Free profits for banks

I never realized that the routine behavior of central banks provides a simple, seemingly risk-free way for commercial banks to make money, at least in the eurozone (I wonder if this system is as easy to game here in the US).  Basically, money just grows on trees for them.  Simon Johnson, MIT econ professor and blogger at The Baseline Scenario, explains this clearly here, so I take the liberty of quoting him at length (besides, the post is 3500 words):

However in the European Monetary Union there are now 17 nations and a plethora of banks.  So, to put it crudely, there is sure to be a fight to decide who gets the newly printed funds.  The ECB resolved this by what seemed like a fair rule:  All commercial banks can borrow from the ECB if they provide collateral, in the form of highly rated government and other securities, to the ECB.  So, for example, a Greek bank can gain liquidity by depositing Greek government bonds with the ECB – as long as those bonds are “investment grade”, i.e., highly rated.

This simple and seemingly reasonable rule created great dangers for the eurozone, which have come back to haunt Mr. Trichet.  The commercial banks in the zone are able to buy government bonds, which “paid” 3-6% long term interest rates (for all the sovereign bonds of members) over the last decade, and then deposit them at the ECB.  They could then borrow from the ECB at the ECB financing rate, which today is 1%, against this collateral so pocketing a profit — and then buy more sovereign bonds with the funds.  Mr. Trichet recognized this system had inherent dangers of turning into a new Ponzi game:  if nations spent too much, and built up too much debt, eventually the system would collapse. So at the foundation of the eurozone, Mr. Trichet led a contingent within the EU that demanded all nations live by a “Growth and Stability Pact”, whereby each nation could only run deficits of 3% of GDP, and they had to keep their debt/GDP ratio below 60% of GDP.

Of course, politics trumped Mr. Trichet – as it always must – and the Greeks, along with the Portuguese, used their new found cheap lending system to run large deficits and build up debt.  The cheap access to money also helped feed the real estate booms in Ireland and Spain.

Today, Mr. Trichet and Ms. Merkel are desperate for harsh changes to ECB lending rules that will stop this ponzi game.  They want to penalize profligate spenders.  They also want profligate nations to pay more interest.  Soon, due to its poor credit rating, Greek debt will be treated like poor collateral, so banks will no longer be able to borrow as much with Greek debt as collateral.  When these changes at the ECB come into effect in 2011, the days of Greece being able to borrow easily at low interest rates in the euro zone will close once and for all.  (emphasis mine)

Professor Johnson reports here that “Fitch just took the Greek rating to BBB minus, i.e., at the floor where the ECB now lets banks borrow against (“repo”) government debt.”

For the final kicker, the ECB dumped a heavy load of fuel on the fire, making it all but guaranteed that any European government will be able to engage in ever-more reckless debt issuance close to the day of reckoning.  But when that day comes, the crisis will be much larger.  Again, Professor Johnson:

Last week the ECB had a chance to dismantle this doom machine when the board of governors announced new rules for determining what debts could be used as collateral at the ECB.  Some observers anticipated the ECB might plan to tighten the rules gradually, so preventing the Greek government from issuing too many new bonds that could be financed at the ECB.  But the ECB did not do that.  In fact, the ECB’s board of Governors did the opposite:  they made it even easier for Greece, Portugal, and any other nation to borrow in 2011 and beyond.  Indeed, under the new lax rules you only need to convince one rating agency (and we all know how easy that is) that your debt is not junk in order to get financing from the ECB. Today, despite the clear dangers and massive debts, all three rating agencies are surely scared to take the politically charged step of declaring Greek debt is junk.  They are similarly afraid to touch Portugal.

I must add that The Baseline Scenario is an excellent blog, with some of the best coverage of the financial crisis and the world of Too Big to Fail.