Reading between the lines from the Bank of Italy , Back to 2012 in the month of July Mario Draghi, on the verge of yet another Eurozone collapse, promised the world that he would do literally “whatever it takes” to defend the Euro, banks in the insolvent continent took his promise seriously, and ramped up their participation in the most epic Ponzi scheme conceived in Europe to a whole new level. The scheme, of course, was one where banks would buy sovereign bonds issued by their host country (most notably Spain and Italy), and subsequently repo them back to the ECB for near full cash (net of a minuscule haircut) collateral.
The IMF also published a crucial paragraph doing the spillover analysis indicates that a shock from Italy could have a marked impact on the Europe and beyond through trade and financials channels. Bilateral links pronounced vis-à-vis Germany and France;but more broadly Italy is the world fifth largest manufacturer , represents 17% of Euro area GDP and has the world third largest bond market. Give its central role in the global trading and financial system, a significant idiosyncratic shock in Italy could generate regional or global spillovers that would likely be much bigger. In this context the authority’s ongoing efforts to reduce fiscal vulnerabilities and support growth will have benefits beyond Italy – contributing to a more robust recovery in Europe.
The ECB had no real deus ex machina up its sleeve. What it did have is an imaginary “forward guidance” construct – a monetary “all in gamble” backed by what little faith in the ECB remained – dubbed the OMT (or the Outright Monetary Transactions) program, its only purpose was to boost confidence and to force the selling wave to end, replacing it with mindless buying.
It succeeded for a while.
The biggest drawback of the OMT, however, is that it was never actually meant to be put into operation, and a year and a half after its inception, there is still no legal term sheet, or conditionality framework, in which it would be enacted into practice. The reason is simple: the OMT was never supposed to be actually enacted as an outright, unsterilized monetization mechanism, and certainly not before the Merkel re-election. Doing so who destroy any chance the Chancellor had of storming to the top, as it would become clear to Germany that the only possible fallback plan Europe has, is to jump head first in a strategy made quite clear by both the Fed and the BOJ, namely epic, unbridled unsterilized monetization of debt, bringing those so painful Weimar Republic flashbacks with it. Something Germans is all too familiar with.
In other words, beginning in July 2012, Europe’s only strategy became hope. Hope that nothing bad would ever again happen. Hope that monetary policy can mask the absolute failure that fiscal policy across the continent (and world) had and has become. Hope that nobody ever calls the bluff of either the ECB, or the global central bank syndicate.
Over the weekend, Sylvio Berlusconi just called that bluff by telling his ministers to submit their resignations.
What happens next is unclear. What is clear is that as the chart below shows, Italian banks now own €400 billion, or a record amount of Italian sovereign paper, four times more than before the crisis. While this strategy worked miracles while everyone was behind Draghi, now that Italy has hit a dead end, and hope as a strategy has failed, the simple game theoretical question is: will he who sells first (again), sell best? The answer will depend on whether Italian banks can mangle accounting rules, and like the ECB pretend they have no Mark-To-Market concerns about bond prices.
If enough bonds were purchased and moved to “Held To Maturity” accounts, then perhaps a selling avalanche can be avoided. If not, then Mario Draghi’s OMT is not only about to be tested, but once said test fails, the ECB president will be scrambling to come up with even bigger and more bombastic promises that all shall be well. Alas, since he already has gone “all in”, one can see why things may be a little more different this time.
Finally, with hope no longer a strategy, perhaps none other than Italy’s Prime Minister has shown what the only remaining “option” for Italy is. As Bloomberg reports, Letta, facing a collapsing government, spoke at a conference organized by a Christian charity group earlier today. During his speech, he got applause after asking audience to pray for Italy. He said “We will give it our all because we are hyperdetermined, but allow me to add that if you find yourself saying some prayer for Italy in these three days, it will certainly be useful to us.”
And there you have it: when hope fails, there is still that one final fallback. Prayer.