Over a year ago, we first explained what one of the key terminal problems affecting the modern financial system is: namely the increasing scarcity and disappearance of money-good assets ("safe" or otherwise) which due to the way "modern" finance is structured, where a set universe of assets forms what is known as "high-quality collateral" backstopping trillions of rehypothecated shadow liabilities all of which have negligible margin requirements (and thus provide virtually unlimited leverage) until times turn rough and there is a scramble for collateral, has become perhaps the most critical, and missing, lynchpin of financial stability. Not surprisingly, recent attempts to replenish assets (read collateral) backing shadow money, most recently via attempted Basel III regulations, failed miserably as it became clear it would be impossible to procure the just $1-$2.5 trillion in collateral needed according to regulatory requirements. The reason why this is a big problem is that as the Matt Zames-headed Treasury Borrowing Advisory Committee (TBAC) showed today as part of the appendix to the quarterly refunding presentation, total demand for "High Qualty Collateral" (HQC) would and could be as high as $11.2 trillion under stressed market conditions.
A bank in some European country such as Spain lends money but the collateral, Real Estate or commercial loans, are going bad. The bank then securitizes a large pool of this collateral and pledges it at the ECB to receive cash. In many cases to take the pool the country has to guarantee the debt. So Spain, in my example, guarantees the loan package which is then pledged at the ECB and is a contingent liability and which is not reported in the debt to GDP ratio of the country but nowhere else that you will find either. “Hidden” would be the appropriate word. Then as time passes the loans get even worse so that the ECB demands cash or more collateral because they will not be taking the hit; thank you very much. The bank cannot afford to post more collateral so that the country, Spain, must post the collateral and add an additional guarantee for the new loan or they must post cash which is oftentimes the case. Consequently as time passes and more cash has been spent the country, Spain, begins to run out of capital and the 10.6% deficit figure, that Spain announced recently, is not anywhere close to the actual reality so that they will get forced to officially borrow more money from the ESM as the sovereign guarantee of bank debt becomes unsustainable.
It all makes so much sense. Broad European stocks have just completed their best week in 5 months. Even though today saw some of the exuberance wear off a little, the market is up 3.6% broadly (with Spain and Italy up around 5%) as everyone anticipates something magical from Draghi next week. Macro data is a disaster. Micro (earnings) data is far worse then expected. Italy remains government-less. The money (Merkel) faces problems at home. The Buba is strongly critical of the ECB and OMT/ESM plans. But apart from that, stocks ended near multi-year highs. The EUR closed down modestly on the week. European sovereign bonds are perhaps the canary in the coalmine here - as they have been smashed to near record low yields, the last 3 days have seen spreads leaking back wider (even as stocks continue to surge).
Europe's 'Dow', the EuroStoxx 50, has suffered the biggest 4-day rout in 10 months as the broad Bloomberg 500 index plunged by the most in five months today amid terrible consumer, car registration, and economic collapse on the continent. DAX is at 4-month slows. Despite the bloodbath in European stocks, the ever-efficient European bond market (free to trade and totally un-manipulated) is now around unchanged on the week (while stocks are down 3-4%). European financials are leading the drop but it is broad-based. EURUSD also rolled back over nearing its biggest drop in 9 months. Swiss 2Y at 3 month lows. Bunds bid. European VIX surged to 5 week highs over 23%.
The debate about the usefulness of sovereign credit default swaps (SCDS) intensified with the outbreak of sovereign debt stress in the euro area. SCDS can be used to protect investors against losses on sovereign debt arising from so-called credit events such as default or debt restructuring. With the growing influence of SCDS, questions arose about whether speculative use of SCDS contracts could be destabilizing - and this caused regulators to ban non-hedge-related protection buying. The prohibition is based on the view that, in extreme market conditions, such short selling could push sovereign bond prices into a downward spiral, which would lead to disorderly markets and systemic risks, and hence sharply raise the issuance costs of the underlying sovereigns. The IMF's empirical results do not support many of the negative perceptions about SCDS. In particular, spreads of both SCDS and sovereign bonds reflect economic fundamentals, and other relevant market factors, in a similar fashion. Relative to bond spreads, SCDS spreads tend to reveal new information more rapidly during periods of stress, admittedly with overshoots one way or the other. Given the current apparent 'stability' in many nations' bond market spreads, the chart below suggests an alternative way of judging what the credit market thinks - the volume of protection bid - and in this case some interesting names emerge.
European bank stocks are officially in bear market territory, now down over 22% from their highs with today's drop closing the index at seven month lows. Financial stocks have played catch down to credit's early warning weakness but still have more room to run. The correlation between financials and sovereigns has been notably broken down in the last few weeks - as it seems an external funding source has saved European sovereign debt (perhaps one that just wants to get away from its vicious cycle-like devaluation and diversify into anything non-JPY-denominated). On the day, Portugal blew wider at the open (+22bps) only to be magnificently bid back to unchanged by the invisible hand. Spain and Italy drifted slightly tighter on the day. Stocks were similarly low range today. Swiss 2Y closed at 3-month lows as EURUSD retraced back from its highs to close practically unchanged from Friday at 1.3000.
Economic conditions in Italy are as depressed as they've been since the end of WWII, the economy is still contracting, Italy's banks are in terrible shape, private sector lending is very strained, and the ECB's policy is not resolving the problems. As is typical in countries enduring this level of economic pain, the political situation is starting to get pretty chaotic. Bersani, the top vote getter in the recent elections, has been unable to form a government, new elections this year are increasingiy likely, and recent polling suggests a dead heat among Bersani, Berlusconi and the anti-establishment party of Grillo. Surge in support for Grillo creates a risk because it is not entirely clear what he would do if he came to power. He has made a clear promise to put the euro to a vote and generally thinks that the European fiscal and monetary policies have been a bad deal for Italy. Obviously, an attempt to revisit those policies by a country as systemically important as Italy could destabilize things fast, and the risk of a radical outcome is growing. And over the past few months there are indications of that risk getting priced in and putting pressure on Italy, particularly on its banking system. Italian banking spreads are up; there has been a modest pullback in banks' wholesale funding, a modest increase in their ECB borrowing and no bond issuance.
Witches Brew: Part 4 - Reality Bites
- The Specter of Things to Come
The road to ruin is on plain display and the playbook is easily seen at this juncture. Let’s take a look at how that playbook will unfold. Contrary to popular outrage of the SOLUTION being IMPOSED it is the correct one once the insured depositors where PROTECTED. In this edition the elites suffered FIRST followed by the private sector depositors who foolishly believed false BALANCE sheets which were POLITICALLY CORRECT but PRACTICALLY incorrect fictions approved by fiduciarily (regulations and regulators allowed ONGOING insolvent operations rather than protect the public by ending and prohibiting them) challenged governments (work for the banks and crony capitalists not for the public at large).
In January, we discussed the stunning fact that Spain's social security pension fund was 90% allocated to Spanish sovereign debt. The latest data shows that this farcical epic reach-around has become even more ridiculous as, according to Bloomberg BusinessWeek, the fund's holdings are now 97% weighted to sovereign bonds. The fund purchased about EUR20bn of Spanish debt last year, while it sold EUR4.6bn of French, Dutch and German bonds. More than 70 percent of the purchases took place in the second half of the year, after Draghi's 'promise' to "do whatever it takes" moment. It appears, since the Spanish government does not explicitly have its own Fed to monetize debt, that it has merely plundered another quasi-governmental entity to do the bond-buying reach-around. The fund, which was profitable last year on this bond-buying in its self-sustaining way, still contributes 1% to Spain's deficit as contributions to the fund are outweighed by the benefits paid. Rules have been changed to enable this drastic concentration but at 97%, it is perhaps no wonder that Spanish bonds have been more volatile in recent weeks - as the implicit government buyer is now almost all-in. The potential for a vicious circle here is immense - but perhaps that is the point, more TBTF sovereigns for Draghi to deal with.
After months of posturing, promising, prevaricating, and proclaiming; the time is rapidly upon us where the central planner of the world will have to actually make actions rather than words. As SocGen notes, Central Bank decisions at the BoJ, ECB and BoE will take centre stage tonight/tomorrow but it is the BoJ announcement that is most highly anticipated after the epic jawboning. SocGen’s Sebastien Galy: "Only the truly brave can feel confident trading into the BoJ event"; adds, "It is not completely clear what economic consensus is expecting in terms of BoJ decision apart from broad outlines." Given positioning, the risk of disappointment and short JPY covering cannot be underestimated should Kuroda underdeliver.
The sound and fury of a European leadership denying the template-nature of Cyprus was deafening last week following D-Boom's comments and while we suspect the Cyprus deal was from unique and exceptional, it is clear, as Citi's Matt King notes that Cyprus’ significance was always going to stem more from the precedent it created than from its size. In choosing a relatively conventional good bank, bad bank model, the authorities have done much to alleviate the damage that would have been caused by an arbitrary tax on uninsured depositors. But the very “success” of the solution now being adopted seems likely to lead to its replication elsewhere. While arguably good news for the sovereigns and for longer-term growth prospects (though the chasm to be crossed to that growth is treacherous), its negative repercussions for senior bank bondholders still seem far from being priced in. The Cyprus model has three key features, which highlight the effective elimination of many of bondholders’ supposed protections: hasty implementation under national legislation, application to all bonds by statute, and extremely low recoveries. Against this, of course, is the argument - noisily voiced by the authorities - that Cyprus is unique. We, like King, disagree.
For the last year or so, Mario Draghi (the omnipotent head of the ECB) has discussed 'market fragmentation' as a major concern. The reason is clear - his easy money policies are entirely ineffectual in a monetary union when his actions do not 'leak' out to the real economy. Nowhere is this fragmentation more obvious than in the inexorable rise in peripheral lending rates (to small business) compared to the drop (over the last 18 months) in the core. Simply put, whether it is demand (balance sheet recessionary debt minimization) or supply (banks hoarding for safety), whatever the punch ladeled from the ECB's bowl, it is not helping the most needy economies. Of course, that was never really the point anyway - as we have pointed out many times; the actions of the ECB are (just as with the Fed) to enable the banking system to live long enough to somehow emerge from the black hole of loan losses and portfolio destruction that they heaped upon themselves. This chart is yet another example of proof that monetary policy is entirely ineffectual in the new normal - and yet the central planners push for moar...
EU Bank Depositors: Your Mattress Is Starting To Look Awfully Attractive - Bank Risk, Reward & CompensationSubmitted by Reggie Middleton on 03/28/2013 08:48 -0400
You should be recieving about 46% interest to compensate for the risk of using a Cyprus bank! Use this calculator to determine how much interest your EU (that's right, it ain't just Cyrpus) bank should be paying you. Guaranteed your getting ripped off! Wake up, and smell the confiscation coffee.
When the ECB first announced the LTRO in late 2011 (and executed in early 2012) we explained how the ECB's encumbrance via this 'aid' is in fact a major negative for the rest of the capital structure. We were proved correct and even as Draghi lied and stated there was no stigma, the market priced the LTRO-encumbered banks notably weaker. Of course, the banks with the greatest need for support were the ones who grabbed the ECB's punchbowl that time and it seems as fears re-awaken in Europe, risk-appetite towards these ECB-dependent banks (relative to non-LTRO banks) is waning rapidly. The so-called LTRO Stigma (the spread between LTRO and non-LTRO bank credit) is back at 5-month wides as investors rotate away from any and every bank outside of the core. This weakness rubbed off everywhere in Europe as Italian and Spanish bonds saw their worst day since the Italian elections as European stocks slumped and Europe's VIX is now 4.5vols higher than Monday's open.