Repos are at the heart of the European distress

As financial markets convulse over the European Union once again, RepoWatch would like to remind its readers that at the heart of the problem lies the repurchase market.

Yes, some European countries spent too much money and now are burdened with too much debt. So let’s look at where they got that money.

They got it in part by selling bonds to banks, which then used the bonds as collateral to get cheap repo loans and other short-term debt for themselves. Then they used this new money to pay for the bonds and to make more loans, including on U.S. real estate. 

This finance chain fueled prosperity in Europe for a decade, ever since the European Monetary Union was founded in 1999 with repos as a fundamental instrument of monetary policy. 

It was easy for governments to borrow and easy for banks to build up substantial short-term debt – all on the assumption that the European Central Bank and the European Union would never let a country fail because the impact on banks and the financial markets would be catastrophic. 

Now many lenders are jittery, threatening to flee or already gone. Sovereign debt values are falling. Banks are choking, and some are relying on central banks for survival.  Financial armageddon looms ….

There’s something drearily familiar about all this. Homeowners in the U.S. and other countries borrowed too much money because they could, thanks to securitization and repos. American college students borrowed too much money because they could. European governments borrowed too much money because they could. Giant banks borrowed too much money because they could. And then one day they couldn’t. 

Economists Peter Boone and Simon Johnson explained the flaw in the European market in “Europe on the Brink,” in July 2011 and updated their thinking May 28, 2012, with “The End of the Euro: A Survivor’s Guide.” 

From “Europe on the Brink”:

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.

Read RepoWatch’s August 15, 2011, review of the Boone/Johnson report and comments from others here.

Boone is a visiting senior fellow at the London School of Economics and a former investment banker. Johnson is a professor of entrepreneurship at MIT’s Sloan School of Management and a former IMF economist. Both are senior fellows at the Peterson Institute for International Economics.


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