European banks transformed the euro’s risk-free sovereign debt into a leveraged carry trade

Evidence

If you were a European bank back in the late 1990s seeing sovereign bond yields falling, it might have bothered you since a source of risky profits was disappearing. On the other hand, if this new ECB gizmo really did get rid of exchange-rate risk for the sovereigns issuing the debt and take inflation off the table by housing in Frankfurt the only money press in Europe, then it really was a banker’s dream—a free option—safe assets with a positive upside, just like those CDOs we saw in the United States. So you would be a fool not to load up on them, and European banks did exactly that. But as yields converged, you would have to buy more and more bonds to make any money. There was, however, a small but significant difference in yield between the bonds of Northern European sovereigns and those of the periphery after the yields converged. So, if you swapped out your low-yield German and Dutch debt and replaced it with as much PIIGS debt as you could find, and then turbocharged that by running operating leverage ratios as high as 40 to 1—higher than your US counterparts—you would have one heck of an institutionally guaranteed money machine. — Mark Blyth, Austerity, 225

Categorization

• XREF: The ‘free option like CDOs’ framing directly parallels the US housing bubble anatomy Blyth covered earlier; also connects to the leverage-driven moral hazard literature and Mattei’s account of eurozone fragility. — connects to: Austerity transmitted sovereign-risk to the banks that held the bonds. — Mark Blyth, Austerity: The History of a Dangerous…, 31; Core-country banks bought peripheral sovereign debt and levered up more than US banks — Mark Blyth, Austerity: The History of a Dangerous…, 37; Euro adoption erased perceived country risk in sovereign bond yields — Mark Blyth, Austerity: The History of a Dangerous…, 220 (+7 more)
• ADDENDUM: The carry-trade mechanics here are the banking-side infrastructure that conditions how austerity was later imposed on PIIGS sovereigns — relevant background for the sacrifice framing.

Broader Connections

• Downgraded sovereign debt collateral trapped leveraged European banks in a funding spiral #expands (0.93) — Mark Blyth, Austerity, 238
• European bank exposure to periphery sovereign debt reached dangerous multiples of national GDP #corroborates (0.88) — Mark Blyth, Austerity, 239
• Eurozone sovereign bonds replaced US mortgage securities as the systemic repo collateral #expands (0.85) — Mark Blyth, Austerity, 237
• The sovereign debt crisis is a transmuted and camouflaged banking crisis #responds-to (0.85) — Mark Blyth, Austerity, 35
• Eurozone banking integration outpaced national resolution, producing too-big-to-bail systemic risk #corroborates (0.75) — Mark Blyth, Austerity, 227