Draghi's 'Doom Loop' Revealed

Good article from Reuters today on how Draghi brought PIGS bond yields down in 2013.
(Nothing to do with Enda’s State of the Nation speech on ‘Market Confidence’ etc.)


Draghi is a controversial character - ex. Governor of Bank of Italy - whose actions in the Bank of Sienna scandal are worth googling.

Bernanke can do direct QE where the FED now buys over 70% of all US Sovereign Issuance.
This has flattened the US yield curve with benefits for reflating assets + injecting carry into US banks.

In Europe however the Germans were not so keen for the ECB to nakedly buy PIIGS debt (as they could default as Greece did in 2010).
Instead, the ECB have given local PIIGS banks large amounts of liquidity at cheap rates to buy their own sovereign debt.
LTRO I & II (ended Q2 2012) where temporary successes, however once the new capital was spent, PIIGS yields exploded again.
Post Draghi’s ‘whatever it takes speech’, PIIGS banks have been getting 0% repos with the ECB to buy PIIGS sovereign debt.

As PIIGS debt requires no backing bank capital (unlike loans), or any mark-to-market, PIIGS banks loaded up for free carry again.
This saw PIIGS sovereign yields collapse again in H2 2012 / 2013 (but exposure of PIGS banks to domestic sovereign debt exploded).

[Note - people sometimes assume that the end of LTRO II in Q2 2012 was the end of the PIGS banks sovereign bond buying.
The OMT repo facility has been even more powerful and seen an even greater build of sovereign bond exposure in PIIGS banks.]

[Note - people assume PIIGS bond auctions are successes due to large international take-ups, however PIIGS banks cannot use the ECBs repo facility to buy ‘primary issuance’ (they can use their own cash) - they therefore get international banks / I-banks to front-run the ‘primary auction’ and buy off them in the ‘secondary market’ later.


From Draghi’s perspective it puts the PIIGS sovereign’s banks ‘ass in the pan’ as a sovereign default is now a domestic banking collapse.
This is very like what the Greek & Cypriot banks did (under their government direction) in 2009/10 which led to their collapse.

From the German’s perspective, doing a repo facility instead of LTRO III, meant that the ECB’s balance ‘technically’ stabilised.
(I say ‘technically’ as the ECB’s exposure to PIIGS debt is effectively growing - although its Target2 imbalances are offset).

From the PIIGS banks’ perspective it is a no brainer.
Irish banks converted insolvent tracker mortgage books - earning <1% at +200% LTV - and repo’ed them for Irish debt @ 5% carry.
It injected large carry into the Irish banking system (but created a perverse situation where Ireland has had zero mortgage foreclosure).
More importantly falling sovereign yields gave US investors (who think ECB is same as FED) courage to buy Irish assets off Irish banks.
(the effective knowledge of the typical US REIT active in Irish real estate market about things like Draghi’s Doom Loop is weak).

The problem now is who is really guaranteeing this PIIGS debt AND what happens when the PIIGS banks run out of collateral to pledge.
As any bond trader knows, when new money dries up, prices fall (i.e. needs a constant ‘flow’ of buying - the FED has learnt with QE3).
We will therefore definitely need another LTRO III for this (and many more IF the PIIGS don’t use the lower bond yields to reduce debt).
A huge moral hazard is that PIIGS governments use the carry of Draghi’s trades for political projects, and not pat down debt.
This would be a disaster for Draghi as to maintain sub 5% PIIGS sovereign yields, constant LTROs would be needed.

Parts of the ECB are therefore getting cold feet about the quantum of PIIGS bank domestic sovereign debt buying.

There are also calls from the ‘Bundesbank’ (remember that institution), to apply risk weightings to sovereign holdings in PIIGS banks.
The PIIGS banks however are no so overloaded with their own sovereign debt, such a step would make them insolvent.
The cessation of sovereign PIIGS debt build up by PIIGS banks (nobody else wants it at these yields), would see yields explode again.

If the ‘Draghi Doom Loop’ is ever stopped / reversed, the consequences will serious on multiple fronts - sovereigns, banks, everything!

New data published on Monday by the European Banking Authority revealed that
the proportion of EU sovereign bonds owned by domestic banks had edged up from
64 per cent three years ago to 66 per cent, as at the end of June. But in the
weaker eurozone countries the ratio jumped dramatically, to as much as 99 per

In Ireland the tally rose from 66 per cent to 84 per cent.

It’s worst than that. At one stage only 15% or so of Irish sovs were in domestic hands… of course, this is why you want to keep a national set of banks - so you can indebt future generations and dole out the borrowed pork to your soldiers of destiny.

Can someone explain the significance of this?

I’m looking at it 2 ways:

  1. the reduction in Irish yields (and other PIGS) is a sham
  2. We’ve a huge concentration in Irish sov in Irish banks meaning the sovereign in umbilically linked to the banking system


It is Draghi’s version of QE (similar to older version that Greenspan used to use, running it through the banking system rather than onto to the FED balance sheet direct - that was until Greenspan broke the banking system).

Give the domestic banks very low / 0% loans to buy their own sovereign bonds. It is free carry and under Basel, no bank capital is needed to support it (infinite return on capital), plus you do not have to mark to market (EU sovereign debt is risk free). It enables an individual countries banking system - with the support of the ECB - to behave like a mini FED

It artificially drives down yields (makes your country seem more solvent, which it is at artificially low yields).

Also ties your banking and sovereign system - a sovereign default is a banking collapse. It addresses the moral hazard issues the Germans had trying to use Bernanke type QE in Europe where the ECB buys loads of Greek bonds and then Greece defaults (tried that one). When you combine this with the new depositor bail-in proposals for failed banks, a sovereign will to anything to avoid default (unlike Greece who did nothing until it got its write down).

Very good article today in FT on it

Could it be anything to do with exiting countries from the Eurozone.

Link to the EBA’s summary report on the issue (page 13 table 2)

Note that the EBA themselves draw the correlation with stressed countries having the highest % of domestic ownership of sovereign debt

When does the NTMA next need to raise funds?

Does this mean the banks are writing their own bonds with free money?

It is the same structure as with the Promissory Note (which the Central Bank was financed to buy) - Irish banks are being given free money to buy Irish sovereign debt from which they get the interest. They are doing it in such scale that they are driving down the yields on Irish sovereign debt which in turn makes it easier to offload properties to US buyers who think that Ireland is in good financial shape (given how low the sovereign yields are).

A state owned bank buys state bonds. The state owned bank borrows against state bond from the ECB and pockets the spread, the government gets very low yields.

Why doesn’t our government go flat to the mat in issuing bonds and take full advantage of this while we can? It’s basically the ECB bailing out our banks and our government?

Is that what this is about;


If I was Noonan, I’d be issuing bonds until I knew my pension was covered well into my grave!

Could the government effectively get its debt interest rates down to near the ECB rates if it just kept issuing bonds?? With the assistance of AIB?

You have it exactly and this mornings 10 year bond is a tool to earn a higher spread.
(very like the Prom Note deal).

Answered here: viewtopic.php?f=19&t=61596
Allegedly funded to 2015, but will go back to the market next Jan or Feb.

So the Germans were against this? Because, if this is allowed, it is **guaranteed ** to be abused by governments?

And eventually ending with the same consequences as the Deutsche mark?

The Germans are for this (on the basis Draghi would need some buy in)
What the Germans were against was the moral hazard of the ECB buying sovereign direct.
If the domestic banks do it it ties them to any default.

It certainly makes it easier. I think we’ve returned to something more akin to the Exchange Rate Mechanism (ERM) which preceded the Euro. We actually still only have a promise of a Euro into the future.

Thanks all. I think I’m slowly getting it…

Hence the need to kick to exit countries, debt and assets which are held domestically get haircut via devaluation. The bail-in will be deposits not getting a direct haircut but being converted to punt nua, the positive side of the equation is that the same happens with debt.

The Eurozone Core is mainly not affected.

Me too.

So what happens when Draghi turns off the tap on the 0% cash?