Otmar Issing, former ECB chief economist and former Bundesbank member, suggested today that weak European banks need to "disappear" and opined that the eurozone in its current form does not necessarily need to be saved. Issing noted that there are too many member nations (something which perhaps should trigger a bit of introspection or self-loathing considering Mr. Issing helped draw-up the euro in the first place), an untenable situation that has essentially allowed fiscally irresponsible members to spend as they please and "pile up debt" without fear of reprisal:
We should have started with a smaller number, no doubt about that, with stricter rules...and the idea that we should have a policy that no country ever should leave is something which is an invitation to blackmail.
Blackmail indeed. Essentially Issing believes that while the breakup of the EMU would be a "disaster," allowing weak countries to jeopardize the ECB's own reputation and financial stability by holding the less-than-desirable prospect of a so-called "messy exit" over the central bank's head is becoming equally dangerous.
While Mr. Issing is no doubt confined to exercising some minimal level of political correctness in voicing his opinions, what he and many others would like to say is that the if the ECB continues down its current path it will run the risk of becoming insolvent. The bank's recent move to more than double the amount of Greek T-bills the Bank of Greece is allowed to accept as collateral is sheer lunacy as it permits the Greek Treasury to fund the Greek government by essentially printing euros all in an effort to keep Greece from defaulting on a bond sitting on the ECB's book.
Furthermore, the central bank's continual relaxation of collateral requirements has led to a situation wherein even mortgage-backed securities and car loans are acceptable. When the ECB announced its new collateral rules on June 22 it noted that residential mortgage-backed securities, loans to small and medium sized businesses, and auto and consumer finance loans would be subject to haircuts of 16%, 26% and 32% respectively. This was the only protection the bank had against the credit risk posed by the newly acceptable "assets." Friday, the Financial Times suggested that one option on the table for alleviating funding pressure throughout the EMU is for the ECB to either reduce those haircuts or eliminate them altogether. This would mean lending on a dollar for dollar basis to banks, which post credit card and auto loans.
Perhaps most worrisome of all however is the precedent set by the ECB when it refused to take comparable writedowns to those taken by private creditors during the Greek PSI. This clearly indicates that the central bank has no intention of taking a conservative approach and aggressively writing down the periphery debt on its books. A quarter of the ECB's rapidly expanding balance sheet is comprised of periphery debt. If there are more Greek-style bond swaps, the ECB must participate on equal footing with the private sector or risk perpetuating the unrealistic and untenable situation whereby the central bank continues to carry debt at par that is unquestionably not worth that much. As David Einhorn's half-decade long fight with Allied Capital (painstakingly detailed in "Fooling Some of the People All of the Time") reminds us, one cannot simply carry billions of dollars worth of debt at par simply because writing it down is undesirable and inconvenient.
Put simply, the ECB and the EMU are on disastrously shaky ground. The whole enterprise that is the euro single currency experiment looks more and more like a house of cards every day. I believe that for the reasons cited above the euro will eventually reach parity with the dollar and may sink even lower than that as investors gradually realize that the ECB's position has become unsustainable. For that reason, I recommend betting against the euro. Furthermore, the recent double-digit rallies in European equities have no basis in reality that I can detect and as such I believe that eventually, a final day of reckoning (whenever it comes) will take European stocks to multi-year lows. Current levels for both European equities and the EURUSD pair provide excellent entry points for bets against the sustainability of the eurozone in its current form. Position accordingly before reality sets in.