ECB Insolvency, Negative Equity, Writedowns, And A Falling Euro

Aug.13.12 | About: CurrencyShares Euro (FXE)

Last week, I published an article entitled "Why The ECB Is Racing Towards Insolvency". Up front, it should be noted that the issue of the ECB's solvency is absolutely nothing new. It has been debated for well over three years. Moving on, one of the reasons for concern about the condition of the ECB's balance sheet cited in my article was that the central bank carries assets on its books at par that are clearly not worth that.

Some commentators apologize for this by arguing that it doesn't matter whether these assets are written down or not because even if they were and the write-downs were to plunge the ECB's balance sheet into a negative equity position, it could still operate--it is a central bank after all.

If the whole notion of solvency doesn't apply (of course it does apply, the whole debate is semantics because central banks unquestionably can be in a position of accounting insolvency) why then, has the ECB been so reluctant to carry assets at realistic prices? As the Financial Times notes,

"...the central bank has avoided crystallising losses, preferring to play for time, in an effort to paper amortise the pain (or hope it goes away.)"

The reason is that the credibility of a technically (by accounting standards) insolvent central bank would be severely impaired and credibility is a big issue when you're talking about confidence-based systems backed by fiat currency.

The issue is particularly acute in relation to the ECB as its credibility is already under attack thanks to its inability to arrest the eurozone debt crisis. In my view, one of the biggest blows to the ECB's image is the fact that its monetary policy transmission channel is broken and it has allowed sovereign spreads to take precedence over the official rate in terms of dictating retail rates in the periphery. On top of this, even Karl Whelan (who has argued that the idea of an insolvent central bank doesn't matter) has noted that it is unlikely that a negative equity position would legally be allowed to persist in the EMU. As he pointed out on

"The actual rules relating to central bank balance seem a bit murky but it is generally understood that any element of the Eurosystem that had negative capital would need to be recapitalized by governments providing them with assets."

The political backlash associated with such a recapitalization would likely be quite severe.

Indeed the issue of carrying assets at par may take center stage in the very near future and thus this issue is particularly relevant. Increasingly, there is a call for Greece's obligations to be reduced as the country looks likely to fall short of targets set by the Troika. According to BNP Paribas, around 70% of Greece's public debt is held by the official sector (the PSI transferred a massive amount of Greece's debt and the risk associated with that debt, from the private to the public sector) thus any relief will have to come from either eurozone member governments, the EFSF, or the ECB. As BNP notes,

"It would be politically difficult to impose a haircut on bilateral and EFSF loans...[but] a potential haircut on the ECB holdings, together with the ECB foregoing the interest it receives on old GGB holdings, could be an option."

Of course by haircut, the bank effectively means 'write down'. This has been suggested before by Credit Suisse and indeed the ECB itself has referenced the possibility.

The problem with this is that it is an impossibly slippery slope. Once the ECB writes-down its Greek holdings it could only avoid writing down its other impaired positions by either denying that they are in fact impaired or by claiming that haircuts taken on Greek obligations were a one-off emergency measure taken to avoid a default by Athens. Regardless, it seems inevitable that the ECB will be forced to write down its assets eventually and subsequently risk operating with negative equity. This would likely cause irreparable damage to the bank's already fragile image.

Additionally, it is certainly worth mentioning (and this is admittedly a highly debatable subject) that in the event of an EMU breakup, TARGET2 (im)balances represent potential foreign currency denominated liabilities, an item which could bankrupt the ECB both from a technical and a real-world perspective.

For the reasons cited above, I believe it is inevitable that the ECB will be forced to operate with negative equity at some point and this position will damage the credibility of both the central bank and the currency it prints. Based on this analysis, I stand by my original stance that the ECB faces insolvency (albeit of a technical, accounting-based nature) and accordingly, I recommend betting against the euro (NYSEARCA:FXE).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.