Confidence in a Lender of Last Resort Leads to Systemic Risk

The heads of the world’s largest banks are calling on the ECB to restore confidence to European debt markets and many are advocating “unlimited” purchases of Eurozone debt. The consequences of failing to do so, they say, will lead to a debt crisis spiraling out of control. But are ECB interventions into European debt markets and its implicit status as lender of last resort actually to blame for what may become a debt crisis contagion?

In an article published this past August, I wrote about how the renewed ECB intervention in Italian and Spanish debt markets that occurred in early August 2011 was artificially pushing up prices and creating unrealistic low yields on the two countries’ debt. I ended the article warning of the unintended consequences that would be borne on investors acting on the false prices.

From the article:

“The yield on the 10-year Italian and Spanish bonds fell from 6.2% and 6.4% respectively to 4.9% in the month of August alone…These are huge swings. But how much of those declines were as a result of ECB intervention as opposed to a market driven reduction in the fear of sovereign defaults? It is unlikely they would have dropped at all without the presence of the ECB…Those that choose to base decisions off of today’s manipulated prices will be proven fools, unless of course their mistakes once again are bailed-out.”

Many banks and institutions bought into sovereign debt markets following the August ECB intervention including the world’s largest money manager, Blackrock, which bought heavily into Italian bonds in early October when yields were trading around 5.5 percent. Banks bought in not because they read the rising bond prices as a signal of fiscal health in Spain and Italy, but rather because it was a very strong indication that the ECB would step in and purchase bonds whenever they reached a dangerous threshold in yield. The action institutionalizes risk. The caveat I provided at the end of the article: “unless of course their mistakes once again are bailed-out” is proving to be an investment strategy.

The yield on the 10-year Italian bond is now 6.65 percent and was as high as 7.48 percent on November 9. The yield on the 10-year Spanish bond is now 6.8 percent and still rising. Yields have surged. Buyers of the debt over the past two months, as I warned, have been proven fools. This is, however, unless their investment strategy works and they get the unlimited bond purchases from the ECB.

Those clamoring for massive ECB intervention, namely Blackrock, Societe Generale, Morgan Stanley and others have significant and potentially crippling exposure to European debt, much of it amassed recently as yields rose. The decision to invest in European debt wasn’t based on undervalued bonds providing a pretty picture of risk/return, but rather an opportunity to purchase excess yield with a guarantee against default and the ability to capture principal gains when the central bank pays premium prices for their junk.

Banks would not have bought European debt and exposed themselves to massive write-downs had the ECB not extended “confidence” to them as an implicit lender of last resort when it pushed down yields in August. But they did, and now there are enough systemically important financial institutions committed to the eurozone to warrant yet another bailout from a central bank. Contagion could have been stopped by letting the smallest of the problems, Greece, default and restructure. Of course they didn’t and the rising yields of Italy and other peripheral countries were bought up, committing more banks and institutions collecting mispriced yield.

Systemic risk isn’t created because of a breakdown in confidence. Rather, it exists because of a build-up in false confidence. Every instance of failing to address the root of the problem commits more and more money, resources, and people to the inevitable, but otherwise avoidable, contagion.