John Hussman and Neil Hume on the Modigliani-Miller approach to the eurozone crisis

The document is here, Hussman writes:

We’ve seen some theories that Europe intends to address the problem through ECB lending to banks, taking distressed debt as collateral, with the banks turning around and buying more distressed debt.

Apart from the fact that this would be the sort of “legal trick” that the ECB would be unwilling to facilitate, this would imply an increase in bank leverage ratios far beyond the 30-40 multiples that already exist (which would be a disaster when tighter Basel III capital requirements kick in). In practice, depositors would flee, and you would end up with a European banking system where bank bondholders, not the ECB, would be subject to the losses, since the ECB’s collateral claims would be senior.

As I noted last week, what investors really want isn’t just for someone to buy distressed European debt, but for someone to buy that debt and willingly take a loss on it so the money doesn’t ever actually have to be repaid. This is a solvency issue – a shortfall between money owed and the resources to credibly repay it. There is no legal trick to get around that. Ultimately, you either have to restore credibility, or you have to restructure the claims through default or devaluation.

The FT Neil Hume source and discussion is here, very good comments there as well.  My view is simple: unless they pull the plug on the new plan, it will be very hard to stop this from happening.  What kind of firewall can you erect between a domestic bank and its regulating government?  Arbitrage is a strong force.  And why should an insolvent bank fear more leverage?  It’s a form of doubling down, not a solution, and it is one way of hoping for a longer-run growth bailout.  To meet a problem of leverage with…more leverage is not exactly unheard of.

More practically, the markets are not taking the new plan well (though not for this reason, I think) and it probably will have to be revised in any case.


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