As overnight markets leg higher once again, with all risk assets correlating higher, UBS provides a Japanese perspective on the problem of European bank under-capitalization and the impact of the 3Y LTRO. Obviously the relative take-up of the 'bailout' will decide just how much 'free-money' the banks can potentially reap (were they 'ultimately' all-in enough to do the carry trade) before the EBA's capitalization deadlines, but it is clear that even in an extremely large take-up scenario (and extended deadline) - the earnings will not come close to covering bank (capitalization) needs. The Japanese rear-view mirror perspective on this is hardly supportive as the Europeans follow the same 'short-term-solutions-and-zombification-via-capital-needs-extensions' strategy which will inevitable require the investment (read bailout) of public funds (as it did in Japan in both 1998 and again in 2003). UBS recommends buying JGBs on any selling outcome from the current market's perceptions - and given the shifts in TSYs in the last two days, we can't help but want to grab some of that knife.
UBS JGB Strategy: Mid-term outlook: 3yr LTRO viewed from Japan's experience, Can carry trade save the EU?
Hopes have heightened that the 3yr LTRO might inspire a market rebound. As such, we shall now look at the LTRO in terms of the impact it might have on the bond market, as well as on other market players. Here, our analysis concludes that it is highly likely that any term profit and loss improvement seen by banks will fall short of providing enough punch to resolve the issue of bank undercapitalization by the end of June 2012.
Operations: Banks buy sovereign debt on the open market, and then offer them to the ECB as collateral for 3yr loans. To arrive at banks' net profit under this scenario, we subtract (2) costs from (1) revenues.
(1) Revenues: Revenues from sovereign debt carry trade (or dividends in the case of shares) go to the banks, not the ECB. This is because the ECB is simply lending sovereign debt rather than making outright purchases. Revenues from sovereign debt carry (in the case of 3yr Spanish bonds at 3.56%) ? (1) 3.56% carry in our example
(2) Cost: Banks borrow funds from the ECB, pledging sovereign bonds as collateral. They then pay interest to the ECB against those borrowings (repo cost). The interest rate for the loans is set at the policy rate which is currently 1%.
The cost to banks of borrowing funds from the ECB ? (2) 1% repo cost in our example
(3) Net profit: In our example, (1) revenues minus (2) cost results in net profit of 2.56% of borrowings for the bank (3.56% – 1.00% = 2.56%). The sovereign bond in our example will be redeemed three years hence, and the transaction will yield 2.56%. If sovereign bonds with maturities over three years are used as collateral, then the bank assumes corresponding yield risk up to the time of maturity.
(4) Risk: If, for instance, Spanish bond yields were to fall by more than 2.56% three years hence, thereby dropping below the 1.00% mark, then the respective bank would have enjoyed higher returns had it instead purchased from the open market and continued holding the bonds, rather than pledging them as collateral to the ECB. However, some take the view that such a low-yield scenario is fairly unlikely to happen, which may be why this arrangement is sometimes referred to as the "ECB carry trade."
(5) Scale: UBS forecasts that banks will borrow EUR 320bn through the LTRO facility. If that entire amount generated net profits for banks at a rate of 2.56% per our example, then the banking sector would reap annual profits of: EUR 320bn × 2.56% = EUR 8.2bn. That amount alone would improve the term profit and loss position of banks. Moreover, that amount would roughly double if LTRO demand comes in at EUR 600bn, the markets high estimate for the facility.
(6) Evaluation: However, profits on our EUR 320bn LTRO forecast is halved to EUR 4.1bn if we put the date to the end of June 2012, the deadline by which banks are subject to the core Tier 1 capital requirement of 9%. Accordingly, banks are going to fall short of the EUR 114.7bn recapitalization amount required by the EBA. This is a clear-cut example illustrating what we meant in yesterday's report in regard to the difficulties inherent in resolving the issue of bank undercapitalization through improvements in profit and loss conditions alone.
Conversely, if the EBA deadline were to be extended to 3 years, the same as the LTRO facility, banks could then generate EUR 8.2bn annually over three years, bringing their total to EUR 24.6bn, thereby generating earnings equivalent to 20% of the EUR 114.7bn amount. At any rate, LTRO will have more of a positive impact on term profit and loss if today's LTRO figure is significantly large, and if by some chance yields on sovereign debt that has been purchased by banks reach all-time highs.
(7) Japan's experience: The issue of bank undercapitalization looked at through the lens of what Japan has gone through reveals the importance of (1) achieving short-term solutions through investment of public funds, and (2) extending deadlines for achieving capital adequacy ratio targets. Japan's experience in the 1990s was similar in that the government's efforts to overcome the problem of nonperforming bank loans by gradually improving the term profit and loss position of its banks fell short due to the severity of bank undercapitalization. Consequently, the situation ultimately necessitated investment of public funds in 1998, and then again in 2003.
(8) Short-term market impact and strategies: Investor risk appetite would be stimulated and yields would rise if the LTRO facility were to exceed the estimated EUR 320bn amount, and also the EUR 600bn high-end forecast. However, even if that were to happen, it still would not be enough to resolve the previously noted issue of undercapitalization. Accordingly, we recommend buying (BONDS) if such a scenario should trigger selling in the markets.