mathbabe

I’m a bit confused about the “successful” European sovereign debt auctions we’ve been hearing about lately.

If I’m a European bank, say in Italy, Spain, or Portugal, or maybe even France, then about 10 months ago or so I’d be buying all the sovereign debt of my own country that I can get or that my country wants me to, because I’d figure, hey we’re in the same boat- if my country defaults then we’re going down, probably exorcised from the Euro zone.

But nowadays, because of Greece’s example, it seems increasingly likely that a country could default on its bonds, and if orderly (and “voluntary”), the country gets to stay in the Euro zone and the banks get to live on- if they can.

So if I’m a European bank now in a peripheral country, I’m going to try to stay solvent in the case of my country’s default. And I don’t even need to be completely solvent, I just need to be more solvent than most of the other banks in my country, because, especially if the Euro zone does stay intact, they probably won’t allow all the banks to fail, but they might easily let the weakest banks fail.

Wouldn’t that reasoning mean I’d avoid buying my country’s crappy debt? So why is crappy debt bought at all anymore? I realize that the yields are high, but I don’t think they’re high enough, and I just don’t get it. Maybe I’m being dumb. Here are the possibilities as I see them:

1. I’m exaggerating the problem altogether, and the debt is actually fairly priced and not so risky. In answer to this let me quote Princeton economist Alan Blinder, a former U.S. Federal Reserve vice chairman, in this Wall Street Journal article about what to worry about in 2012: “Europe is absolutely my No. 1 concern. It is so far in the lead I can’t think of what my No. 2 concern is.”
2. The governments are putting backroom pressure on the banks to buy their debt. This seems quite probable. I definitely get the impression that there’s real politics behind the accumulation of Greek debt in French banks, for example, because otherwise the enormous holdings in BNP Paribas and others is frankly impenetrable, and certainly not in the interest of the bank itself.
3. There is some short or medium term gaming of the system going on right now, using the ECB’s recent action to restore “liquidity” in order to look better. Specifically, we have this quote from Bill Gross of PIMCO: “Amazingly, Italian banks are now issuing state guaranteed paper to obtain funds from the European Central Bank (ECB) and then reinvesting the proceeds into Italian bonds, which is QE by any definition and near Ponzi by another.”
4. Actually, the next time peripheral countries issue debt nobody will show up to buy it.

I’d love to hear comments from people who have different theories.