.

So our European partners would consider failure to repay ELA to be bad form. But that still seems to leave the pace of repayment, and the funding of this repayment, as very much an open question. In the meantime, let’s not kid ourselves about hidden benefits from these payments.

Anglo Bond Note from DoF

The talking point about repayment of Anglo bonds not costing the taxpayer any money had received a sufficiently wide rollout that it was clear that this was something government politicians were being told was a good thing to say. Via Constantin, here is a note from the Department of Finance apparently distributed to government TDs.

The note tells the politicians that “It is important to state that the redemption of the bond will be made by the IBRC. It will not be funded by the Exchequer.”

Is it really important to state that? Why? So someone sitting at home might think that we’ve stumbled upon some money that eases the burden of paying the bonds, even though the US assets were being sold at a loss? So they might forget that the alternative to using the money to pay off the bonds is to return it to the exchequer?

Anglo has lost all of its equity capital multiple times over and has been continually recapitalised by the state. Money is fungible. All resources being used to pay off the bonds are state resources.

This talking point doesn’t work. Time to give it a rest. Please.

State Gains from “Error”

Fairly amazing story

The general Government debt is to be written down by 2.3 per cent, or €3.6 billion, following the detection of an accounting error.

The Department of Finance said the National Treasury Management Agency (NTMA) had notified it of a double count brought about a change in its relationship with the Housing Finance Authority.

Does this mean we can cancel the €3.6 billion budgetary adjustment? (Just kidding).  Now if only we could correct the “error” of supplying the IBRC with €31 billion in promissory notes, we’d be saved.

Greek Referendum

Papandreou says

“We have faith in our citizens, we believe in their judgment and therefore in their decision,” Mr Papandreou said after rejecting a call for early elections by some socialist politicians. “All the country’s political forces should support the [bail-out] agreement. The citizens will do the same once they are fully informed.”

Does he believe this? What are the implications for the euro?

EFSF Scales Back Irish Bond Issue

This is hardly confidence-inspiring news. EFSF is supposed to save the Eurozone and offer Ireland cheap and long-term funding. What if the markets decide not to play ball and decline to offer the facility sufficient funding at low rates or long maturities?

The eurozone rescue fund has scaled back a planned bond issue designed to finance the bail-out of Ireland amid uncertainty over the level of demand.

The offering will provide a key test of investor sentiment after the announcement last week of new plans to tackle the eurozone debt crisis.

The bond from the European Financial Stability Facility will only target €3bn, instead of €5bn, and will be in 10-year bonds rather than a 15-year maturity because of worries over demand. A 10-year bond is more likely to attract interest from Asian central banks than a longer maturity …

Already delayed from last week, EFSF officials decided to price this week because market conditions could deteriorate if they held off any longer.

The bond is expected to price at yields of about 3.30 per cent, and about 130 basis points over Germany, the European market benchmark. This is a big mark-up since the middle of September when existing 10-year EFSF bonds were trading around 2.60 per cent and only 70bp over Germany.

Not good.

Update: Eoin points us to an Oct 13 statement indicating they intended a €3 billion issue. Thanks Eoin. It appears the FT over-egged this one. They’re probably right about the delay, the reduced maturity and the higher yield

Anglo Bonds No Cost to Taxpayer Talking Point Gets Full Rollout

In advance of next week’s $1 billion Anglo bond repayment (congrats to all our international hedgie readers), the government talking point that repayment of this bond doesn’t cost the taxpayer a cent is now getting a full rollout, with Michael Noonan on RTE Radio’s News at One today and Leo Varadkar on Tonight with Vincent Browne both at it.

Both ministers were insistent that because the IBRC (i.e. the new Anglo-INBS institution) has sold loans worth €2.5 billion for a loss of €500 million, thus realising €2 billion, that paying the remaining €3.7 billion in unguaranteed senior bonds won’t cost the Irish taxpayer any money.

Let’s make this as simple as possible: Even if you wanted to view this repayment as costless because Anglo has its “own funds” to repay the bond, ask yourself who would be the beneficiary of these “own funds” if they weren’t used to repay unguaranteed bondholders. Every cent going to these bondholders is coming from Irish taxpayers.

Slightly less simplistically, Leo acknowledges that we are putting large amounts of money in the form of the promissory note payments (“the only money we’re putting in is the promissory note” — ah yes, “Other than that Mrs. Lincoln ….”). How did they arrive at the figure for the promissory note? The figure was arrived at by figuring how much money was required to keep Anglo solvent, i.e. paying back all its bonds debts. If we didn’t pay back the unguaranteed bondholders, then we could revise the promissory note payments down.

I know that the remaining unguaranteed bond debts are dwarfed by the approximately €40 billion Anglo owes in ELA but this talking point is irritating all the same. Honestly guys, please stop.

How Would a Greek-Style Haircut Affect Ireland?

Someone asked me today how a Greek-style haircut for private bondholders would impact on the Irish debt situation if applied here. Without any claim that this is a prediction for what could happen to Ireland, or a policy recommendation, here are the calculations.

While the figure grabbing the headlines is the 50%-60% haircut for private holders of Greek sovereign bonds, it appears that the bonds bought by the ECB will not be written down, nor will the IMF loans. FT Alphaville discuss a UBS report that calculates that a 50% haircut for private bondholders actually implies a 22% reduction in total debt.

In Ireland’s case, the latest EU Commission report estimates (page eight) that our year-end general government debt will be €172.5 billion or about 110 percent of GDP. The report also estimates that by the end of this year, we will owe €38.2 billion to the EU and IMF.  (Table 4 on page 23).

We don’t know how much Irish sovereign debt the ECB own but it’s believed to be a large amount. I do remember a report from Barclay’s claiming they owned €18 billion by June 2010. Let’s say ECB owns €22 billion of Irish debt (that’s just a guess, I really don’t know). Combine that with €38 billion from EU-IMF and you have €60 billion in debt that wouldn’t be getting a haircut. Better guesses of ECB holdings of Irish sovereign debt are welcome.

Now apply a 50% haircut to the remaining €92.5 billion of our debt and you reduce the debt by €46.25 billion, or 29 percent of GDP, getting the debt ratio down to 81 percent. (Of course, we’d still be running large deficits, so it would start increasing again.)

So that’s the answer. Perhaps worth noting, however, is that an alternative method of writing down Ireland’s debt by close to 30 percent of GDP without haircutting private bondholders at all would be to have Anglo’s ELA debt to the Central Bank of Ireland written off.

According to its interim report Anglo owed €28.1 billion in ELA at the end of 2010 but this had risen to €38.1 billion by the end of June. This is because Anglo transferred €12.2 billion in NAMA senior bonds to AIB in February to back the deposits that were being moved out of the bank.

On July 1, Anglo was merged with Irish Nationwide Building Society (INBS) to form what is now called the Irish Bank Resolution Corporation (IBRC). As of the end of 2010, INBS had €7.3 billion in loans from the ECB. However, €3.7 billion of this was backed by NAMA bonds and other assets that were transferred to Irish Life and Permanent. INBS has been in receipt of ELA since February to replace this lost funding. While this has been admitted by a Department of Finance official (see this story) the exact figure has not been released. I assume it is about €4 billion.

So my estimate is that the IBRC now owes about €42 billion in Emergency Liquidity Assistance to the Central Bank of Ireland. If the European authorities ever decide they like the idea of haircuts for Irish debt, it would be fair to ask which of a fifty percent haircut or a write-off of ELA would be more likely to damage Ireland’s reputation or cause financial market contagion.

Anglo Bonds: Not Coming From the Taxpayer

Via NAMA Wine Lake, I came across this very important statement from An Taoiseach on September 28 about repayment of Anglo bonds

If the Anglo bondholders are paid, they will be paid from their own resources. This will not come from the taxpayer. The Minister for Finance has been dealing with this situation at the ECOFIN meetings.

This is really good news. I had been under the impression for some time that all of the funds used to pay Anglo bondholders came from the taxpayer. But apparently that’s not the case. Phew, that’s a relief. Hats off to the Minister for his excellent work at those ECOFIN meetings.

Update: In case anyone thinks Enda’s on his own here with this idea of Anglo bondholder payouts not coming from the taxpayer, listen to Leo Varadkar on RTE’s This Week today (32 minutes and 25 seconds in). When asked about the looming payout to bondholders, Leo says

Well that’s not quite the case. What’s happening in relation to the Anglo bondholders is they’ll be paid from Anglo’s own resources, from the sale of its own property assets, for example. The only money that is being put into Anglo Irish by this government is the promissory notes, the €3 billion a year that we are required to give to Anglo, or what is now the IBRC, as a result of the deal made by Fianna Fail and the Greens, and we are trying to have that changed. That is our major objective at the moment.

I recommend strongly that the government retire this particular piece of spin immediately. Every cent that is given to bondholders is an additional cent that will have to be poured into Anglo by the Irish tax payer, whether as promissory note payments or some rejiggered version of these notes.

Ireland and Iceland: One Letter, Six Months, Three Years On

Reading Paul Krugman’s recent posts (here and here) reminded me that I forgot to write a post about my recent trip to Iceland. I presented at a very interesting conference on sovereign debt organised by Reykjavik University. Here is a link to slides and papers, which were presented on October 7 and 8.

My presentation was titled “One Letter and Six Months? Ireland and Iceland Three Years On”–the slides are here. One issue I discussed was whether Euro membership ultimately helped or hurt Ireland.

Much of the discussion surrounding Iceland in 2008 focused on the fact that they were outside the Eurozone and so could not obtain liquidity support from the ECB. While this was viewed as a negative factor, one could argue today that the (enforced) Icelandic approach avoided the mistakes associated with confusing a solvency crisis with a liquidity crisis. My conclusion: Without a clear policy on bank resolution, the Eurozone is not a good place to have a systemic banking crisis.

Income Tax Rates

I’d be interested to know the source of the figures cited in this article by Vincent Browne on income tax rates paid by higher earners. It certainly isn’t the last Revenue Commissioners statistical release on tax payments by income distribution, which relate to 2009. Anyway, it’s interesting to compare the figures reported in the article with the tax payments generated by plugging in the same salaries into this useful online tax calculator.

Kilkenomics 2011

I’ve agreed to participate in some sessions at this year’s Kilkenomics which will take place between Wednesday November 2 and Sunday November 6.  While obviously leaving myself open to (perhaps fair!) jokes about the differences between economists and comedians, I’m looking forward to it. I’d recommend people to take a look at the line-up. There are lots of interesting sessions on important issues and many excellent speakers, including Jeff Sachs from Columbia.

Irish Times: “Overseas Deposits Increase Significantly”. Really?

The lead story in today’s Irish Times carries the headline “Overseas deposits at Irish banks increase significantly”. Well, here’s a chart showing non-resident deposits for the three definitions of the Irish banking sector published by the Central Bank: All Banks, Domestic Group (which excludes IFSC banks) and Covered Banks.

How many of you can see the series increasing significantly at the last data point, in the usual sense of the word, meaning a large increase? It appears the headline reflects the following wording provided by Dan O’Brien (who would not have written the headline): The small but significant increase in deposits …” In other words, Dan is saying that overseas deposits didn’t rise significantly but the small uptick could potentially be a good sign for the future.

Beyond the headline (sub-editor screwups seem to be very common at newspapers) what’s odd about the story is that even though the latest data on overseas and resident deposits don’t show much more than a continuation of recent trends, the rest of the piece treats the release as though something interesting has happened, including the obligatory crowing from Minister Noonan:

The Central Bank statistics on deposits point to a stabilisation of the Irish financial system. Responding to the developments, Minister for Finance Michael Noonan said the “deposit figures illustrate growing national and international confidence in the Irish banking system. It is particularly impressive that the deposit position of the Irish banks has improved at a time of such global uncertainty.”

He described the cash inflows as an “an endorsement of the Government’s restructuring of the banking system. This restructuring has reduced the cost of the banks to the State and has also seen the banks beginning to access international money markets without the benefit of the State guarantee.”

For those interested in actually seeing what’s going on with deposits (yes I know the chart above is rubbish — I don’t know how other people get decent quality graphs up on this site!) here’s a Powerpoint presentation (also here in grimer PDF) with charts for total deposits, non-resident deposits, resident deposits, and private sector resident deposits. In addition to the Total/Domestic/Covered breakdown, I’ve provided charts for an IFSC/Domestic Non-Covered/Covered breakdown.

I surmise from these charts that the non-resident withdrawals have largely tailed off and that the trend for resident deposits in the covered banks remains a downward one.

ECB and State-Owned Banks, Again

There are a lot of reasons why attention has turned to the idea of leveraging EFSF via one of a number of possible methods. If this can be done, it takes a big step towards solving both the solvency and liquidity issues plaguing Euro area sovereigns and banks – on the liquidity front, a €2 trillion or €3 trillion fund is big enough to buy up Spanish and Italian bonds for a number of years, while €440 billion is big enough to absorb a lot of the potential losses.

The financial press are abuzz with various mechanisms that could be used to leverage up the EFSF. However, I was surprised today to twice read that Gros and Meyer’s proposal to have EFSF (or some vehicle funded by EFSF) register as a credit institution and borrow from ECB is likely to be illegal.

The Wall Street Journal reports

Klaus Regling, chief executive of the European Financial Stability Facility, told a podium discussion that “there are serious concerns” that such a scheme wouldn’t be allowed under the EU Treaty, which forbids the ECB from financing governments directly.

And at the FT’s Money Supply blog, Ralph Atkins writes

But Jens Weidmann, Germany’s Bundesbank president and ECB governing council member, has already made clear his opposition. Giving the EFSF access to ECB funding, Mr Weidmann argues, would be “monetary financing” – central bank funding of governments – which is banned under European Union treaties …

More crucially, an ECB legal opinion issued in March made clear that the European Stability Mechanism – a permanent fund expected to replace the temporary EFSF from 2013 – would not be allowed access to its liquidity because of the ban on monetary financing. “The ECB recalls that the monetary financing prohibition…is one of the basic pillars of the legal architecture of economic and monetary union,” its lawyers wrote then. I am not a lawyer, but to me that would also rule out giving the EFSF access.

The ECB legal opinion states

Article 123 TFEU would not allow the ESM to become a counterparty of the Eurosystem under Article 18 of the Statute of the ESCB. On this latter element, the ECB recalls that the monetary financing prohibition in Article 123 TFEU is one of the basic pillars of the legal architecture of EMU

Of course, we in Ireland have been here before. Back in 2009, a number of very serious people assured us that nationalising any banks would be inadvisable because the ECB was prohibited under the monetary financing clause from lending to nationalised banks. (That Anglo were at the time borrowing in a big way from the ECB didn’t seem to get in the way of what seemed like a great argument).

As I pointed out back then on a few occasions (e.g. here and here) this wasn’t true because while Article 123 of the current consolidated Treaty on the Functioning of the European Union states

1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

This is immediately followed by

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.

So while the ECB may recall the monetary financing prohibition, you could argue that they don’t recall it very well.  One could quibble that EFSF is not currently not a “publicly owned credit institution” but it’s hardly high octane financial engineering to create a vehicle funded by EFSF that counts as such.

Dan O’Brien on Burning Bondholders

Dan argues the ECB case for not burning Anglo bondholders in today’s Irish Times. I’ll quote the main argument at length

Apart from Ireland, nobody else in the euro zone has sought to make seniors take their losses so there are no cases to which one can point as evidence. But an immediate neighbour’s experience has been watched very closely. Denmark last year introduced the toughest bank resolution laws in Europe. These laws, which govern the winding-down of bust banks, are more similar to those in the United States than those across the rest of Europe. In the US, senior bank bondholders have traditionally got their just desserts if the institutions they invest in fail.

When two Danish banks failed earlier this year, their seniors were burned. This raised funding costs for the entire Danish banking system.

From the euro zone perspective, the ECB is obliged to consider that if a default precedent were to be set in the senior bond market, then at the very least funding costs for all banks in the zone would rise. The savings for Ireland of a few billion euro would be offset many times over by the generalised increase in funding costs for the already-teetering euro zone banking system.

That there is good reason – in the collective European interest – not to burn seniors does not lessen the injustice of having Irish citizens pay for European bankers’ losses (although the hugely subsidised bailout loan is a partial de facto spreading of the burden).

The point that burning senior bondholders may raise the cost of funding for banks is a fair one. But the relatively lower cost of bank funding obtained from a policy of supporting all senior bondholders is hardly a free lunch. The additional risk that the market would perceive as being attached to bank bondholders would have been transferred away from sovereigns.

Now one could argue that some sovereigns in the Euro area are in a position to take on this kind of risk in order to protect their banking systems. But others clearly are not.

My position on this is that there is no need for the question of burning senior bondholders to be a simple black or white proposition. As I discussed in this paper, the EU could adopt a policy that sees senior bondholders only incur haircuts if equity and subordinated bonds have been wiped out, the bank has been nationalised, and the state has incurred costs of x% of GDP to bring the bank back to solvency.

What x is could be a matter for policy discussions, and could evolve over time. But a policy that set x=5% would mean that the EU is only ruling out bailouts that would place enormous burdens on the state. Indeed, given the state of Euro area public finances, there simply isn’t room for another round of expensive bank bailouts so an approach of this sort may help to reduce the perceived riskiness of much of Europe’s sovereign debt.

This policy could see the remaining Anglo senior bondholders receive severe haircuts without implying a contagion effect for other institutions apart from those the market suspect to be severely insolvent and to which states should probably be reluctant to offer blanket liability guarantees.

But, of course, such a policy would tradeoff state and private sector interests in a balanced way and, as I argue in this paper, M. Trichet’s approach to the question of debt defaults has consistently been characterised by dogma rather than balance.