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Lehman three years on

19 January 2012 By Neil Unmack

The Bundesbank is no match for King Arthur. The legendary Celtic ruler drew the sword Excalibur from the stone with little effort, but the German central bank has taken over three years to start to offload its own Excalibur, a collateralised debt obligation backed by risky real estate debt constructed by the chivalrous financial engineers at Lehman Brothers. The bonds are among collateral the euro zone central banks had accepted in exchange for loans to Lehman and several Icelandic banks, which failed in 2008, forcing the euro zone to take a 5.7 billion euro provision, subsequently reduced to 2.2 billion euros.

At the time of the Lehman failure, the ECB was lending about 450 billion euros to euro zone banks. In the current sovereign chapter, it is providing much more support: currently about 674 billion euros, including 489 billion euros provided in the first of two three-year liquidity injections in December. The total could increase by up to 400 billion euros more in the second injection in February, Morgan Stanley estimates.

Will the new chapter lead to larger losses than the last one? That’s hard to say. The three-year funds should reduce the risks of a painful bank deleveraging or failures, reducing the chances of losses. But in some respects, the collateral is worse. The ECB is temporarily lifting restrictions on credit claims, allowing banks to pledge less widely-traded debt. But the rules have been tightened to make asset-backed debt pledged simpler. In any case, the ECB might avoid much of the political flak any losses will bring. It has said that any losses on credit claims will be borne by the national central banks, and indirectly by the national governments, not the ECB.

Whatever the comparison with last time, it’s clear that the provision of three-year funds brings big risks onto the central banks’ balance sheets – probably worse risks than many private creditors would be prepared to take on. Such risk-taking may be a less bad way to proceed than letting banks fail from a lack of funding, but it would complicate the work-outs of any banks that do fail. If losses materialise, Mario Draghi, the ECB’s president, will regret not having an Arthurian Excalibur, which came with a sheath that made the wearer invincible.


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