ECB FOCUS-Bond buying risks making ECB Europe’s bad bank

* ECB is sucking in risk from commercial banks

* Leaves it, euro zone governments exposed to Greek default

* Analysts warn ECB could end up printing money

* Halting bond purchases may be tricky

By Marc Jones and Krista Hughes

FRANKFURT, May 17 (BestGrowthStock) – The European Central Bank’s
decision to buy tarnished debt in the euro zone risks turning it
into Europe’s de facto “bad bank” and putting cash-strapped
governments and taxpayers on the hook for yet more money.

The ECB was forced to abandon its long-held opposition to
buying government debt last week in an effort to calm the debt
crisis gripping Greece and other weak euro zone countries.

The decision has had a mixed reception. Many analysts have
welcomed it as a sensible move, pointing to the instant success
it has had in bringing down out-of-control market borrowing
rates for the region’s most indebted states.

Others, however, including heavyweight ECB policy maker Axel
Weber, who heads Germany’s Bundesbank, have criticised it as a
step too far that could create inflation dangers by expanding
the money supply.

Economists also warn it leaves the ECB highly exposed to any
Greek default, while providing commercial banks with a pain-free
way to offload Greek debt that they have on their books, along
with other unwanted euro zone bonds.

The ECB’s programme potentially also involves direct
financing of companies through buying corporate debt, and while
the bank can in theory sell bonds as well as buy them, analysts
expect activity to be one-way for some time. With markets still
nervous, any halt to net purchases of government bonds could
quickly permit yields to bounce back to crisis levels.

That makes the ECB look rather like the “bad banks” some
governments have set up to cleanse their banking sectors, and
ramps up the central bank’s risk profile.

“It’s swapping bad assets against good so while it’s not
going to increase the size (of the ECB’s balance sheet), it will
deteriorate the quality,” said Charlez Wyplosz, professor at the
Graduate Institute of International Studies in Geneva.

“It’s a transformation of their role, pretty much like other
central banks have done. The others did quantitative easing;
they (the ECB) are doing qualitative easing.”

CONSERVATIVE

The ECB’s scheme is much more conservative than programmes
by other big central banks during the global financial crisis.
The U.S. Federal Reserve has more than doubled the size of its
balance sheet to about $2.3 trillion by buying mortgage-backed
securities and debt as well as longer-term U.S. Treasuries.

By contrast, the ECB has already announced plans to
sterilise its bond-buying, absorbing back the funds released by
taking one-week deposits from banks.

Announcing the plans on Monday, it revealed it had settled
16.5 billion euros worth of bond purchases by last Friday. That
is minor compared to the 2 trillion euro size of euro zone
central banks’ combined balance sheet, but the ECB has not put
any limit on how many government bonds it will buy.

“It depends on how much they buy, of course, but if the
purchases get to a scale of around 300 billion euros or more, it
really does raise questions about the risk being taken by the
ECB,” said Marie Diron, a former ECB economist who is now at
Oxford Economics in London.

“They don’t have the full information on the state of public
finances in these countries.”

DEFAULT, INFLATION WORRIES

A combination of large-scale buying and a Greek debt default
or restructuring would leave a gaping hole in the ECB’s
finances, and could inflame the ECB’s relationship with
governments if it is forced to turn to them for help.

Greece currently has 300 billion euros of sovereign debt,
most of which is held by Greek and other European commercial
banks. A Reuters poll of economists last week, taken after the
European Union announced a trillion-dollar financial safety net
for the region, found them estimating a 10 percent chance of a
Greek debt restructuring in the next 12 months.

If Greece defaulted or restructured, the hole left in the
collective balance sheet of euro zone central banks would be far
larger than the 5.7 billion euros set aside for losses after
Lehman Brothers and an Icelandic bank went bust in 2008 without
repaying money borrowed from the ECB via subsidiaries.

In the same way, the ECB would face losses if it bought
bonds issued by a company which later collapsed, although so far
market participants have not reported buying of corporate bonds.

If Greece defaulted, it might spark a chain reaction of bank
collapses, leaving the ECB with more bad assets on its books.

Deutsche Bank economist Gilles Moec said the ECB and
national central banks had buffers to protect against any
losses, but these might not be enough in the case of a
“systemic” loss.

“The first line of defence is to call on its capital or
reserves,” he said.

The ECB and national central banks had combined capital and
reserves of 77 billion euros at the end of April. Measured
against total assets of 1,894 billion euros, this gives a
leverage ratio of 24.6 times capital. As a comparison, many big
commercial banks have ratios around 30 times or higher.

If the ECB follows the same approach as it did in 2008, any
losses from defaults would be shared among the national central
banks according to their share of ECB capital — meaning Germany
and France would be hit with the biggest share.

German Chancellor Angela Merkel’s coalition government has
already felt the anger of voters on the issue of using
taxpayers’ money to rescue Greece, suffering a major regional
election defeat earlier this month.

“As the member states have to provide additional capital to
their own central banks, in the end the stronger euro area
countries — mainly Germany and France — would have to take up
potential losses related to the ECB’s asset purchase programme,”
Citi economist Juergen Michels wrote.

Geneva’s Wyplosz said that if governments did not have the
resources, there would be a risk of a vicious circle which could
end in the ECB printing money.

“We are going in circles here. We have governments which are
in very difficult situations, that are being implicitly being
bailed out by the central bank,” he said.

“Everybody is bailing out everybody without any cash. The
end of the story is that somebody needs to print the cash and
that is the central bank and that’s where we get inflation
threats.”
Investing

(Additional reporting by Mark Felsenthal; Editing by Andrew
Torchia)

ECB FOCUS-Bond buying risks making ECB Europe’s bad bank