The market's reaction to Draghi's comments over the last week have been visceral in its schizophrenia. While his 'temporary' provisions, three-year LTROs specifically, provide a life-line of liquidity (a la TLGP - and how is that working out for the US banks having to roll now?), they hardly address the real underlying problem of the vicious circle between sovereign debt's now-risky nature and financial balance sheets bloated with zero-risk-weighted re-hypothecated peripheral bonds. The last week has seen a roller-coaster of Senior-Sub debt decompression and compression, liquidation-like drops in commodities, lower correlation across European sovereign debt, and significant dispersion in high- and low-beta equity and credit markets (notably as we have previously discussed, some of which will have been driven by index roll technicals). The issue comes down to whether this is the Bazooka (buy-buy-buy) or not enough (fade-the-rallies) and BARCAP's macro sales and European Banks' research team have, like the rest of the market, been exchanging views on this perspective. While their take on the liquidity explosion is that it doesn't solve the almost unsolvable solvency problem but it the deeper insight that perhaps it is not the actual mechanics of this liquidity bazooka but the perception that democracy itself has been suspended in favor of bank and sovereign survival that interests us more. Furthermore, they do an excellent job on breaking down the mythical carry trade potential of these LTROs and mutual sovereign financing benefits since near-term profit potential would be offset by additional sovereign risk -
meaning that funding markets could stay closed for longer.
From BARCAP Macro Sales:
Our European Banks Team (Simon Samuels and Mike Harrison) are manifestly the best European banks strategists in the market. I can't speak highly enough of them. I therefore want to pass on a small essay they have written on the ECB providing infinite 3 year liquidity at 1% to anyone who wants it. However before I do that below - I have to disclose that in this instance I think they have completely missed the point. They analyse the ECBs recent decision to provide infinite funding to anyone who wants it for 3 years duration at only 1% cost. The term 'back door bazooka' has been termed because this could be seen as a way for the ECB to fund the hoovering up of all PIIGS debt but using the banks as an intermediary. Lets say I'm a European Bank - i borrow a lot at 1%, invest in Italian 10 years at 7% and earn a 'free' 6% carry trade profit. So banks can rebuild capital as this is easy profits. Sovereigns get funded. And all is well. This sounds super cool. And it is cool. But Samuels/Harrison argue it is not cool enough. Please do read their essay for yourself as they are market leading. But the point i think they make is that liquidity helps but ultimately we are dealing with a solvency issue here.....just because you are more liquid doesn't mean you won't go bust.
That is exactly right. Solvency is the key. Obviously. But they miss the big point. The big point - and the real bazooka surely - is that democracy has been suspended in Europe. Most obviously in Italy but the spread of 'technocratic' government is relentelss now on the contintent. In my view it is the removal of the democratic obstacle that is the true bazooka for solvency. Liquidity is needed to keep the patient alive for 3 years or so. But that's pointless if no surgery is done over that time to heal the patient. The surgery is now a go. The democratic experiment is over. Fiscal reform ignoring the will of the people (as the will of the people has bankrupted Europe) is on. I am amazed that this suspension of democracy has not got more attention. The powers that Monti now has would have made il Duce blush! But i think a lot of Europeans are inherently 'liberal' and that this recognition of the failure of the welfare state model and the need for the suspension of democracy is slightly awkward to discuss around the dinner table while smoking your Gitannes, wearing a beret, looking thoughtful and moaning about capitalism. But it is the reality.
That's my view. I think we do have a solvency bazooka. Am i saying therefore buy everything? Hardly. We remain in thrall to the politicians. But at least the politicians now have economics degrees rather than bandanas....... Below i now follow on with Harrison/Samuels's excellent piece. This is an important debate...let me know if you want me to get them into your life..And so to their piece...... Enjoy!
[Chart Below shows Sovereigns outperforming Sub Financials today - again we suspect that market participants are not as enthralled with this bazooka as many believe they should be and in fact this is more technical index protection selling due to its significant cheapness (wideness to fair-value).]
From BARCAP European Banks Team:
Three year ECB funding: A back-door bazooka or fast-track to 'zombie-ville'?
There's been a lot of focus recently about the ECB's introduction of two 3 year LTROs, scheduled for 21 December and 29 February. The bull case here rests on the idea that it will allow banks to do an attractive (and zero risk-weighted) sovereign debt carry-trade - thereby easing sovereign yields and simultaneously boosting banks' earnings (which will help with the EBA recaps). In extremis, bulls argue, pumping ECB liquidity into banks effectively creates a 'buyer of last resort' for sovereign debt - thereby ending the current crisis. We think that this view is wrong. Whilst we see the 3 year LTRO as a positive development for the sector in terms of warding off the threat of a funding-induced credit crunch in 2012, the 3 year LTRO is not the right tool for banks to fund a sovereign carry-trade with, and would likely make non-ECB funding access harder not easier.
In summary, what the ECB announced last week is as follows:
- Two 3 year LTROs (long-term refinancing operations) - ie banks can borrow money from the ECB for 3 years rather than the current maximum of 13 months. But banks can pay the money back anytime after the first 12 months if they want.
- The operations are done as "fixed rate, full allotment"...which basically means that the banks can get as much as they want provided they have sufficient collateral.
- The amount that it will cost the bank is the "average rate of the main refinancing operations over the life of the respective operation"...which currently stands at 1% (so it'll act like a floating rate note) Obviously, the banks have to post collateral if they want to borrow from the ECB, so the amount that they can borrow is limited by the amount of available collateral that a bank has However, the ECB also relaxed the rules on what counts as valid collateral (eg they can now include a broader set of credit claims) and halved reserve requirements (freeing up to EUR100bn of collateral).
The sovereign carry trade potential of the 3 year LTRO is limited
At first glance, the 3 year LTRO looks like a very attractive tool to use in a carry trade. Banks could borrow from the ECB at 1% to buy (say) Italian 10yr debt yielding 6%-7%, and pocket the difference (after adjusting for haircuts). Even better, since (for many banks) sovereign risk carries a zero percent risk weighting, this trade would carry an infinite return on equity. So banks would have the incentive to do as much of this as possible - creaming off profits (which help meet the EBA's EUR114bn capital shortfall) whilst simultaneously easing the most distressed sovereign bond yields. The logical conclusion here would be that the ECB could engage in quasi-QE, using the Eurozone banks as a proxy 'buyer of last resort' for sovereign debt, standing ready to purchase as much sovereign debt on the secondary markets as is needed. This would end the current crisis at a stroke - and would be entirely within the confines of current EU treaties.
Unfortunately, we don't think that it will be quite as easy as that. Here's why:
Banks might not want to use 3-year money to fund a sovereign carry trade: The earliest that banks can pay back the 3 year LTRO is after 12 months - which is probably longer than banks would want. If a bank uses the 3 year LTRO to do a carry trade in its trading book on (say) Italian debt and the trade goes against them, they'd have to sell the Italian bonds and buy bunds (or dollars or whatever) instead. This could potentially lead to negative carry problems, or leave them crystallising a large loss if bund yields then rise from their current historic lows. Alternatively, if the bank placed the trade in their banking book to avoid the volatility of marking-to-market, they'd still face the risk of posting extra collateral if there were further sovereign downgrades, and ultimately have an even bigger problem on their hands if the markets' worst fears on sovereign solvency are realised. So whilst it's plausible that such a trade might be attractive to some banks, there is no riskless free-lunch on offer here.
Access to non-ECB funding becomes harder not easier - so more banks could become 'addicted' to the ECB: At a time when the EU / EBA is asking banks to hold more capital because of sovereign risk, it would be strange to see banks increasing the exposure to the very asset class that everyone is most worried about. Moreover, if banks load up even more on SGIIP sovereign debt this will make it harder not easier for banks to issue term debt. So funding markets will stay closed for longer. This in turn would mean that more banks become more reliant on ECB funding. We anticipate that neither the ECB nor bank managements would want to see this play out.
It's not exactly what the ECB had in mind: It's likely that the ECB wants banks to use the 3 year LTRO to help them manage the EUR600bn of senior unsecured debt that falls due in 2012 (much of it in the first quarter). So whilst the ECB might go along with some degree of carry-trading, this is perhaps limited by European banks' need to roll over their term paper next year.
There's still stigma in using the ECB: This latest move from the ECB (combined with recent actions from other central banks) clearly makes a stronger economic case for accessing ECB money. This can reduce the stigma for banks using ECB funding - but is unlikely to eliminate it entirely. Whilst some banks could conceivably turn a profit from taking ECB money, they would be justifiably concerned that that they could struggle to convince investors afterwards (especially in debt markets) that they only used the ECB for profit-making rather than because they needed the funding.
Do banks actually want to hold peripheral sovereign debt?: Up until the end of September, it made sense for banks to sell down their holdings of SGIIP sovereign debt because the EBA's capital shortfall calculation is based on sovereign bond holdings at the end of Q3. This helps partly explain why, for instance, banks reduced their holdings of Italian sovereign debt by c10% between Q2 and Q3. Since then, banks have had no further incentive to sell down SGIIP sovereign paper from a regulatory / capital shortfall perspective. Yet the continued gyrations in peripheral sovereign bond prices means that they remain tricky assets to hold. Would banks want to do a carry trade on volatile instruments?
Of course, even though banks might not want to use ECB liquidity to buy sovereign debt, moral suasion by politicians could effectively force them to do so. This seemed to be hinted at last week in a statement by the French President, Nicolas Sarkozy, who stated the the ECB's increased liquidity provisions for lenders meant countries like Italy and Spain could look to their banks to buy their sovereign debt. In effect, Sarkozy is advocating just the sort of 'backdoor bazooka' to solve the crisis that was alluded to above. Would this be good or bad for the sector? We suspect that the market reaction here would fall into three stages:
(i) A near-term positive for the sector as investors hope that the end of the crisis is in sight.
(ii) Medium-term uncertainty as banks become ever-more reliant on the ECB, and question marks surface as to whether or not the strategy will work (eg are yields coming down fast enough? Far enough? Are all the SGIIP sovereigns definitely solvent rather than merely illiquid?).
(iii) The longer-term equity story for European banks could be potentially compromised by political interference: if banks make super-normal profits via an ECB carry trade, it would not be unrealistic to think that political notions of "fairness" could start to be applied to banks' lending and pricing decisions.
Whilst the 3 year LTRO is helpful for managing the senior unsecured funding hump in 2012, balance sheet encumbrance increases even as the provision of credit to the wider economy eases
Even though we anticipate that banks' use of ECB 3 year monies for carry trade purposes will be limited, it is still an incremental positive for the sector, versus having no central bank backstop at all. As noted above, European banks have got circa EUR600bn of unsecured term debt maturing in 2012, with much of it falling due in the first quarter. Given that unsecured funding markets are, effectively, closed for the time being, rolling over this money has appeared challenging for European banks.
As such, having the ECB as a potential replacement for the market funding is vital. Of course, even before the 3 year LTRO was announced, banks could access ECB monies for maturities of up to 13 months - with most ECB funding taking place at 1m-3m maturities. The cost for this is the same 1% as for the 3 year LTRO. So, in theory, banks could have replaced all of the maturing EUR600bn with this shorter-term ECB money anyway (provided that they had adequate collateral). However, it would have been understandable if some banks had not wanted to fund too much of their balance sheet on such short maturities. It's clearly a reasonable assumption for banks to bet that they could always roll-over ECB funding on favourable (ie non-punitive) terms. After all, over the last few years, the ECB has made very clear how far it'll go to protect systemic stability - why should that change? But at a time of heightened macro concern, a 'reasonable assumption' might not be good enough for more risk-averse institutions. Faced with a choice of taking 1m-3m ECB money or shrinking, these banks would opt to shrink.
By offering a 3 year LTRO, the ECB has side-stepped these concerns. The longer-term ECB money can now be used to replace maturing senior unsecured debt - if required. Banks can use this to maintain credit provision to the real economy. So the 3 year LTRO may help to reduce the risks of funding-driven de-leveraging - even if the deleveraging risks from the EBA's capital shortfall remain.
But it's not all good news here. Banks' access to ECB funding requires them to post collateral. So we could have a situation where banks exchange (market-based) unsecured funding with (ECB-based) secured funding. But if banks encumber more of their balance sheets via ECB repos, then this reduces the amount of assets that senior unsecured bond holders would have a claim over in insolvency. This means that ECB funding subordinates the remaining senior unsecured investors. This balance sheet encumbrance may, therefore, increase the cost of banks' non-ECB unsecured funding and make it difficult for banks to wean themselves away from the ECB and back on to senior unsecured. So 'excess' bank usage of the 3 year LTRO runs the risk of creating more banks who are 'addicted' to ECB money - ie the classic model of 'zombie' banks. Furthermore, it's arguable that the provision of emergency central bank funding to the sector is 'proof' that many wholesale funding business models in Europe do not work and re-inforces the need for structural change for large portions of the banking system.
Furthermore, the impact on lending margins is more than a little bit ambiguous. In theory, banks borrowing from the ECB at 1% for 3 years is a pretty massive subsidy versus the theoretical cost of replacing this funding in the market. The key question here is whether banks pass this subsidy on to customers or whether the ECB funding offers banks an opportunity to boost their margins. Ordinarily, competition would see the fall in funding costs passed straight through to customers. As argued above, political notions of 'fairness' might put pressure on banks to do exactly this rather than increase profits.
But this can create a problem. Banks that do not access ECB funding (perhaps in a show of strength) would be put at a competitive disadvantage versus those banks that do. If ECB-funded banks pass through the lower funding costs to customers, they will likely take market share from the 'stronger' banks and structurally depress RoEs for the non-ECB funded part of the market. If ECB-funded banks don't pass through the lower funding costs they will make fatter margins, so they win again. Taken in isolation, this would seem to be be a deeply perverse example of moral hazard. However, banks considering whether to use the 3 year LTRO have to weigh up the potential near-term competitive advantages they can gain with the longer-term risks of potentially becoming 'addicted' to ECB funding. The answer here ultimately may be determined by how quickly debt markets in Europe can normalise: if the stigma of ECB funding dissipates and political interference is limited, then weaker banks who use more ECB money may be advantaged versus stronger banks who do not.
A more clear cut conclusion can perhaps be drawn about how the 3 year LTRO may help to mitigate credit quality concerns in peripheral Europe. High sovereign funding costs typically mean high bank wholesale funding costs. But the banks pass this on to their customers (where they can), meaning that the interest rate on loans for the end-customer increases most in the economies least able to absorb the extra cost. This creates a vicious circle where high sovereign funding costs ultimately reduce tax receipts - thereby worsening the sovereign debt dynamics. By severing the link between bank funding costs and sovereign bond yields (for maturities <3 years), the ECB can help prevent this vicious circle from becoming established.
It may improve the optics of near term funding / liquidity measures - whilst actually delaying the timing of the terming out
Technically speaking, by offering banks longer-term funding, the ECB has made it easier for banks (eg the French) to term out their funding. This will likely flatter the LCR and NSFR ratios that banks report in advance of full compliance in a few years time. Of course, this may be a bit of a fudge. It's not clear whether using ECB money really counts as terming-out funding. Surely the point of a bank terming out their funding is to make them more resilient to liquidity squeezes. But ECB funding isn't subject to these vagaries to the same degree. Could a bank claim in good faith that they have fixed their funding profile by pushing loads of their liabilities onto the ECB? We suspect that this may be a hard sell. If using 3 year ECB money actually delays the timing of banks 'properly' terming out their funding, this could potentially be a negative for attracting longer-term investors.
Overall, the 3 year LTRO is a (small) incremental positive for equity markets rather than a 'game changer'
If a major European sovereign defaults, then very clearly the whole sector will sell off. If sovereign risk disappears, then the whole sector will likely rally. In the absence of a 'backdoor bazooka', we think that it's unlikely that the 3 year LTRO particularly changes the story here. So any benefits to the sector from the LTRO potentially provides material upside as / when sovereign risk declines.
The longer LTRO does help banks mange their way through the 2012 senior unsecured funding hump, it lowers the incentives for banks to shrink and potentially reduces risk at the shorter end of the yield curve. This is a clear positive for the sector - but we don't think that a funding-driven credit crunch in 2012 had been priced in anyway. So the equity market response may be muted here - although net net, the risks of additional credit quality deterioration in Italy and Spain are reduced. We do not see the 3 year LTRO as offering European banks a 'no-brainer' carry trade, so we'd expect bank appetite for this purpose to be limited. Indeed, if banks were to engage in a sovereign debt carry trade at this stage in the cycle, we think that the risks to the sector would be to the downside: near-term profit potential would be offset by additional sovereign risk - meaning that funding markets could stay closed for longer. Whilst it's clearly difficult to say with certainty, our rates team suggests c EUR250bn of demand for the auction in December (see "The ECB: Non Standard Delivery", Laurent Fransolet). We anticipate that if substantially more than this was requested by the banks for carry trade purposes, non-ECB funding could potentially become even more dysfunctional.