Thursday, 7 June 2012
Spain's government sells 10 year bonds at 6.5%. These are mostly bought by Spanish banks who take the bonds to the ECB to discount them at the repo window at less than 2%. Spanish banks make a nice clean turn of 4.5% but have to carry a strong maturity mismatch as ECB funds are for term much shorter than 10 years. With the money from sale of bonds the Spanish government can bail out Spanish Banks without having harsh austerity conditions that would apply from an IMF/EU bail out. Spanish banks receive money twice; once from Spanish government as share capital increase and once from the ECB through repo. They pay out once when they purchase the bonds. So Spanish banks improve their capital and liquidity. If this circularity is repeated many times it could solve everybody's problem as money is created by the ECB until they get scared that it Is creating inflation and roll it back. Then the house of cards falls flat. That's circularity!