FT Alphaville " Buiter on good news, bad news Citi's Willem Buiter has gone all good idea/bad idea on us. = the introduction of the ECB's Outright Monetary Transactions (OMT) facility, the decision of the German Constitutional Court to allow German participation in the ESM with small additional conditions, and the strong performance of centrist, pro-European parties in the Dutch election. = ongoing disagreement about a banking union, including whether all or only systemically important or cross-border banks should be supervised by the ECB. We have written about all of these things before in some detail and won't go through all of Buiter's summary again (the full note is in the usual place if anyone fancies it). But we would like to point out one or two nuggets and take a moment, down below, to discuss some default possibilities in the periphery. First on the OMT and the idea it has somewhat increased the risk of a voluntary exit in the stronger core countries due to a greater chance of backdoor debt mutualisation. From Buiter: This is because there is a risk (small in our view), that the extent of backdoor mutualisation of EA periphery sovereign debt through the OMT would be greater than the tolerance limits in Germany, Finland, the Netherlands and Austria especially, for creating a limited transfer Europe through the ECB/Eurosystem. The OMT facility will not deliver unlimited, open-ended or uncapped mutualisation of EA sovereign debt. It will, however, result in some, possibly significant, mutualisation over and beyond what seemed likely prior to its creation. The upperbound to the mutualisation tolerance threshold of the majority of the ECB Governing Council is given by the non-inflationary loss absorption capacity of the Eurosystem. According to our estimates, this could easily be as high as €3 trillion... The total outstanding EA periphery general government debt at the end of 2011 was just over €3.4 trillion. In principle, this means that the 7 periphery countries could retire their entire existing debt (except the €210bn or so already held by the Eurosystem as a legacy from the SMP) and replace it with EA periphery sovereign debt with a remaining maturity of 3 years or less. This could all be bought by the ECB as long as the countries inquestion are on ECB-approved programmes and compliant with the conditionality. Recognising this, Maria Draghi has made it clear that the ECB does not want to seea significant shift in issuance to the short end of the maturity structure. We were already shocked by the suggestion there may exist a masochistic sovereign that gamed its maturities to the short term to take advantage of OMT largesse. Shocked, we say. On the German Constitutional Court's recent decision Buiter took exception to the court weighing in on an issue likely to be beyond its legal competency, namely the argument that purchases by the ECB of government debt are banned by the Treaty because they amount to monetary financing. He also got a little pointed: As regards form, the Treaty on the Functioning of the European Union, to which Germany is of course a signatory, makes the European Court of Justice the supreme arbiter of legal matters involving just EU institutions. The matters pertaining to what the ECB does or does not do, unlike matters involving the ESM, are not part of the German Federal Constitutional Court's remit. They fall under the European Court of Justice in Luxembourg. Even though the German court is aware of this and even said so in its statement, it seems unusual to then proceed and comment on a matter out of its jurisdiction anyway. As regards substance, both a cursory and a deep reading of Article 123 TFEU make it clear that the article says nothing about monetary financing. Monetary financing concerns the liability side ofthe balance sheet of the central bank. Article 123 TFEU exclusively puts restrictions on the asset side of the balance sheet of the central bank. It bans overdraft facilities or any other type of credit facility with the ECB or the NCBs for any member state government institution and for Union institutions and direct purchasesof government debt by the ECB and NCBs. This suggests the desirability of Basic Law and TFEU amendments banning bodies that don't know debit from credit to rule on matters that depend crucially on that distinction. Now, to the one bad-idea mentioned above - banking union squabbling and delay. He argues, as he has argued before, that without a banking union - a single eurozone-wide supervisor for all banks; rapid convergence of banking regulations among the 17 eurozone member states; a single bank resolution regime or authority and an associated resolution and recapitalisation fund; and a single eurozone deposit insurance scheme and fund - the euro area cannot survive. And he is getting a bit miffed by the ongoing resistance in Germany to a single supervisory mechanism for banks under the overall control and authority of the ECB: Germany wants to keep national control over its regional banks (Landesbanken) and local banks (Sparkassen) and co-operative banks (Volksbanken). These institutions have been widely criticized in the press for engaging in dubious lending practices, and have often appeared to be instrumentsof regional politics rather than profit-oriented financial institutions.... Without the first step (the single supervisory mechanism (SSM) that Germany is now trying to emasculate), the next step - the ESM as bank recapitalisation fund and proto-bank resolution fund, cannot take place. This is extremely serious. National supervisors in the core EA nations have, under the guise of prudential regulation, imposed de facto capital controls on interbank flows from the core to the periphery, including flows between subsidiariesof the same cross-border bank and between subsidiaries and parent. This results in cross-border bank X lending in South Tirol (Italy) to corporate clients at rates 350bps higher than for comparable corporate risks in North Tirol (Austria). When the Austrian subsidiary tries to send funds to its Italian parent it is stopped by theAustrian supervisor/regulator. With banking union, and with the ECB in charge of supervision, it will come down heavily on capital market "balkanizing" national supervisors, whose actions destroy the monetary transmission mechanism in the euro area. Finally, on to defaults where it's bad news for Greece, Portugal and Ireland: We are still likely to see multiple sovereign debt restructurings of EA periphery sovereigns, starting possibly with Greece and probably lasting into 2015. We expect Portugal will likely require sovereign debt restructuring, possibly in 2014-15, but could happen even earlier, both through OSI and through PSI (Private sector involvement). Unless Ireland benefits from major OSI, say in the form of a mutualisation through the ESM of up to €64bn worth of sovereign debt - the counterpart of the capital injection into its banking system provided by the Irish authorities between 2008 and 2010 - we believe it too is likely to see sovereign debt restructuring And middling news for Spain. He thinks three things would have to go wrong for the Spanish sovereign to be unable to keep its creditors whole: The first is that the banks" need for externally provided capital exceeds the €100bn available from the ESM by a significant margin - this is quite likely. The second is that the Spanish central government will blink first in its confrontation with the 17 autonomous regions, some of whom refuse to follow the austerity mandate imposed on them by the central government. The third risk (and this is still only a suspicion) is that, like every other country where the central government imposed borrowing constraints on lower-tier authorities but forgot to forbid the granting of guarantees, Spain's autonomous regions, municipalities and social funds have created special purpose vehicles that borrowed when the lower tier governments could not, that were guaranteed by these lower-tier authorities and that soon will have to move their unserviceable debts to the guarantors and hence to the central government. Again, we'd be shocked... just shocked. Related links: Volatility and the OMT - FT Alphaville Buiter says bring out the helicopter - FT Alphaville Who's bluffing about a Grexit? This entry was posted by David Keohane on Monday, September 24th, 2012 at 13:39 and is filed under Uncategorised. Tagged with Banking union, Karlsruhe, OMT, Willem buiter.