Who’s Down with OMT?

Spanish Notes Rise on Bailout Speculation; Portugal Debt – Bloomberg.

Massive government interventions always lead to unintended consequences. ECB President Mario Draghi announced the Outright Monetary Transactions (OMT) plan in early September. OMT is merely a euphemism for printing euros to bail out distressed sovereigns and banks.

Investors have demanded higher interest rates for PIIGS debt due to deteriorating economic conditions and the increased chance of a eurozone breakup. By announcing its plans to buy debt maturing in one to three years on the open market, the ECB hopes to bid up prices so that the PIIGS can continue issuing debt at a lower interest rate, that is a cheaper price.

In the short-term, this plan will continue to work and keep interest rates lower than they should be. In the long-term, the plan is doomed because it sows the seeds of its own destruction through those pesky unintended consequences.

It is counter-intuitive that interest rates on a country’s debt should decline on news that this country is seeking a bailout. The reason for this dynamic is that speculators are attempting to frontrun the ECB. There is now a floor under the price of these bonds which makes them more attractive. This lowers the price of this debt in short-term.

The first unintended consequence of OMT is that it will actually encourage banks to sell their debt back to the ECB in the long-term. OMT is actually a backdoor bailout for European banks that loaded up on PIIGS debt. Once OMT commences these banks will be able to sell their holdings at a profit, so they will. They could continue to hold onto to it, but then they are holding on to the risk of a default, too.

Using the Greek bailout pattern as a template for the upcoming Spanish one, Spain is in a depression and will experience at least a partial default in the near future. When it becomes apparent that a default is in the cards, these banks will dump all of their Spanish debt.

The prospect of a default is self-fulfilling, and the banks mass sales in anticipation of default will lead to default while the ECB spends taxpayer money to buy the debt on the open market.

The European taxpayer is actually double-screwed. He will be paying the costs of a Spanish bailout and for the close to worthless bonds held by the ECB; remember that the ECB is supposedly no longer a preferred creditor and will take a hit along with all the private investors. (We’ll see) This is the endgame for Spain when it enters OMT.

The other unintended consequence of this program is that it will force other countries to enter the program. The financial markets are a zero-sum game. A euro invested in Spain is a euro less to invest in the debt of other countries.

When the ECB begins buying Spanish bonds to hold down yields, money will flow from other risky eurozone countries to take advantage of the price floor. Italy will be the first to feel the effects of this process.

Even though it is in better economic and fiscal shape than Spain, its bonds will now be riskier because there is no OMT price floor. Italy’s interest rates on its short-term debt will begin to rise as it loses investors. When the interest rate hits a certain threshold, it too will be forced to enter the program.

Eventually, each distressed country will be forced to enter OMT, and the ECB will need to print more and more euros to accommodate them. With each printed euro, a currency crash followed by a massive financial panic becomes more and more likely.

Meanwhile, while OMT does bail out the banks and the sovereigns, it does virtually nothing for the mass unemployed. An economic depression will continue to persist during the print-fest. The only way out of the debt trap and the depression is to abandon the euro and the politicians who seek to maintain it.

Down with OMT
Signor Draghi

Down with OMT
Signor Draghi

Whose down with OMT
All the Piiggies!






2 thoughts on “Who’s Down with OMT?

  1. OMT is completely dependent on ESM attachment. The ESM is an absolute change of rules. Its demands for funds to attached countries need to be fulfilled within a week, and are not subject to parliamentary approval. Not to mention the absolute immunity of its unelected officials. I think it’s not about what firepower it *has*, but about what firepower it can summon.
    European political integration was very difficult if not impossible for Merkel to implement, as you previously pointed out. Luckily, we still know that when two dogs don’t agree, you can try tying them together by force, and if they don’t eat each other’s head off, they’ll learn to get along.
    Europe will be printing Euros, yes, but the US, GB, Japan, etc have a good headstart on that.

    Spanish debt is concentrating in Spahish banks, one would think at a cetain point, Germany would be willing to walk away at minimal loss. But the set-up of the ESM paints a different picture. Any thoughts?

  2. German and French banks have a lot of Spanish private and public debt on their books. I do not believe that they would have a minimal loss. Even considering Greece, a much smaller country, a default would be catastrophic for these banks. That’s why it’s being kept afloat despite German posturing about allowing it to exit the eurozone.

    All 17 Eurozone countries have used the same currency for years while trade imbalances built up. Most of these euros flowed from countries running trade deficits to Germany with a huge trade surplus.

    There is simply not enough assets in Germany in which to place these funds. Sovereign debt still is getting a preference and not being marked down on the banks’ books, so they have loaded up on it.

    The bottom line is that no matter what Germany is saying to mollify its voters, Spain will not be allowed to default. There will be a bailout announced after the American election in conjunction with one for Cyprus and revised terms for Greece. I think this will trigger the domino effect in the rest of the countries.

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s