European Central Bank Acts to Stem New Debt Crisis

One of the massive catalysts for yesterday’s large financial markets fall, which I covered in “Are You Scared of Stock Market Falls,” was the decision Thursday by the European Central Bank to only include the debt of Ireland and Portugal in the European bailout-package-authorized sovereign bond buyback program.  Realizing its mistake, the ECB stated Friday that it would consider adding the debt of Italy and Spain into the buy program.

Recall that this program is designed to create demand for these bonds so that there is a floor under their prices/a cap on their yields.  All financial markets are auction markets and what happens when there are limited bidders/buyers is that prices fall.  Compounding price falls is that sophisticated investors can bet against these sovereign debt assets by shorting the bonds.  So when the prices of the bonds fall these investors make more money.

This was one of the reasons that the European bailout package granted the ECB the ability to bid for these bonds.  One, it creates a price floor for the bonds and ensures that the markets are liquid.  But two, it also makes sophisticated investors think twice about shorting the bonds.

Hopefully the ECB voicing its possible intention of putting a floor under Italian and Spanish debt will stem another debt crisis in Europe.  Kudos to the ECB for recognizing its mistake.  Shame on the ECB for making such an obvious mistake in the first place.  Duh!

Jason