Is the EU trying to fix the wrong finance problem?

Axel Schmidt/dapd

(MoneyWatch) Last week, the European Central Bank (ECB) announced it was further loosening the standards on what collateral it is willing to accept for loans. It will now take any asset-backed securities as long as they are not rated as junk. This move, intended to make it easier for Spanish banks to get access to cash, is seen by some as further proof that the ECB has been trying to fix the wrong problem all along.

The ECB will now accept securities backed by residential and commercial mortgages, loans to small and medium-sized firms, car loans and leasing and consumer finances, rated as low as BBB-. (Any rating below that is considered to be junk status.) The move is the second loosening of standards in just over six months. On Monday Spain formally requested eurozone rescue loans to re-capitalize the nation's banks, which are awash in bad debts.

The ECB took the move because Europe's banks have all-but stopped loaning money to each other, so it is now the only source of cash for the banks of many nations. Having the central bank take the place of interbank lending usually works best in a situation where otherwise healthy banks do not have access to cash because fear has frozen the markets. The Fed did this in the wake of the collapse of Lehman Bros. in 2008. This move is widely believed to have helped keep the U.S. economy running at that time.

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While this is a solution when the problem is one of liquidity, it is not one when it is a problem of solvency. That is when financial institutions owe far more than their assets are worth and are therefore bankrupt.

As David Santschi, executive vice president at TrimTabs Investment Research, put it:

The problem in Europe is really a problem of solvency; it's not a problem of liquidity. If money printing could solve the problem, we wouldn't be worried about Spain or Portugal or any of these countries right now, right? The ECB could just print $2 trillion, $5 trillion, $10 trillion and just be done with it. But, the problem with printing money is, lending printed money to people who are bankrupt or insolvent doesn't make them solvent.

U.S. banks were faced with a similar challenge when the American housing market collapsed. There is little doubt that if they had had to declare the value of their assets, those would have been dwarfed by the amount of money that had been loaned against them. While the Fed's move did ease investor and consumer fear by making sure anyone who wanted to would have access to money deposited in the bank, that by itself was not enough.

The U.S. government approved a change in accounting standards which allows banks to declare a mortgage's value to be what it would have sold under "normal circumstances," and not during a time of what was referred to as a "distressed market." This is called the mark-to-market rule and has made it possible for banks which under standard accounting rules would have been insolvent to continue doing business. Regulators are hoping that a rebound in housing prices will save these banks from having to address this issue.

So far no official has publicly suggested a similar move by the EU, perhaps because it would only further damage what little investor confidence remains in many European economies.

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    Constantine von Hoffman is a freelance writer and writing coach. His work has appeared in outlets such as Harvard Business Review, NPR, Sierra magazine, Brandweek, CIO, The Boston Herald, TheStreet.com, CSO, and Boston Magazine.