On July 20, the ECB announced it would no longer accept Greek sovereign debt as collateral. Left without any viable alternatives and facing a looming 3.2 billion euro payment due Aug. 20 on a bond held by the ECB, Greece subsequently requested that the amount of short-term bills the Bank of Greece was allowed to accept as collateral in exchange for euros be raised. The ECB granted the request. The new arrangement allows Greece to print T-bills and then sell them to its own banks who then pledge them to the Bank of Greece as collateral for euros. In this way, Greece has already printed 5 billion euros into existence.
As disturbing as this is, the truly worrisome question is whether other (and bigger) struggling countries will resort to the same financial chicanery should cash and collateral run dangerously short. According to Reuters, the answer appears to be "yes." Spain's banks borrowed a record 38 billion euros from the ECB in July, bringing the total borrowed to 402 billion. Consider that, according to the Wall Street Journal, Spain accounts for 33% of all eurozone ECB borrowing, while the country's economy only makes up 12% of eurozone GDP. What is more disconcerting than that, however, is that according to the above-cited Rueters article:
...the section of the Spanish central bank's balance sheet that usually denotes so-called 'emergency liquidity assistance,' where losses are borne by Spain itself...[rose] from a lowly 2 million euros in June... to 402 million euros [in July].(emphasis mine)
What's happening, then, is that apparently Spain's banks have run out of ECB eligible collateral and have resorted to ELA funding wherein the Bank of Spain sets the collateral requirements rather than the ECB. This can prove to be a valuable lifeline, but it should be noted that the quality of the "assets" being pledged as collateral is likely to be quite poor. After all, the ECB has already relaxed its collateral rules substantially, so if the assets being pledged to the Bank of Spain for ELA assistance aren't even good enough to meet the ECB's relaxed requirements, one wonders if the Bank of Spain is in fact accepting IOUs that it has very little chance of ever collecting on.
If this turns out to be the case (and it probably will be the case, considering that the percentage of nonperforming loans (NPL) to total loans in Spain continues to climb), the pledged assets will end up being written off by the Bank of Spain, but the euros issued in exchange for that soured collateral cannot be pulled from the system, a point also raised by Pater Tenebrarum:
...what the Bank of Spain does when it extends ELA funding is that it prints euros and not pesetas. Therefore [the] risk [is] borne by all users of the euro, as a future write-off of the assets the BoS gets in return for extending these funds could potentially leave the newly printed money stranded in the economy.
This could be just the beginning. Investors should understand that if Spain gets shut out of the long-term bond market like Portugal and Greece, it will be reduced to the issuance of T-bills to fund itself. Combine this with the fact that the 100 billion euro bailout for the country's banks looks less and less sufficient with each report on NPLs, and Spain could quickly find itself in Greece's shoes -- that is, selling T-bills to its own banks so it can pledge them to the Bank of Spain for funds.
Investors must understand the potentially disastrous situation that is currently in the making: If the ECB decides to buy a massive amount of Spanish bonds to keep the country afloat and then the country losses access to the long-term debt market anyway, the ECB cannot give back those bonds. It will be saddled with them and forced to allow Spain to print its own euros (a la Greece) to pay the bonds. This is inflationary to the extreme, not to mention the fact that it imperils the ECB's balance sheet at just the time when the central bank can ill afford to print its way out of trouble.
The evidence continues to mount in favor of the prediction that sooner or later, this situation will implode. As the evidence piles up, so do the reasons for investors to consider allocating at least a portion of their portfolios to assets and securities that will appreciate in the event of a systemic collapse, such as short positions in broad market indices (SPY and QQQ), long puts on instruments tied to those indices, long positions in volatility proxies, and long positions in gold (GLD).