Goldman And Citi Analyze ECB Bond Purchases And The State Of The Debt Crisis

by: Colin Lokey

Over the course of several articles I have outlined the problems that plague all variants of the ECB bond buying initiative. First, I have noted that in order to stay within its mandate the ECB must ensure that its purchases are made in the secondary market and must only purchase short-end debt. In practice, this may be difficult to implement. In order to be truly effective, the purchases should come from the domestic banks of the sovereigns seeking aid. This way, the ECB can maximize the chances that the proceeds from the purchases will be reinvested in debt issued by the receiving banks' sovereigns. However, it is quite possible that most of the short-term debt government debt held by these periphery banks has already been pledged to the ECB in liquidity operations.

Second I have explained that it would be quite difficult for the ECB to set so-called "target ranges" for periphery spreads as the very act of setting those ranges effectively communicates to the market how risky the ECB considers each country to be. Additionally, such targets would need to be reset to reflect changing economic conditions and this too would communicate to markets when the ECB perceived risks to be rising.

Finally, I explained that conditional EFSF/ESM primary market purchases will never be able to guarantee that the beneficiaries live-up to the signed Memorandums (MOUs) because generally, economic conditions are deteriorating rapidly in the periphery.

Of course this is just my take, informed partly by many other like-minded individuals and groups, who are cited in the above mentioned articles. It is certainly worth evaluating the assessments of others in order to develop a more well-rounded understanding of how the ECB's actions are likely to play out, and if it is even possible to turn the situation around at all. To this end, here is a discussion of Goldman's (NYSE:GS) commentary on the matter and, following that, a look at Citi's (NYSE:C) take on the state of the crisis.

First, Goldman Sachs believes that the ECB will indeed announce some new bond buying plan in September, but notes that, as I have indicated above, "the operational specifics are controversial." Goldman expects that the central bank will avoid setting any "hard" (i.e. not a range) caps on spreads owing to the limitations such caps would put on 'flexibility' (i.e. the ECB wouldn't have the flexibility to opt out of limitless balance sheet expansion).

Goldman goes on to list three objectives of central bank government bond purchases: 1) easing private financial conditions by purchasing longer-dated assets, thereby driving prices on those assets up and average portfolio durations down, which subsequently encourages investors to rebalance their portfolios by purchasing more longer-dated assets, 2) directly funding governments by purchasing assets in the primary market, an option which is prohibited in Europe, though Goldman notes that the act of buying similar debt in the secondary market is "functionally equivalent", and 3) reactivating private markets that are not functioning correctly by restoring spreads to levels commensurate with the solvency of the sovereign. Goldman argues that the ECB has justified its purchases by reference to number three. I would argue that the market is a far better judge of what spreads should be given that the central bank faces an inherent conflict of interest in judging the 'correct' level for yields.

In any case, Goldman notes that the two headed approach to the problem wherein the rescue funds make purchases in the primary market while the ECB acts in the secondary market

"provides capacity for the necessary volume of purchases, while maintaining the conditionality that was absent from the ECB's previous securities markets programme."

However, Goldman also notes that the program comes with inherent risks, not the least of which is the fact that the ECB is not a political body and as such it "lacks...legitimacy". More importantly perhaps, is Goldman's warning that these purchases may discourage governments from implementing the necessary reforms to ensure these problems do not arise again in the future. This echoes the sentiments of Belgian bank governor Luc Coene who noted that market pressure is a way for investors to convey to governments that changes need to be made to restore confidence.

Citi's analysis of the current state of the eurozone debt crisis is notable because essentially, the idea is that it is a self-perpetuating quagmire the solvability of which is highly questionable. First, Citi notes that the region is caught in a "vicious triangle" wherein nonperforming loans rise resulting in calls by regulators for greater capital buffers and more liquidity. This in turn leads to a reduced appetite for risky assets triggering a fall in corporate investment, household spending, and demand in general. This leads to rising unemployment, falling home prices, and decreased profitability which causes more loans to become nonperforming, and the cycle starts anew.

Citi goes on to note that the deleveraging in Europe really has not gotten off the ground yet and debt has simply been shifted from "one pocket to another" as falling household debt has been replaced by soaring government and financial sector debt. One can certainly place some of the blame for the delayed deleveraging on the LTROs, the funds from which, if the collapse of the money multiplier in Europe is any indication, remain idle in bank vaults.

Perhaps most interesting of all, is Citi's contention that regarding Spanish and Italian debt, required premiums are now greater than sustainable premiums. Citi does the math and concludes that a risk averse investor requires 800 basis points of premium to compensate for the risk on a 5-year periphery bond. Clearly, the periphery cannot pay 800 basis points to borrow for 5 years. Ultimately, Citi comes to the disturbing conclusion that the "losses are not quantifiable."

There is a consensus building that ultimately, it will be quite difficult to salvage the euro in its current format. In the mean time, the market continues to trade as though there is no question about the survival of the currency bloc. There is a rather obvious disconnect here. As I have said many times before, it is quite prudent to hedge against a systemic shock from Europe. There are a variety of simple ways to do so ranging from indirect plays in the U.S. markets such as long puts or short positions on broad indices (SPY, QQQ, etc) or alternatively long positions in volatility. Of course investors can also bet against European indices directly (FEZ, EWI, EWP, EWG) or the euro itself (NYSEARCA:FXE).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.