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Economists: Repos underlie financial crisis in Europe

The financial crisis in Europe grows out of banks’ excessive use of repos and their assumption that government officials will not let the repurchase market fail, according to a July 2011 report by two economists.

In “Europe on the Brink,” economists Peter Boone and Simon Johnson say the European Central Bank’s willingness to make repurchase loans to banks, with sovereign debt as collateral, allowed too much borrowing by governments and banks. 

Now that governments are threatening to default, it’s not clear whether Europeans are willing or able to bail out the governments and banks – as the U.S. did in 2007-2008 – to prevent the collapse of the repurchase market. That uncertainty is destabilizing financial markets in Europe. 

From Boone and Johnson, who are senior fellows at the the Peterson Institute for International Economics:

The euro crisis is not under control. Deep structural flaws have become apparent. …

“Europe on the Brink” focuses on the moral hazard created by a repurchase market that is so big and so interconnected that parties are convinced it will not be allowed to fail. As a result, they feel free to engage in risky borrowing and lending.

RepoWatch made a similar point about moral hazard August 10, noting that in recent crises – including the financial crisis of 2007-2008, the Greek debt crisis, and the U.S. debt ceiling talks – governments worked hard to protect the value of collateral and prevent a repo meltdown, seeming to confirm that the repurchase market has become too big to fail.

But Boone and Johnson believe it’s likely that officials will ultimately have to let some European governments default on their debt, and that will expose banks and the European repurchase market to huge losses.

At this stage in the debate, we see little chance that Europe can avoid ending the “moral hazard” regime, in which case it needs to plan for widespread sovereign and bank debt restructurings.

The instability is not likely to cause a serious contraction of credit in the United States, according to the authors, who write:

We doubt the problems in Europe would generate Lehman–style trouble for the United States and Japan.

Europe has come to this pass largely because the European Central Bank and banking regulators made the repurchase market very profitable for banks, write Boone and Johnson. For example, banks could buy sovereign debt paying maybe 4 percent, turn around and use those bonds as collateral for a repo loan from the European Central Bank costing 1.5 percent, and pocket the difference.

Meanwhile, the banks also still owned the bonds, and collected the interest on them, which made the banks look financially strong to outsiders, who could then be enticed to lend even more money to the banks. 

The success of this business plan depended on the stable value of the sovereign debt. But if governments are allowed to default, the value of the debt, the value of the bonds, will fall. From Boone and Johnson:

The vast majority of sovereign bonds held by banks and insurance companies are marked on the books at purchase price rather than current market value. If the European Union embarks on programs to  restructure these bonds, the potential capital losses for the EU financial system are very large.

The paper by Boone and Johnson has been getting attention. Economist Arnold Kling, a member of the Financial Markets Working Group at the Mercatus Center at George Mason University near Washington, D.C., said August 5 it is “the best analysis of the Eurozone crisis.” Financial Times editor Gillian Tett wrote August 4:

As a brilliant paper from the Peterson Institute points out, the structure of the eurozone system has encouraged its financial institutions to become heavily reliant on short-term funding; the 90 banks covered by the recent European Banking Authority stress tests, for example, need to refinance €5,400bn of debt in the next two years, equivalent to 45 per cent of European Union gross domestic product. Until recently, it was easy to roll over these funds because of the implicit moral hazard in the eurozone (it was assumed nobody would default) – now this assumption has cracked. There is thus a rising risk of an accelerating capital flight. Short-term funding could yet dry up, as it did for dollar-structured investment vehicles in 2007, and Bear Stearns and Lehman Brothers in 2008.

Here’s how Boone and Johnson explain the development of repo problems in Europe:

Key rules regarding money creation in the euro area explain the current dangerous situation.

Since its founding, the European Central Bank has used repurchase operations as a major tool of monetary policy. In practice, this means that the 7,856 banks (monetary financial institutions at the end of 2010) in the euro area are able to buy sovereign debt of any euro area member nation and then present these to national central banks, which act on behalf of the ECB, as collateral for new finance. The ECB set collateral rules that made short–term paper more attractive than long–term paper (Buiter and Sibert 2005, 7-14).

Initially the Bank also treated all nations equally, regardless of credit ratings. Later it adjusted collateral requirements for nations to reflect their credit ratings, although these adjustments were minor.

As a result of this system, it became very profitable for banks to buy short–term government paper and deposit that paper with the ECB in return for loans. The margin between the returns on the government paper and ECB lending rates became profit for the commercial banks.

This system generated three major developments that have contributed to the build–up of risk.

First, the ECB repo system made government bonds highly liquid, because a buyer could always turn to the Bank for funds. This increased market access for smaller European nations that would otherwise have had difficulty issuing a great deal of debt.

Second, while the ECB did not promote this explicitly, investors grew confident, with good reason, that the Bank and the European Union would never let a sovereign fail. There were good reasons to believe this. All major European banks built up substantial portfolios of short–term sovereign debt and sovereigns, in turn, issued more of this debt. It became very clear that sovereign defaults could be catastrophic for the banking system, and so would be very unlikely to occur.

Finally, the system became even more dangerous as many banks went on a credit expansion spree. European banks issued short–term bonds in order to finance additional long–term loans. This was possible because the balance sheets of banks were filled with assets that could be used as collateral at the ECB. Investors concluded that banks would not have liquidity problems given their ECB access, and they assumed that if solvency issues arose, governments or shareholders would be prepared to inject capital to prevent defaults.

Peter Boone is a visiting senior fellow at the London School of Economics, and Simon Johnson is a professor of entrepreneurship at MIT’s Sloan School of Management.

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