European Bad Bank

Due to the stability of the single currency in the first decade of the eurozone, certain governments (and banks and citizens) could borrow cheaply at low interest rates. Due to this credit boom the discounted value of sovereign bonds rose to much higher levels than the fiscal abilities of some governments could possibly afford. Equivalently, the price was rising beyond the fundamental value of the asset called Greek government bond. This is exactly a bubble and the problem is what to do with that. Sovereign debt in the Eurozone is becoming increasingly toxic.

For the moment the Eurozone authorities simply sustain the bubble saving the banks that hold potentially toxic government bonds. The ECB does not care what happens to Greece or Ireland but what happens in all Eurozone. The fate of national economies is rather irrelevant. The issue is how many toxic losses the European banking system can suffer without collapse.

The Merkel announcement of orderly debt restructuring in 2013 has been criticized in terms of a self-fulfilling interest rate explosion of sovereign debt. When the burst of a bubble is announced in a specific future date its price will fall now and interest rate swill rise. But some governments (Greece and Ireland for the moment) are already outside the financial market and interest rates do not affect them directly. The problem will be for the banks that will be forced to sell their bonds at low prices and suffer the haircut.

Suppose now that a European bad bank emerges that buys all sovereign debt junk in a ridiculously low price. The price should achieve the maximum possible haircut without jeopardizing the stability of the system. That should not be negotiable with the banks. After all they passed the stress-tests, didn’t they?

Then the bad bank takes its time to decide what to do with the junk. It could bet on the successful financial adjustment of heavy borrowers. Actually it would negotiate with national governments another – perhaps lower – haircut. That will not be too hard as long as it holds the political means to impose fiscal disciplne on its obligators.