Greece may seem a long way from Newport Beach, California. Well, it is. But, we live in the global village, or some other dim construction. In his June 16, 2011, edition of The Credit Strategist, Michael Lewitt explained "the interconnected nature of global financial markets render Europe's problems the world's problems.... [T]here is no longer any periphery."
Lewitt also writes: "The list of interconnections goes on and on....[G]lobal regulators... have no real sense of what type of contagion effect would occur if Greece were to default. No doubt they believe it is significant enough that they are willing to do virtually anything humanly possible to prevent this scenario from unfolding."
That is demonstrably correct. Since 2007, global bureaucrats have broken any law that has hindered their attempts to ward off our inevitable reckoning. Attempts to prevent a euro eruption have become preposterous. The European Central Bank (ECB) is clearly in extremis.
The interconnections that start with Greece and the ECB wind their way through the European, then U.S., banking systems, government bond yields, and the dollar. Extrapolating the script ("that they are willing to do virtually anything humanly possible..."), the ECB will print euros like never before (and never after, since its credibility will be nil.) Doing so, the ECB will enlighten the perplexed as to the central, financial tendency since 2007: the proportion of "money good" financial paper to the expanding universe of IOU's is dwindling. As the percentage of worthy paper declines, the relative affection for government issues that would otherwise fail a screen test are, instead, improving. Specifically, the deluge of euros will, all else being equal (an escape clause of Greenspanian inspiration), drive U.S. Treasury yields down.
A week does not go by without the ECB reducing its standards of collateral. The cost is not only its credibility as a central bank (which, in any case, it is not) but in the composition of its deteriorating balance sheet.
To make matters worse, Greece is the smallest economy among the impoverished PIIGS: Portugal, Ireland, Italy, Greece, and Spain. Since others will probably follow Greece, the current impasse is all the more discouraging. The Greek government cannot meet its July interest payment obligations to banks, central and commercial. It can no longer borrow from banks or in the bond markets. (This is also true for Ireland and Portugal, and possibly others.) The Greek government has bills and salaries to pay. The ECB is doing its all to avoid default. This presents a dilemma: the further it goes in preventing (in fact: forestalling) a default by the Greek government, the more it compromises its legitimacy by breaking its own rules and ruining its balance sheet. A credit-sensitive bystander would say the ECB's legitimacy and balance sheet are cases of the emperor wearing no clothes but conventional opinion being afraid to state the obvious.
Remembering that the euro is an experiment - a currency that is only 13-year-old and not issued by a sovereign government - the European Central Bank should, above all, adhere to the highest standards of integrity.
Let's go back a year. After a meeting at the European Central Bank on May 6, 2010, the ECB confirmed its commitment to never buy sovereign (government) and corporate debt. On May 10, 2010, The ECB announced an unlimited program of buying sovereign (government) and corporate debt. On the same day (May 10), the ECB and IMF announced a $957 billion "shock-and-awe" loan program to calm markets. Said one European Union official: "We shall defend the euro whatever it takes." The double-talk from European Union and ECB officials still pours forth. As St. Augustine or Bernie Madoff said: "Once you go down that road, you can't stop."
Market prices insist the ECB and Jean-Claude Trichet (president of the European Central Bank) are paragons. Wide-awake Europeans disagree. Donald Coxe (Coxe Advisors LLP) wrote in his May 26, 2011, edition of "Basic Points": "As the citizens of the economically strong countries (and citizens with wealth to lose across the entire Eurozone) reflected on their personal financial conditions, they recognized a new fundamental risk: Their pay-checks, pensions, life insurance, bank deposits, bond investments, and cash were euro-denominated."
The ECB's balance sheet stands behind the euro. To generalize, as long as it is trusted, the euro will trade at par in commercial transactions. (In contrast, it was common when U.S. banks issued their own currencies for businesses to apply a discount - maybe 15% - to a currency from another state: for instance, to an issue from a Cincinnati bank when used to buy onions in New York.)
On the left-side of the ledger, the ECB holds €1.9 trillion (about $2.6 trillion) of assets. On December 31, 2010, it posted €82 billion in capital and reserves. The leverage ratio is 23:1. If the value of ECB assets falls by 4.3%, it will be insolvent. ("Insolvent": the last time around (2007-2008), The Authorities successfully cooed the media into stating the financial system had "liquidity" troubles. This was true but it was a secondary problem. The primary problem was the too-big-to-fail banks that failed.)
What do those assets consist of? The ECB holds €480 billion of asset-backed securities (ABS) and €360 billion of "non-marketable financial instruments." That comes to 44% of total assets. These asset-backed securities are not the old reliables, such as the once highly-radioactive ABX.HE 07-01. That is, an index composed of sub-prime mortgages that was bundled in 2007 (the '07'), and sported a price that sank in tandem with the rising default rate of the mortgages it housed. No, these are vintage 2010 securitizations, in which year the ECB permitted European commercial banks to bundle their bad mortgages and mortgage securities, sell them at par value to the ECB, which then paid fresh euros to the banks.