Tick By Tick Research Email - A Delirious Mr Mario Draghi

Tick By Tick's picture

Dear All

When contemplating what I was going to write about for the first instalment of this weeks' market comment, I thought I had it cracked.  However, by 2pm on Friday, my original subject matter had to be put on the back burner so that I could explain exactly what just happened.  By what, I am referring to the mass cull of Sovereign Credit ratings across the Eurozone and the profound effects that it will have globally despite what Mr Sarkozy may opine.

Where to start? Where to start?  Well, whilst the ratings are a significant blow to the ego of a certain brown-haired little French man, the market - at least the rational participants - had been expecting such a move for a couple of months now.  The team at Zerohedge even seemed to joke about the matter on Twitter weekly.  It seemed that every Friday the hope filled equity markets would be thrown into turmoil by a "downgrade rumour", only to find the murmurs unfounded and for participants to resume their hope fuelled rally on Monday morning.  However, this time, the new "i've grown a pair" S&P decided to actually follow through with the threats and warnings that have been emanating for months.  A move that we should all applaud.  Someone had to bring things back to reality.

"A man in debt is so far a slave"

Ralph Waldo Emerson

Those following the Sovereign bond yields or viewers of the mainstream press could have been fooled into thinking that things were actually on the up.  On Wednesday, Germany successfully managed to auction off their 5 year bonds at a record low yield (by the end of the trading day) of 0.74% with a healthy bid-to-cover of 2.8 which, compared to a couple of shaky previous auctions, is a move in the right direction.  Despite the low yields suggesting a bearish formation going forward, the primary focus was on the elusive bid-to-cover that reflected a strong uptake of the new debt.  Roll on Thursday and the ever delusionary Spaniards manage to issue both 3 year and 10 year debt at significantly better levels than expected which, of course, sent the equity markets in pandemonium.  Were saved.  Hoorah!  Later that afternoon, Mr Draghi bought us back down to the real world with a sobering speech warning of the threats that still exist in the Eurozone but was quite clear that the measures HE has put in place seem to be working.  (We will elaborate next paragraph).  To add a cherry to the already glorious week for the Eurocrats, even Italy managed to secure the first 4.75bn Euros of funding it needs this year.  Just another 305bn Euros to go then.  No sweat.

"A second reason why science cannot replace judgment is the behaviour of financial markets" 

Martin Feldstein

Now for the Who? What? and Why? Well back in December, the "genius" that is Mr Draghi set up the ECB's Long Term Repo Operation to plug the liquidity crisis (yes, he still struggles with the liquidity solvency differentiation).  In doing so, he offered all of the European banks colossal amounts of cash - just the cool half a trillion freshly printed Euros - at the dirt cheap interest rate of 1% in exchange for any collateral they could muster.  A similar situation to one of us mere mortals swapping an old car for Buckingham Palace.  Of course, the banks took up Mr Draghi's kind offer and proceeded to hoard the money back with the ECB within the hour.  Hmmm.   

Now without full verification via the ECB holdings data, it can only be assumed, and not proved, that some of these insolvent illiquid banks have finally plucked up the courage to purchase the profligate nations' debt to earn a carry.  A decision that they are now, almost certainly, regretting following the downgrades.  The issue is a little more complex than the media suggest, but in the simplest of terms, when a bank is asked to fulfil a certain level of capital adequacy, there needs to be some form of security assumption behind that capital.  As a result, the clever fellows over at the Basel Committee decided that a discount factor needs to be applied dependent on the different credit ratings.  For instance, before Friday, holdings of Italian debt would have been assigned a risk weighting of 20%, a figure that after the announcement is now 50%.  Great news all around ey?  This is not the only factor either, as I have previously stated, holding assets of (soon to be) deteriorating value on your balance sheet will also increase your financial leverage and, after both Bear Stearns and MF Global, we all know how that story ends.  

"When you combine ignorance and leverage, you get some pretty interesting results"

Warren Buffet

So now that the banks have reduced the quality of their capital and loaded up on even more risk assets, we can all rest assured that there is no more liquidity issue according to Mr Draghi.  Do remember, his measures are "working".  Only solvency to fix now..but wasn't that the...  Moreover, it isn't like pension funds have to sell debt instruments when they fall outside a band of credit ratings is it? 

Before, I share a number of articles for the start of the week.  I cannot help but mention the late Friday afternoon QE3 rumour that wiped out almost all of the downside experienced following the S&P leak.  I ask only two questions of you:  If QE3 were to happen, what level do you think the price of Oil would reach?  And secondly, if the high price of one commodity asset was going to accelerate a US decline, what do you think it would be?

This week, we have a great selection of articles for you to read.  These include the full S&P FAQ sheet on the downgrade which is a must read, Macro Man's annual predictions, David Rosenberg's review of the bullish argument, the Economist looks at Purchasing Power of Parity and a truly scary Spanish Unemployment graph.  Enjoy.

1) Credit FAQ: Factors Behind Our Rating Actions on the Eurozone Sovereign Governments - Standard and Poors (Click HERE)

2) 2012 Non-Predictions - Rates - Macro Man (Click HERE)

3) David Rosenberg Explains What (If Anything) The Bulls Are Seeing - David Rosenberg (via Zerohedge) (Click HERE)

4) The Big Mac Index - The Economist (Click HERE)

5) Spanish Unemployment (23.3%) - Zerohedge (Click HERE)

Before I go, I would like to remind you all that this week will see the US Congress debate the raising of the upper limit of the US debt limit which always proves interesting.  More to come later in the week.

Best Regards

George Adcock 








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arg's picture

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gwar5's picture

I think all of these dinks know it's a solvency issue. By playing it as liquidity issue they believe they can save their credibility and positions of power. They don't want us to bolt and default. They can pile up more debt and position themselves as our technocatic monarchs.


Freegolder's picture



So, you argue that the banks have swapped all of their 'garbage' collateral with the ECB. Then you say that the banks have 'reduced the quality of their capital'.

Sorry, but you can't have it both ways. Although you would try.



hooligan2009's picture

the deals are

if you are, for example, an italian bank, you can borrow cash from the ECB at 1% and buy italian government bonds (BTP's) at a yield of 6.5% to 7.5% or whatever the yield trades at. You earn a carry of the yield less the financing rate. You then deliver the BTP's to the ECB as collateral to secure your (1%) cash borrowing. All you have to do is promise to repay the cash in three years time and receive those wonderful Italian bonds back onto your books that you just pruchased with the ECB's cash. Just to help, if you get a better deal on something esle, you can unwind the deal any time you like for no "break fee" AND it used to be that the government debt of your own domicile is zero risk weighted. So Italian banks (used to have?) have a zero risk to Italian Government debt. 

Why are banks the only ones allowed to get this apparent windfall and not any Luigi in the street? Well because Luigi is a dumb fuck who never worked or could work for a central bank, or the trading desk of a hugely broke Italian bank's dealing desk. 


If you are, for example, a non-Italian bank, you can still secure your ECB borrowing with the wondeful BTP's, you just can only use half of the BTP's because for you, the risk weighting is 50% and you have to dleiver 200 euros of itlaian bonds for every 100 euros you borrow. So you can only earn half the carry. 


what's to stop you talking to a Spanish bank who can have a zero risk weight for SPanish Government bonds, or a French bank who can have a zero risk weight to the French Government bond market..and well hmmm..nudge nudge wink wink..I'll risk weight yours if you risk weight mine!

Welcome to the world of regulatory arbitrage.

The other way to look at it, is why have the cash balances at the ECB gone up so much? Could it be that the carry into Sovereign debt is being self-financed by taking hte hit on a borrowing cost of 1%, lending it back to the ECB at 0.25% (cost of 0.75%) and earning the carry yield (5.5% say) for a net gain of 4.75%? After al the ECB is acting as the new clearing house on the block for all your margin trading, much like a futures exchange.

There's probably 5 brazillion things wrong with this logic..but there you go. I have finance envy, cos I am asolvent but I can't get finacning in any size I want with any collateral crap I can lay my hands on, because I am NOT an insolvent bank! 

Its SOLVENCY stupid (not LIQUIDITY!).

falak pema's picture


"When you combine ignorance and leverage, you get some pretty interesting results"
Warren Buffet/
A lot of people in the market feel that this is the moment to jump in FX trading... As for Signore Draghi he has my sympathy in current job; its enuff to give the best a screaming head ache that not even the best Chianti or Grappa could resolve. Santé!  This Tuscan boat wreck looks like the ECB's real life replica on the rocks; lets hope Draghi has more "cojones" than that Costa boat captain!


Ghordius's picture

I definitely remember having been quite sad when Trichet left.

Ah, the dear remembrance of the word "Stabeeeleeetee...."

bank guy in Brussels's picture

Title of this article needs to be corrected from "A Delerious Mr Mario Draghi" to:

"A Delirious ..." unless you meant 'A Dolorous ...'

Try that spell-checker thingie. Not a perfect tool but a useful help sometimes.

Imminent Crucible's picture

Adcock is being silly. Draghi isn't "delirious" and he isn't confusing illiquidity with insolvency. He knows that Greece is insolvent, and he wants liquidity to be pumped through Greece to the banks that hold their bonds, so the banks can escape both illiquidity and insolvency. And total ruin.

Goldman Draghi is not there to fix Greece's problems--he's there to fix the banks' problems at the expense of the Greek people.

The author is too naive to be in this business.

StychoKiller's picture

Time to fire up the oil printer, gents...