Mario Draghi has settled on a plan to pull the EU banking system back from the brink and hammer down sovereign bond yields at the same time. The European Central Bank chief has announced that he will launch an emergency liquidity assistance program on December 21, that will provide âlimitlessâ loans to struggling banks at rock-bottom rates (1 percent) for up to 3 years. Market analysts believe that Draghi is creating an incentive for banks to purchase high-yielding sovereign bonds from debt-stricken countries using the cheap money they borrow from the ECB. If, for example, a bank takes out a loan for $5 billion euros at 1 percent and buys the same amount of 10-year Italian debt at 7 percent, he will net 6 percent difference on the trade. Itâs a carry trade windfall, a direct subsidy from the central bank. The ECBâs loans are intended to ease the stress for liquidity-starved banks while lowering the cost of funding for governments that have been walloped by the debt crisis. Draghiâs plan is actually a type of backdoor quantitative easing (QE), the main difference is that the banks are being used as middlemen to purchase the bonds. But, at the end of the day, itâs all the same, which is to say that the ECB has printed money in exchange for dodgy collateral that is fast losing its value. The method was pioneered by the Fed when it swapped $1.45 trillion in reserves for toxic mortgage-backed securities (MBS) held by banks in the US. Three years later, thereâs still no market for this unwanted dreck that has ballooned the Fedâs balance sheet to more than $2 trillion dollars. Draghi has had to downplay what heâs doing for political reasons. Any talk of QE would put the hard money evangelists at the Bundesbank in a furor. So the ECB has issued a press release that grossly understates the potential size and impact of the program saying itâs merely designed âto support bank lending and money market activity.â Right. Draghi also has to conceal the fact that the new facility flaunts the âno bailout clauseâ (Article 123) in the Treaty on the Functioning of the European Union. The central bank is strictly prohibited from providing monetary financing for member states. Butâas weâve seenâthe program is designed to divert money into sovereign debt thus providing fiscal support for the governments. In other words, the cagey Draghi is fudging the rules and stealthily carrying out âlender of last resortâ operations. Thatâs bound to ruffle a few feathers in Berlin. If the plan to lend the banks money to buy bonds sounds oddly circuitous, itâs because it is. Draghiâs trying to establish plausible deniability about what heâs up to. But the politicians know whatâs going on. Just listen to what French President Nicholas Sarkozy said when the ECB made its original announcement. This is from Reuters: âFrench President Nicolas Sarkozy said the ECBâs increased provision of funds meant governments in countries like Italy and Spain could look to their countriesâ banks to buy their bonds. âThis means that each state can turn to its banks, which will have liquidity at their disposal,â Sarkozy told reporters at the summit in Brussels.â (Reuters) Got that? Sarkozy knows whatâs going on and heâs on board. Heâs probably also figured out that the loans will never be repaid in full. How could they be? Most of the debt the ECB will be accepting, was massively inflated during the bubble years. Sovereign bond prices are as likely to bounce back in the next few years as are housing prices in the US. In other words, they wonât. The ECB will be stuck with a gigantic stinkpile of junk assets such as A rated asset-backed securities (ABS) comprised of residential mortgages and loans to small businesses. Eventually, the losses will be passed on to EZ taxpayers just as the Fedâs losses will be passed on to US taxpayers. No difference. In the meantime, Draghi will have breathed new life into the foundering EU banking system and brought it back from certain death. Itâs worth noting that the funding markets are currently frozen and the banks are unable to sell equity; so theyâve effectively become wards of the ECB. Last week alone EU banks borrowed 292 billion euros from the ECB with an additional 41 billion in one-month funding. Absent a central bank lifeline, the system would already be in its death throes. Whatâs happening to EU banks is what happened to US banks after the subprime timebomb went off. As their stash of mortgage-backed securities (MBS) suffered repeated downgrades, their capital cushion deteriorated, and their balance sheets dipped into the red. Many of the countryâs biggest banks were technically insolvent. Then came TARP and QE1, and, well, you know the rest. Thatâs why Draghi is doing his level-best to get the banks a liquidity-infusion pronto. The situation is getting worse by the day and policymakers have been unable to successfully activate any of the 3 proposed emergency lending facilitities; the EFSF, the ESM or the $200 billion IMF facility. All three, are still in various stages of incubation, so the onus is on Draghi to act. Of course, the logical thing to do would be to acknowledge that there was a humongous asset-price bubble and act accordingly; give bondholders haircuts, wipe out equity holders, restructure the banks and backstop the sovereigns with guarantees of a sustainable rate of interest. But that will never happen, because big finance has a stranglehold on the system, which is why Draghiâ a former managing director of Goldman Sachsâis calling the shots. There wonât be any bank restructuring or haircuts, not if Draghi has anything to say about it. Just more bailouts as far as the eye can see. So, how much garbage collateral is the ECB willing to take? Well, according to the Financial Times blog (FT.Alphaville), thereâs roughly â¬7,100bn.. of corporate and SME (small and medium size enterprises) loans on eurozone banksâ balance sheets. Thatâs 7 trillion with a âTâ. Hereâs a clip from the post: ââ¦.we thought weâd share with you Goldmanâs thoughts on how these corporate and SME loans might be valued as collateral. Itâs well below â¬7,100bn but still a big chunk of change: From Goldman report: âIt is unclear how much of this â¬7.1 tn will ultimately qualify as collateral. That depends primarily on the size threshold (for individual loans) and the minimum IRB [internal rating based] ratingâ¦.. But preliminary expectations are for some 20%-50% of corporate loans qualifying as collateral, before the haircuts are applied.â (âLet there be credit claim collateralâ, ft.com/alphaville) So, the ECB could be in for a major balance sheet expansion, perhaps as much as 3 trillion euros of unmarketable toxic sludge is set to wash up onto their balance sheet. Meanwhile, the wastrel banks that caused the mess with their loose lending and poor risk management will be making money hand over fist swapping Italian and Spanish high-yield paper for low-interest loans from the dissembling Mr. Draghi. There are skeptics, though, people who donât believe that Draghiâs magical miracle cure will lure banks into buying more sovereign debt. Take a look at this from the International Finance Review: âBanks are unlikely to come to the aid of debt-ridden eurozone countries, with many planning to ignore political pressure to use cheap money from the European Central Bank to fund purchases of sovereign bondsâ¦. Burned by Greek losses, and under the scrutiny of shareholders, banks have slashed their exposure to weaker European sovereigns over recent months. Senior bankers say they will cut further, despite pressure to use newly available, longer-term ECB loans to buy government debt as part of an officially-sanctioned carry trade. âWhen investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesnât really matter about the economics of the trade,â said the treasurer of one of Europeâs biggest banks. âAm I going to buy Italian bonds? No.â That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt âwouldnât be logicalâ. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost â¬50bn on its books. Such attitudes will come as a major blow to European policymakers, who had been hoping banks would use ECB money to profit from the carry trade, helping governments in the process.â (âBanks resist European pressure to buy governmentâ, IFR) So, while Draghiâs circumlocutory bailout might work; itâs not a done-deal by a long-shot. The banks are increasingly wary of loading up on government bonds that are quickly losing altitude. EU banks are already on the hook for â¬650bn of liabilities next year alone. Do they really want to get in even deeper? Maybe and maybe not. We wonât know for sure until Draghiâs Long-Term Refinancing Operation (LTRO) kicks-off on December 21. Thatâs when the rubber meets the road. If the plan does succeed and sovereign bond yields fall while the banking system is slowly nursed back to health, then Draghiâs stock will rise considerably. In fact, heâll be the most powerful man in Europe because heâll be able to dictate economic policy by merely adjusting the amount of sovereign debt he accepts as collateral from the banks. This is unspoken goal of the emergency liquidity assistance facility, to put big finance in the catbird seat so they can impose hairshirt austerity measures on debt-stricken nations through the coercive manipulation of bond yields. Itâs a foolproof way of trouncing representative government and handing the levers of power to unelected bankers. But then, thereâs nothing really new about that, is there?