Saturday, December 17, 2011

"The Sarko Trade"

President Sarkozy's last name has lent itself to all sorts of interesting combinations. The most recent is what the Financial Times calls "the Sarko trade."

Via Reuters:
French President Nicolas Sarkozy said the ECB’s increased provision of funds meant governments in countries like Italy and Spain could look to their countries’ banks to buy their bonds.
“This means that each state can turn to its banks, which will have liquidity at their disposal,” Sarkozy told reporters at the summit in Brussels.
And it wasn’t just us who were taken aback by the suggestion, which is not too dissimilar to Jon Corzine’s repo-to-maturity brainwave which wrecked MF Global (especially once haircuts hit the underlying assets).
In other words, what President Sarkozy was suggesting after the Brussels summit was that the Eurozone would finance its way out of the crisis without violating any EU regulations by having the ECB lend to banks against collateral, which is permitted, rather than buy distressed sovereign debt outright on the primary market, which is of dubious legality under existing regulations.

The problem with this scheme, as the FT Alphaville article goes on to point out, is that the amount of debt outstanding is so large that it would increase bank leverage ratios many times over. Read the article at the link for a full explanation. But here's the short version:

Everyone’s a winner.
Well that’s the theory anyway. But according to fund manager John Hussman it’s a dumb idea.
From his latest weekly comment:
We’ve seen some theories that Europe intends to address the problem through ECB lending to banks, taking distressed debt as collateral, with the banks turning around and buying more distressed debt.
Apart from the fact that this would be the sort of “legal trick” that the ECB would be unwilling to facilitate, this would imply an increase in bank leverage ratios far beyond the 30-40 multiples that already exist (which would be a disaster when tighter Basel III capital requirements kick in). In practice, depositors would flee, and you would end up with a European banking system where bank bondholders, not the ECB, would be subject to the losses, since the ECB’s collateral claims would be senior.
So if this is actually what Sarkozy and Merkel had in mind as a solution to the crisis, it seems that key financial sector actors are not buying it.