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Eurozone Banks Dump Bad Paper on Taxpayers

Bloomberg is reporting on what looks like a brazen con being pulled on taxpayers by eurozone banks and governments. It goes like this: During the recent credit bubble the PIIGS country banks created and then sold a bunch of low-quality mortgage bonds. Now they're buying them up at big discounts to the original price, booking a profit on the trade, and using those securities as collateral for low-interest-rate loans from the European Central Bank.

European Banks Bolster Capital With Shunned Bonds: Mortgages

Spanish and Portuguese banks are leading European lenders in buying back their own mortgage- backed securities at distressed prices to bolster capital and stockpile eligible collateral for European Central Bank loans.

Banco Bilbao Vizcaya Argentaria SA (BBVA), Banco Comercial Portugues SA (BCP) and other lenders this year repurchased 6.6 billion euros ($8.4 billion) of asset-backed bonds they issued, more than double the level for all of 2011, according to data compiled by Deutsche Bank AG. Banks buy the debt, packages of loans in which they kept subordinated portions, for less than face value, and book a capital gain similar to the discount.

The purchases follow European Banking Authority demands that banks raise 114.7 billion euros by last week after the sharp fall in the value of bonds issued by governments in the 17-member shared currency. The deals are poised to accelerate after the ECB last month reduced the minimum ratings it will accept for mortgage securities offered as collateral for cheap loans, adding incentive to lenders to buy back debt and pledge it with the Frankfurt-based institution.

"Compliance with the EBA rules has been the main reason of all buybacks we are seeing so far, but there will be more deals since the ECB will take more of that paper," said Frank Erik Meijer, head of asset-backed securities at The Hague-based Aegon Asset Management, which oversees 220 billion euros of assets. "Lenders with little or no other sources to raise capital and funding can turn to this strategy."

Northern Rock

The bigger the discount the mortgage debt is trading at the larger the incentive for banks to repurchase their own deals because that translates into greater capital gains.

U.K. lender Northern Rock Asset Management Plc last month offered to buy back bonds issued under its Granite program as some were trading at 58 percent of face value. They've risen to 69 percent of face value after the Newcastle-based lender bailed out by the U.K government said it would offer 64 percent to 77 percent of par.

Incentives are greatest for Spanish and Portuguese lenders, where yields over benchmark rates for mortgage-backed securities are as much as 17 times higher than comparable notes pooling home loans in the U.K. Eleven Spanish banks and four Portuguese lenders have put out tenders to repurchase some of their securitizations, according to Barclays Plc data.

Few Alternatives

European lenders have few alternatives to raise capital as demand for shares of financial companies has plummeted amid the crisis over the common currency.

Sales of stock from European financial institutions fell 71 percent to 2.7 billion euros, data compiled by Bloomberg show, as Europe's sovereign debt crisis has spread from Greece to Spain, roiling credit and equity markets. The Bloomberg Europe Banks and Financial Services Index (BEBANKS) declined more than 28 percent in the last year.

Shares have fallen even as the European Central Bank pumped 1 trillion euros of three-year loans, known as the LTRO program, into the system since December, making it easier for them to fund such transactions. ECB provides the secured loans at a rate of 1 percent.

"LTRO money has made it easier for banks, especially from peripheral countries, to use funding to raise capital at a moment when other possibilities such as sale of stock or asset sales are virtually closed," said Conor O'Toole, the London- based asset-backed securities analyst at Deutsche Bank. "Even as buybacks are at record levels so far this year, we expect a second round of tenders."

Rating Changes

Last month, the ECB, which demands residential mortgage- backed securities to be graded by at least two credit rating companies, said it will allow a second ranking as low as the least investment grade, six steps below the prior requirement. The central bank also widened the range of asset-backed securities it accepts as collateral.

Banks can pledge between 40 and 50 billion euros of bonds, which were not eligible due to rating cuts, said Bank of America Merrill Lynch analysts including Alexander Batchvarov.

Securitizations pool assets ranging from corporate loans to mortgages and slice them into securities of varying risk. The transactions remain on the originator's balance sheet when it retains the riskiest slices.

Bilbao, Spain-based BBVA bought back 638.2 million euros of bonds backed by mortgages, consumer and company loans in a deal allowing it to record a 250 million euro capital gain, according to a June 28 regulatory filing. Banco Comercial Portugues offered to buy back as much as 300 million euros of bonds it issued between 2003 and 2007 mostly under its Magellan program backed by residential mortgages.

Some thoughts

Stripped of all the terminology, this scam comes down to European governments investing taxpayer funds in risky mortgage bonds -- in order to prop up banks that made a lot of ill-considered loans in order to generate big year-end bonuses. This may be legal, strictly speaking, but it's definitely not moral, and to the extent that European taxpayers figure out what's happening, the result should be, um, noisy.

It's also interesting that the banks admit that they have no other source of cash. The markets at long last appear to have recognized that most big European (and American for that matter) banks are stuffed so full of bad paper and on the hook for so many billions in derivatives that they're terrible bets. Now only governments with docile citizens are left to keep the zombie banks animated.

This game, like many others in today's global financial system, can go on as long as the currencies the central banks are creating remain viable. Once euros and/or dollars lose their attractiveness as a store of value, the end will come quickly.


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