The ECB's Day in Court

Today, Jan 14, 2015, the European Court of Justice (ECJ) will hand down a legal decision on the ECB's Outright Monetary Transactions (OMT) program. This non-binding decision could potentially derail, or pave the way, for ECB sovereign bond purchases as part of (1) an ongoing Greek bail-out; and (2) a widely anticipated Fed-style quantitative easing (QE) program. Or the ECJ's decision may be wishy-washy and do neither. In that case, the German Constitutional Court - who deferred judgment on the issue to the ECJ - will eventually decide whether the provisions of the OMT violate their own constitution.

Market reaction could swing wildly based on the direction and strength of the decision. Since I'm not European sovereign debt specialist I won't make any strong predictions, but I will note that the rock-bottom interest rates and tight spreads (ex-Greece) probably reflect a presumption that sovereign QE is coming. In spades (spades >= EUR 500 billion?). If that presumption is rattled, it could get ugly for a bit, which probably means a panic flight into US Treasuries and a 10y yield bouncing off 1.60%. No guesses as to which way the court leans, as its way outside my expertise to handicap it.

We start with the barest outline of relevant EU law leading up to the OMT court case, and hand it off to some international law specialists for their opinions.

That's a lot of acronyms, and FWIW I apologize in advance that there are a lot more are coming. (FTW!)

Preliminaries

The following two treaties form a kind of constitution for the European Union (EU) and serve as the primary source of  EU law.  The treaties establish a variety of governing institutions, a fiscal and a monetary union, but not a political union. There is very little loss of national sovereignty when countries join the EU.

I make absolutely no attempt to summarize the treaties or comprehensively address the legal issues surrounding the ECB's various stimulus programs. Below is the barest outline of what I find useful when considering the potential ramifications of the court decision scheduled for Jan 14, 2015.

The Treaty on European Union (TEU) 

• Also known as the Maastricht Treaty, it was signed February 1992. After ratification by votes in all member nations, it became effective November, 1993. 
• This treaty established the European Union (EU) and set a variety of criteria that member states had to meet and uphold in order join the EU. 
• Within the TEU are the euro convergence criteria. The euro convergence criteria are five economic conditions that EU member states must meet before they can join the European and Monetary Union (EMU) and adopt the euro as their currency. These criteria set conditions on inflation rates, budget deficits, debt to GDP ratios, exchange rates and long term interest rates. 
• Note: The United Kingdom was one of the countries that joined the EU but opted out of becoming a member of the EMU and adopting the euro. 
• Articles within this treaty also established the institutions of the European Court of Justice (ECJ) and the European Central Bank (ECB), among many others. 

The Treaty on the Functioning of the European Union (TFEU)

• Developed from the European Community (EC) Treaty (1951) and the Treaties of Rome (1957); both the TEU and the TFEU have been amended several times by other treaties. 
•  The following articles within the TFEU are of particular importance for the court decision on the OMT and its potential ramifications for the ECB's quantitative easing program (summaries excerpted from here, except for Article 122 which is excerpted from here; formatting added, edited for brevity):
• Article 127(1) - the primary objective of the ECB ‘shall be to maintain price stability.’ 
• Article 123(1) - the 'no financing' clause. This article was included to prevent the national, regional and local governments of the Member States from borrowing from the ECB or the ECSB. In order to prevent the financing of government deficits by printing money, Article 123 prohibits the granting of ‘overdraft or other types of credit facilities’ by the ECB to the EU institutions or member states including regional or local government authorities as well as ‘the purchase directly of government bonds by the ECB or national central banks.’ 
• Article 125 - the ‘no bail-out’ clause. It states that the EU institutions including the ECB must not assume liability for the debts of central, regional, or local governments of the member states of the euro zone, nor must one member state assume liability for the debts of another. 
• Article 126 - provides that ‘Member States shall avoid excessive government deficits.’ As part of the  Stability and Growth Pact (SGP), Member States have agreed that their annual government budget deficit should not exceed 3% of GDP and that gross government debt should not exceed 60% of GDP.
• Article 122 - the emergency exception clause. Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, on a proposal from the Commission, may grant, under certain conditions, Union financial assistance to the Member State concerned. 

The European Crisis and the European Stability Mechanism (ESM)

There is an important legal decision from 2012 on the ESM that could shed light on the OMT ruling. Here is where I completely hand the analysis over to experts. First, from a German law journal article, The ESM and European Court's Predicament in Pringle (edited for clarity and brevity):

The legal framework of the Economic and Monetary Union (EMU) was not built to withstand a crisis of the current proportions. When it erupted late 2009, no mechanism existed to support Member States facing debt and bond-market difficulties. Under great market pressure, the Union and the euro area Member States pursued improvised solutions. 

During the last several years, these improvised solution funds - the EFSM and EFSF - have proven their worth as they have been used to provide financial assistance to Greece, Ireland, Portugal and Spain’s ailing banking sector. But they could only provide a temporary solution. In order to structurally strengthen EMU, a permanent rescue facility had to be established. Realizing this, the European Council took the initiative at its meeting of 28–29 October 2010 to create a permanent crisis mechanism in order to safeguard the financial stability of the euro area as a whole.  

And the European Stability Mechanism (ESM) was constructed and amended to the TFEU via the ESM treaty. From the ESM website:

The European Stability Mechanism is the permanent crisis resolution mechanism for the countries of the euro area. The ESM issues debt instruments in order to finance loans and other forms of financial assistance to euro area Member States. 

The decision leading to the creation of the ESM was taken by the European Council in December 2010. The euro area Member States signed an intergovernmental treaty establishing the ESM on 2 February 2012. The ESM was inaugurated on 8 October 2012.

The ESM is authorised to make use of the following lending instruments for the benefit of its Members, subject to appropriate conditionality:

• Provide loans in the framework of a macroeconomic adjustment programme;
• Purchase debt in the primary and secondary debt markets;
• Provide precautionary financial assistance in the form of credit lines;
• Finance recapitalisations of financial institutions through loans to the governments of ESM Members.
• Directly recapitalise financial institutions (as an instrument of last resort - when bail-in and contribution from resolution fund are insufficient to return an institution to viability)

If you think that sounds an awful lot like a bail-out mechanism - which contradicts the prohibition in Article 125 of the TFEU - then you understand why the ESM was challenged in court in Pringle. 

Here is an analysis of the ECJ's decision legally authorizing the ESM from Ashoka Mody in The OMT's fragile foundations (excerpts edited for brevity):

At the height of the crisis, the ECJ was asked to review the legality of the European Stability Mechanism (ESM), the vehicle established to ‘bailout’ sovereigns in financial distress. The ECJ’s decision gives us a preview on how it may react. 

The ECJ found a narrow legal space to authorise the ESM. From Article 122 of the TFEU, which permits financial support to sovereigns in circumstances beyond their control, the Court inferred that ‘financial assistance’ was not prohibited. The Court then stretched the ‘no bailout’ interpretation of Article 125 to allow financial assistance in the form of a loan (‘credit line’) to be repaid with ‘an appropriate margin’. Even so, the ECJ was clear. The distressed member state retains the ultimate responsibility of repaying its debts -- others cannot take on that burden. 

But in opening the door for the ESM, the ECJ also closed the door on the ECB. Though not called on to do so, the ECJ warned that Article 123 placed the ECB under by a stricter prohibition, denying it any form of lending (“overdraft or any other type of credit facility”) to a member state.     

The spirit of the ECJ’s view is, therefore, clear. A member state cannot impose a financial burden on another member state; and even the limited form of financial assistance (inter-governmental loans with an ‘appropriate margin’) must be democratically authorised by national parliaments and cannot be routed through the ‘independent’ ECB.

Outright Monetary Transactions (OMT), Greece, and QE

In 2012 as the peripheral European debt crisis was raging, the ECB announced that it "would undertake outright transactions in secondary, sovereign bond markets, aimed at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy." One catch is the country has to ask for financial assistance from the ECB and agree to certain domestic economic measures as conditions of aid.

Returning to the Articles in TFEU, the OMT (a) almost certainly violates the "no financing" clause; and (b) probably violates the "no bail-outs" clause as well.

The Federal Reserve bought US Treasuries as part of its QE programs, printing money and financing the deficits of the US government, in part because the Congress lacked the will to impose fiscal discipline. The Federal Reserve has the mandate and legal authority to do so. The question in front of the ECJ is does the ECB have a similar authority - to continue to bail out Greece via the OMT, to engage in sovereign bond QE - based on EU law?

Ashoka Mody's opinion (same reference as above, edited for brevity and formatting added):

The Greek bailout is almost certainly illegal by the ECJ’s benchmarks. To be legal under Article 125, the financial assistance must be repaid with an appropriate margin. The size of the appropriate margin is presumably a policy decision. But Greece will not repay the vast bulk of its official financial assistance. At the end of a grossly inefficient process, the burden of the sizeable eventual fiscal transfer to Greece will be shared without democratic accountability. In questioning the legality of the OMT, the German Court is essentially asking why the collective incentives will not lead once again to a Greece-like outcome. 

Either the Eurozone authorities must have a clear and credible policy of imposing losses on private creditors -- so that solvency is achieved with high probability -- or they must create a politically-sanctioned method of sharing the burden of other member states’ debts. Neither seems on the cards. If the member states fail to move in either of these directions, and the ECJ – as its own logic dictates – does agree with the German Court, the Eurozone will be once again left without a safety net. 

Mody just represents one opinion. Others think there are ways the ECJ could wave in parts of the OMT under the existing treaties, or sidestep the question altogether by ruling very narrowly and tossing it back to the German court. 

There is an excellent piece written by Deutsche Bank economists which addresses some of the legal issues of the OMT court case. I had a difficult time following all of it, so I won't pretend to incorporate it into my own thoughts or analysis, but you may have a better sense of it.

Private/Public QE: Repercussions of the OMT case at the ECJ

That's all I have for now. I will try to follow up once the decision comes out. Best of luck trading.