On several occasions, I have noted that the ECB's solvency is at stake. Some would have it that this is an absurd proposition since the central bank can print money. As I attempted to show, this assumes that the market's confidence in this supposedly immutable institution is forever unwavering and will not be shaken in the event it is forced to operate from a negative equity position. These concerns were recently echoed by "Out of the Box" author Mark Grant.
In a short piece entitled "There Must Be Someway Out Of Here", Grant notes that Spain, Italy, Portugal, and Greece have implemented a backdoor transfer system via their banks and the ECB wherein the cost of financing their governments is borne by their neighbors. Essentially, governments agree to provide a sovereign guarantee to newly issued bank bonds which are then pledged to the ECB for cash. The banks take the cash and funnel it back to their governments. This operation is profoundly simple for something so incriminating. If there is a way to spin this so it does not sound like the printing of unsterilized euros I am not aware of it.
Grant notes that because of the way this system operates, nations have given up their sovereignty to the ECB and the troika as they depend for their day to day survival on newly minted euros secured via one circular funding scheme or another. In the end however, many of these euros are backed by dodgy collateral and should a nation default, collateral guaranteed by the sovereign will have to be written down or written off regardless of the central bank's ability to circumvent mark to market. As Grant notes,
"There are a number of circumstances that can destroy a Central Bank, any Central Bank, and the first would be the loss of confidence in the institution...the second would be actual losses on their balance sheet and while no Central Bank must adhere to marks-to-market; real losses in their portfolio cannot be brushed under the rug forever."
This is precisely what I have been saying for quite some time now. You can refuse to mark your book to market but when the sovereign backing the assets goes bust or very nearly goes bust, you can only avoid marking down assets by flatly refusing to face reality.
As for the impact of such an event on the ECB, Grant notes that the central bank's paid-in capital stood at just under 14 billion euros at the end of 2011. This means the bank is leveraged at near 300 to 1 on its paid-in capital and quite a bit of its assets are of poor and still deteriorating quality. This state of affairs is untenable as a capital base of 14 billion euros is laughable considering the bank's 4 trillion euro balance sheet. This makes recapitalization a virtual guarantee in the event of a sovereign default. But recapitalization can only come if approved by euro system governments and that is where, in the final analysis, the 'buck' will stop, so to speak.
Once Germany is asked to contribute to a recapitalization of the central bank, the political process will surely highlight, for all German citizens to see, the fact that German taxpayers have already funded the periphery's imports to the tune of 750 billion euros (incidentally, the Bundesbank just released its latest TARGET2 data, and the balance hit a new record of 751.49 billion euros) via the euro system's payment transfer system. Asking them to foot nearly a quarter of the bill for a recapitalization occasioned by the collapse of a country whom they have been secretly funding via TARGET2 for years will be too much to stomach. Invariably, the ECB will lose the market's confidence and the euro will fall precipitously. Investors should play for a steady decline in the common currency (FXE).