European Central Bank

It was just a little footnote to the LTRO announcement. Just a little statement that 40 billion of the collateral received by the ECB was newly issued, newly guaranteed Italian debt.  The more I think about it, the more uncomfortable I get. The ECB claims they have 40 billion of Italian government bonds on their books from the LTRO. The banks say they pledged 40 billion of Italian government debt. The Italian government doesn't acknowledge it as debt. Is this just a ploy to inextricably link the Italian banks to the government. The banks could have borrowed direct from the ECB. Bizarrely enough they may have even been able to post their own non government guaranteed debt directly but that was too obviously Enronesque? We are scared that as these contingent liabilities hit the spotlight we will find that the sovereign debt problem is far far bigger than we have realized. 

• Fed’s Once-Secret Data Released to Public (Bloomberg) - full excel spreadsheet link
• Call for QE to stave off euro deflation (FT)
• King Says Crisis Threatens Europe’s Economy as Stability Outlook Worsens (Bloomberg)
• Russia’s Medvedev calls for reforms, but protesters not satisfied (WaPo)
• EU's carbon tax meets turbulence (China Daily)
• IMF May Delay Boosting China’s Role as Members Fail to Back Quota Changes (Bloomberg)
• China's 2012 social housing target at 7 million (Reuters)
• Bini Smaghi Says ECB Should Use QE If Deflation Risk Arises (Bloomberg)
• Italy to Kick the Cash Habit as Monti Cracks Down (Bloomberg)
• U.S. House Speaker Boehner Signs On to Tax Deal (Bloomberg)

If anybody knows exactly what this collateral is, I’d love to know.

If there is one cross asset correlation that defined 2011 (and the greater part of 2010), it was that of the Euro-Dollar (EURUSD) currency pair and the S&P 500, which have correlated with near unison nearly all of the time. And yet, the stability of this correlation may be getting unglued, because as Goldman insinuated in its market roundup note from yesterday, it is "reasonable to think that the ... reflexive relationship between EURUSD and SPX...will take some time to break, but this correlation should start to fray." Why? Because, "like the FED before them, the ECB is aggressively expanding their balance sheet." Which brings us to the point of this article: much to the dismay of the armies of disgruntled bankers and investors demanding that the ECB print right now, the ECB has in fact been printing, as shown the other day. Only it has not done so in the conventional sense where it assumes an "asset" on its balance sheet while expanding a monetary liability, but indirectly through shadow conduits, such as repo and other liquidity backstops, also as shown yesterday, where no new currency actually enters the system, yet whereby the balance sheet expands just as efficiently (and in doing so, dilutes the underlying currency). It is well known that it has been our contention that in this centrally planned world the only thing that matters is the global provisioning of liquidity by the monetary authority, as the ultimate marginal determinant of Risk On behavior (and inversely Risk Off), is how much ZIRPy cash do speculators (and more importantly Prime Brokers) have at their possession (for outright and (re)hypothecated purchasing purposes). So here we would like to make a distinction: it is not so much how much cash one global monetary central planner will provide to markets, but how much the various standalone central banks will inject, in whole or in part. We contend that for 2012 the key qualifier will be "in part" with the ECB and the Fed printing (either outright or via repo) in staggered regimes, and thus the primary determinant of "risk", the EURUSD, will be the relative ratio of the two balance sheets. This can be seen on the charts below, the first of which shows just how dramatic the ECB expansion has been in the past 6 months, and the second showing the correlation between the EURUSD and the ratio of the Fed to the ECB.

Consider the Central Banks’ coordinated intervention to lower the cost of borrowing Dollars three weeks ago. Remember, this was a coordinated effort, not the Federal Reserve or European Central Bank acting alone.

And yet, here we are, less than one month later, and European banks have wiped out MOST if not ALL of the gains the intervention produced.

Following yesterday's €489 billion LTRO there are few things we know with certainty, primary among them is that the net proceeds from the 3 year refi operation are really €210 billion, due to the rolling of various other duration facilities which are already in use into the LTRO as discussed yesterday. What we do not know, is whether the net proceeds of €210 billion have been used by banks to purchase sovereign debt or as Peter Tchir suggested, are actually used in a reflexive ponzi whereby banks use the explicit ECB guarantee to buy their own debt. Perhaps the best evidence that the LTRO was an epic failure when it comes to subsidizing the peripheral bond market is the fact that hours after its completion the ECB was forced to jump into the secondary market and buy up billions in Italian and Spanish bonds: an action that was supposed to be conducted by the banks themselves. But let's assume that the entire €210 billion form the first LTRO (and there certainly will be more) is used to fund carry trades: what then? Well, luckily UBS has performed a mathematical analysis which looks at how much paper profit banks can extract from said trade and juxtaposes it with the most recent €115 billion capital shortfall calculated by the EBA in its most recent stress test (not to be confused with the second to last stress test which saw Dexia pass with the highest marks possible). The result: woefully insufficient . In other words, anyone who believes that the LTRO will be used by banks as a source of carry "profits" is massively deluded. If anything banks will find creative loophole to prop up their balance sheets and issue more of their own debt instead of chasing pennies in front of the bond vigilante rollercoaster by loading up on more sovereigns. Because the last thing Italian banks can afford is another late Novemeber blow out in yields which brought the system to within hours of imminent collapse.

Banks in weak countries have been issuing debt, getting a government guarantee, and then posting them as collateral at the ECB. There are examples of this for Greek banks for sure, but my understanding is it has also been occurring in Portugal and Ireland. It is the only way banks in Greece (and the other countries) can raise money. It always struck me as a little bizarre, but guess it was done so the ECB could justify lending the money. I always thought it was relatively harmless, and was only adding to the risk of countries that were already in deep trouble – providing a guarantee is NOT riskless. But it appears about €40 billion of yesterday’s LTRO was done by Italian banks that issued bonds to themselves and got a government guarantee, and then posted it to LTRO. So these banks didn’t have any other collateral they could post?  Unicredit has a balance sheet approaching a €TRILLION but they had nothing they could post as ollateral? That seems strange.  Extremely strange. 

Credit calling, are you listening?
On the horizon, defaults are looming
A dreadful sight,
To see high yield's plight,
Walking in a weaker Euroland.

Without a pledge from the German,
Credit spreads are gonna widen
Who wants to pay?
For the peripheral disarray
Walking in a weaker Euroland.

Keeping track of all the various verticals of instability in Europe, which is now forced to improvise on a day to day basis with a leaking dam wall of increasingly insurmountable problems, and is torn between plugging holes in the EFSF/ESM mechanism, Bank recapitalization, generating an overarching fiscal union and, last but not least, getting the ECB involved, has become virtually impossible. Which is why we are happy to present the latest updated UBS flowchart summarizing Europe's sovereign and bank problems. Because there are many. We hope this makes it clearer.

Back in June, which now seems like a lifetime ago, we wrote an article titled: "A Few Good Hedge Funds May Have Called The ECB's Bluff, And Hold The Future Of The EUR Hostage" in which we discussed the weakest link in the Eurozone bailout and in which we warned, rather prophetically as it turns out, "that not only is Bailout #2 in jeopardy of not passing the Greek parliament, but that we may suddenly find ourselves in the biggest "activist" investor drama, in which voluntary restructuring "hold out" hedge funds will settle for Cheapest to Delivery or else demand a trillion pounds of flesh from the ECB in order to keep the eurozone afloat. In other words, the drama is about to get very, very real. And, most ironically, a tiny David is about to flip the scales on the mammoth Goliath of the ECB and hold the entire European experiment hostage..." Why prophetic? Because the FT has just reported that "One of the most prominent hedge funds holding Greek bonds has threatened legal action against officials negotiating the country’s debt restructuring if losses are too deep, raising a hurdle to eurozone leaders’ hopes of quickly reducing the country’s debt levels." Well, Vega may not be quite the David we envisioned but it will do. The bottom line is that the weakest link in the Eurozone rescue, precisely the one we predicted over six months ago, has now been exposed. We fully expect other "activist" funds to be buying up or have already bought up the debt of the other PIIGS, and hold the future of the Eurozone ransom for the princely sum of 1 million dollars.... Or realistically, much, much more. Oh, and so much for ISDA's carefully conceived plan of a "voluntary" restructuring - should Vega proceed to indeed sue Greece it is game over for the worst laid plan of mice and corrupt derivatives organizations.

Yesterday we charted the combined ECB balance sheet which showed that it had hit an all time record of €2.5 trillion, exclusing today's operation (to the stunned surprise of all those who scream that the ECB should be printing more, more, more). Today, we focus exclusively on the various forms of unsecured liquidity measures, such as today's 3 Year LTRO, because as the following chart from Bank of America shows, European emergency liquidity provisioning post today's liquidity bailout brings the total to €873 billion and is just shy of its all time record of €896 billion, a number which we expect will be taken out as soon as the next liquidity provisioning operation. In other words, European liquidity in euro terms, has virtually never been worse. And as today's additional drawdown of Fed swap lines indicates, the USD liquidity crunch is getting worse not better (confirmed by the rapid deterioration in basis swap levels). Perhaps the fact that not only is nothing fixed, but things are about as bad as they have ever been explains why Europe closed blood red across the board, and also why Bank of America continues to push for an outright crash in all risk (and some were doubting our earlier analysis that BAC is outright yearning for a market crash): To wit from Bank of America's Ralf Preusser: "The tender results do not however change either our longer term  cautious outlook on growth, or the periphery. We remain long 5y CDS protection on France, at 210bp (target 300bp, stop loss 175bp)." So let's see: BAC is shorting the EURUSD, which implies they are pushing for a market drop, and now they want French CDS to soar? Who was it that said the megabanks do not want a crash?

There are clear signs of a liquidity crunch in the asset markets right now, and the question I keep hearing is, Is this 2008 all over again? No, it’s worse. Much worse. In 2008 there was a lot more faith and optimism upon which to draw. But both have been squandered to significant degrees by feckless regulators and authorities who failed to properly address any of the root causes of the first crisis even as they slathered layer after layer of thin-air money over many of the symptoms. Anyone who has paid attention knows that those "magic potions" proved to be anything but. Not only are the root causes still with us (too much debt, vast regional financial imbalances, and high energy prices), but they have actually grown worse the entire time. As always, we have no idea exactly what is going to happen and when, but we can track the various stresses and strains, noting that more and wider fingers of instability increase the risk of a major event. Heading into 2012, there's enough data to warrant maintaining an extremely cautious stance regarding holding onto one's wealth and increasing one's preparations towards resilience.

Somehow the revisions to home sales don't affect how many months of supply there is?  I guess so, but that does seem like a stretch. What I'm more curious about is the starts and permits numbers.  Yesterday the market celebrated 685k starts and 681k permits.  We thought we were running at existing home sales of 5 million per annum.  That number was too high by 603,000 on an annual rate.  Are builders basing starts and permits on real demand or were they looking at the NAR numbers?  Were building scratching their hand wondering why they weren't seeing demand but NAR kept coming up with big numbers? Yes, I understand that the new construction market is different than existing home sales, but nothing about these revisions gives me a warm fuzzy feeling.  Maybe with Santa here, the ECB acting as the primary source of lending to banks, or some progress on Capital Hill, the strength in the market makes sense?  I just can't believe that being so far off on existing home sales can be so immaterial.

Now that the LTRO flop has been digested, one of the more curious explanations for the failure comes from Citi's Steven Englander, who suggests that, surprise, surprise, Italian banks were lying yesterday when they said that they were ready and willing to buy Italian debt with LTRO proceeds. To wit: " One dose of cold water were comments from the Italian Bank Association that EBA rules won’t permit Italian banks to buy sovereign debt – this is a complete reversal from reports yesterday that indicated that Italian bank collateral would benefit from government guarantees in going to the ECB and lead to incremental  Italian bank buying of sovereign debt." Gee: someone lying? NAR who could possibly conceive of that... And more to the point, Englander has an interesting observations on the market reaction to the upcoming French downgrade: "the S&P downgrade of euro zone sovereigns is hanging over the market but there is no definite timing – every day brings one rumor or another of an imminent moves. More concretely there is a chorus of French and euro zone officials managing expectations downward. S&P probably wants to manage the announcement so as to have the least market impact, but it is unclear whether that means doing it when most investors are inactive but liquidity is low or the opposite. At this point a French downgrade is no surprise. A one-step downgrade would be a positive surprise, but downgrading core-core Europe – Germany, the Netherlands, Finland – would still be a negative. Today’s LTRO may be a (reverse) template for the reaction to a downgrade: kneejerk selling followed by a rebound." Well, only one way to know for sure what happens post the downgrade - bring it on.