An ECB Gold Grab

Bankers are waking up to the fact that gold – being no one else's liability – is a highly desirable form of collateral...

WHAT AN awful mess the European Central Bank is in, says Dan Denning in his Daily Reckoning Australia.

The short version of the story is that Europe's central bank has become the repository of huge piles of garbage securities posted as collateral in exchange for ECB loans. Those loans — to Irish, Portuguese, Spanish, and Greek banks — are secured by assets that may be significantly overvalued. 

The result is that the ECB itself — the institution responsible for bailing out Europe's banks — could face big losses if it were forced to write down the value of its credits.

Say...does anyone know how you recapitalize a central bank?

The ECB is now trapped. If the banks it's been funding with emergency loans fail, its own assets get destroyed too. 

"The ECB can then learn the basic economic truth that if you lend €160 billion to insolvent banks backed by an insolvent state, you are no longer a creditor: you are the owner," says University College Dublin economics Professor Morgan Kelly.

This little vignette — which is not so little really when you consider that it could mean the shambolic decline of the Euro as a reserve currency — is another reminder that the world's financial system is still buried under a pile of bad debts from the great credit boom. 

That pile has been written down some since 2007. But what Europe shows is that the pile has simply been shoved from smaller intuitions (national banks) to larger ones (the ECB and the Fed).

Write downs in the value of the pile — the collapse of the collateral — still threatens the stability of the financial system. If you make that claim in polite conversation, people may look at you like you have a third eye. But the willing suspension of disbelief of most investors doesn't make the claim less true: many firms and some nation states are headed for insolvency.

It's not like the ECB is stupid, though. You're beginning to see a finely tailored grab for Europe's gold take place. Yesterday, the European Parliament's Committee on Economic and Monetary Affairs said it would allow counterparties in Europe to accept gold as collateral to meet margin liabilities. Hmm.

This sounds like an indirect way of saying that if a country like Greece — once it has sold all its assets to cashed-up bidders at fire sale prices — wants more loans from private banks or the ECB, it'll have to pledge their national reserves of gold as collateral. 

This tells you that once all the financial wealth of a country has been stripped bare, the bankers still recognize that gold — being no one else's liability — is a highly desirable and liquid form of collateral.

At least the ECB has learned its lesson. It has reportedly purchased some €47 billion in Greek government bonds to help Greece work its way out of its debt problem. But exactly what kind of asset is government debt? And what kind of collateral is it for further loans?

Lousy, on both counts. 

Most government bonds are backed by exactly one qualitative kind of collateral: faith. US bonds, as you know, are backed by the "full faith and credit" of the US government. It's always amusing to remember that credit is derived from the Latin "credere," to believe.

If you're thinking that Greece is not any different from the United States, you're mostly right. The main difference between the two is size. Greece is a country of 11 million people with a GDP of around US$300 billion. The US is a country of over 300 million people with a GDP of over $14 trillion.

Don't think the financial markets aren't already busy figuring out how bad it could get in the US The Financial Times reports that:

Traders and investors have stepped up purchases of insurance against a US sovereign debt default, amid heated political wrangling over raising the US debt ceiling... One-year US credit default swap (CDS) spreads have recently jumped on the back of a handful of trades. On May 20, the cost of protection for US sovereign credit jumped 22 basis points to 50bp. That was seen by traders as reflecting the need to cover the risk of Congress failing to pass the debt ceiling by August.

The world owns a lot more US debt obligations than Greek ones. The rumblings in US debt markets are enough to shake the whole world's financial system...again. 

But don't count out the significance of Greece as a predictor of things to come. Social unrest, repudiation of debts, violence, withdraw from the Euro...all of these possibilities will have far reaching effects on the global credit markets. 

They're going to make it a lot more expensive to borrow money.

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