After the Greek ‘no’ vote we believe the ECB is poised to step in and buy rotten debt off the financial system to stop contagion.
The ECB will unleash the full force of quantitative easing (QE) to prevent a Greek default hurting the European financial system.
The ECB has the power, and there is precedence from when the US Federal Reserve bought sub-prime debt and securities from banks and other financial participants back in 2008-09.
The ECB will probably copy the Fed’s playbook. We believe that the fairly stable response from markets on Monday (Europe) and Tuesday (Australia) indicate that markets have been too pessimistic regarding Greece.
The big fear – contagion
Some investors and commentators are fretting about the impact of a Greek default. Some are particularly concerned about default by another country. That isn’t going to happen.
The more logical concern should have been the effect of a Greek default on exposed financial entities, particularly French and German banks.
Figure 1. Who owns Greece’s debt (leading creditors in euros)
Source: BBC, BIS, IMF, ECB, Open Europe
Bad loans to a defaulting Greece would affect banks’ capital ratios in Germany and France.
We believe the ECB is clearly cognisant of this and is not going to let that occur.
The power of QE
It’s easy to forget just what QE can do.
QE can fund Government deficits, keep the general level of interest rates on bonds – and therefore the cost of debt – low for governments. It can strategically help banks recapitalise through avoiding taking massive losses on bad debt.
The ECB will likely buy sub-prime Greek debt, and it will also take over holdings from German and French institutions which have legitimately operated in Greece.
The ECB will take debt off bank balance sheets, warehouse it, and hold the loans for as long as possible.
Figure 2. GDP Comparison of EU countries
The ECB may even buy some IMF holdings of Greek debt. However, it will probably do so covertly, away from the market that has been dominated by the hedge funds.
It’s uncertain how it will deal with private debt. Debt held by Greeks, hedge funds or speculators; basically, anyone outside the government or financial institutions, is clearly at risk.
Speculators may suffer, but overall the losses won’t be felt in the financial system.
It’s easy to forget that this has happened before when the US Federal Reserve (the Fed) bought around $US1.5 trillion of mortgages during the GFC.
For some reason market participants have ignored this market precedent.
The $US1.5 trillion in the US financial system represented around 20 to 30 per cent of all mortgages held by banks. The US Government also underwrote Fannie Mae and Freddie Mac when they were under extreme pressure.
With Greece, we’re talking about something like $US40 billion to $US50 billion of bank exposures. It pales into insignificance compared with what happened in the US.
The Fed bought mortgages which should have been written off, but the Fed held those loans and for the last few years they have substantially come back and generated positive returns.
A more powerful ECB
When the ECB does buy Greece’s rotten debt, it will cement its position as the major creditor to Greece. There will be a transfer from the private sector banks to the ECB. That will give the ECB more power to enforce the financial and fiscal rules as a creditor.
This action will help calm markets further before the true economic reforms are introduced into the Greece economy, or Greece exits the Eurozone.