The European sovereign debt crisis is really a European banking crisis, and by extension a global banking crisis, and so serious is the threat of a global banking collapse that the ECB has resorted to borrowing money from the Fed in order to keep the system from imploding.
Here’s how it works…
ECB head Mario Draghi calls Ben Bernanke over at the US Federal Reserve and asks to exchange some Euros for US dollars – the so called dollar swap lines. The ECB then floods the banking system with these freshly printed dollars through its Long Term Refinancing Operation (LTRO), and the banks then use the money to buy high-yielding Spanish, Italian and Greek debt.
The banks like it because they get to pocket the difference between the 1% LTRO rate and the 6% paid on Italian bonds, which helps them recapitalise their balance sheets. And European leaders like it because it helps keep bond yields low and postpones a debt default from Greece, Portugal, or any of the other struggling Eurozone nations.
Without the Fed/ECB buying up these “toxic assets” the yields on these nations bonds would soar, leading to a debt spiral and either default or a breakup of the Eurozone. Either of which would likely tip a number of Europe’s banks over the edge – many of which are already considered insolvent. This, in turn, would send shockwaves throughout the global banking system. The Fed then, is no longer just the lender of last resort for the US, it’s now the lender of last resort to Europe as well.
So we have insolvent countries propping up insolvent banks, propping up insolvent countries… it’s akin to a Pyramid/ Ponzi scheme, the question is, how long can it go on? My guess is we’ve got at most 2-3 years before the wheels come off in spectacular fashion.