Tuesday, May 29, 2012

Spain threatens the nuclear option to recapitalize BFA-Bankia

I don’t think people realize the huge significance of the proposed plan to recapitalize BFA-Bankia. The Spanish government will print a 19 (or is it 40 now?) billion euro bond and place it directly on the balance sheet of BFA, in exchange for essentially 100% equity of BFA.

The bond is never sold on the public market, so the interest rate of the bond is irrelevant. Since the government owns 100% of BFA, any interest the government pays on the bond goes right back into their own pocket.

From the ECB’s perspective the bond is as good as any other Spanish government bond, so it can be lent to the ECB in exchange for real Euros, which the bank can use to buy a number of things, including Spanish government bonds. The key part is that the bank only needs to pay the ECB’s interest rate of 1.75%.

But why stop there? Once this line has been crossed, the sky is the limit, and only explicit action from the ECB could stop it. Given that Germany is likely outvoted on the ECB governing board, it seems unlikely that the ECB would veto.

Two forms of ECB abuse suggest themselves:

1) Instead of borrowing from the markets, just borrow from BFA instead. All the government needs to do is inject a sufficient number of bonds to periodically recapitalize BFA. Since BFA can access the ECB, effectively the government can borrow at the ECB’s 1.75% without regard to the markets.

2) Put a 10 trillion euros bond into BFA. Deposit it at the ECB overnight at 0.25% interest. Pocket 25 billion of free money and pay it back to the government as a dividend.

I suppose #2 would be the thermonuclear option.

If the Germans are not completely retarded, they would realize that a pan-European bank bailout scheme (together with a treaty change, perhaps banning government owned banks from abusing the ECB) is a much better idea.

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