Euro Banks Swap Cash for Trash

Cheap loans being offered by the European Central Bank to help reflate the Eurozone are encouraging some banks to boost their profits by loading up on risky bonds.

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Desperate attempts by the European Central Bank to pump air into the deflating Eurozone are encouraging leading European banks to load up their portfolios with potentially risky debt. This could lead to big problems down the road if some Eurozone countries do actually default or force the banks to accept big writedowns on loans.

The problem is what’s known as the carry trade, a term that sounds like something out of Jane Austen: “Mr. Willoughby may not be a gentleman, but he is very rich. He has made a fortune in the carry trade, you know.” In fact, today’s carry trade is concerned with a different kind of unsuitability. In place of totally safe investments, bankers buy risky bonds and reap a substantial profit from “carrying” these hot potatoes. The enhanced earnings typically come from the fact that the yields on these bonds are a lot higher than the cost of borrowing the money to buy them.

(MORE: Why the Eurozone Can’t Just Muddle Through)

But the carry trade has become a problem recently because the European Central Bank has started lending huge amounts of money on incredibly easy terms (sort of like mortgage loans in the U.S. a few years ago). The ECB’s new procedures, known as “crisis loans” or LTRO (long-term refinancing operations), are a bit complicated to explain. For a full-length treatment, you can read this article by Ambrose Evans-Pritchard, but here’s the short, oversimplified version:

The European Central Bank has two big worries. One is that countries with a lot of debt, such as Italy and Spain, won’t be able to sell bonds at reasonable prices to cover deficits and also to pay off old bonds that are coming due. The other is that major European banks will temporarily run out of cash and find that short-term loans aren’t available — either because the bonds they own won’t be good enough to be accepted as collateral or because other banks are cutting back lending generally.

The ECB’s solution has been to lend money to banks really cheaply while being extremely accommodating about the quality of collateral. In December, the ECB lent an enormous 489 billion euros to more than 500 banks at a rate of only 1% for three years, an unusually long period for this sort of loan. The U.S. Federal Reserve was also involved, making sure that dollars as well as euros were available. An even bigger such loan is scheduled for later this month.

(MORE: Why Europe’s Backdoor Bailouts Won’t Work)

This lending obviously solves European banks’ short-term cash worries. But it also has another clever consequence. Banks can borrow more than they actually need and use some of the money to buy high-paying debt securities and profit from the difference between the yield on the bonds they buy and the low cost of the loan from the ECB – that’s so-called carry.

For the banks, the question is how much profit to reach for – and how much risk to take. The low yield on three-year German bonds (completely safe) would actually result in a negative cost of carry – in other words, a loss. Investing for 10 years in France (fairly safe) would earn 3%, or a profit of 2%. Ten years in Italy (somewhat risky) would earn a profit of almost 5%. Portugal (probably unsafe) would earn double-digit returns.

The ECB strategy has worked brilliantly, at least so far. Banks have the cash on hand that they need. They are also earning invisible subsidies by the grace of the ECB (and the Fed) by loading up on bonds that have varying degrees of risk.

There are just two drawbacks: First, few banks are daring enough to lend a lot to the most troubled countries, so while yields in Italy and Spain have come down, those in Greece, Portugal and maybe Ireland are still too high for those countries to escape eventual default, as I discussed in an article earlier this week.

Second, banks may be tempted to buy too much low-rated debt. If they do, and one of the countries defaults or is severely downgraded by credit-rating agencies, the banks could find that they have swapped cash for trash. The losses would cut into their required capital and possibly also leave them short of ready money. But such a squeeze could only happen if the bankers get reckless and greedy – and that could never happen, right?

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