Since the much-heralded 3Y LTRO program was envisioned and enacted, we have been clear in our perspective that while this appears to have signaled a removal of downside (contagion-driven) tail-risk for banks (and implicitly to sovereigns), the market's perceptions are once again short-termist. Missing the unintended-consequence for the sugar high is something that we have seen again and again for the past few years but we worry that this time, given the sheer size of the program, that the ECB has got a little over its skis. By demanding collateral for their bottomless pit of low-interest loans, the ECB has not only reduced banks' necessary deleveraging needs (and/or capital raising) but has increased risk for all bond-holders (and implicitly equity holders, who are the lowest of the low in the capital structure remember) as the assets underlying the value of bank balance sheets are now increasingly encumbered to the ECB. Post LTRO, Barclays notes that several banking-systems (PIIGS) now have encumbered over 15% of their balance sheets but LTRO merely extends a broader trend among European banks (pledging collateral in return for funding) and on average (even excluding LTRO) 21% of European bank assets are now encumbered, and therefore unavailable for unsecured bond holders, ranging from over 50% at Danske (more a business model choice with covered bonds) to around 1% for Standard Chartered. As the liquidity-fueled euphoria starts to be unwound, perhaps this list of likely stigmatized banks is the place to look for higher beta exposure to the downside (especially as we see EC B margin calls start to pick up).
Via 'Encumbrance at European Banks' per Lehman's successor entity
Who cares about funding anymore? While €1trn of 3-year LTROs takes funding risk off the table near term and helps buy time in managing the European sovereign debt crisis, we think there remain several reasons to stay concerned about bank funding longer term.
A rising trend of encumbrance: Even before the LTROs, a growing feature in Europe was rising balance sheet ‘encumbrance’ – the pledging of collateral to one group of creditors at the expense of another. The most obvious example of this is the rise in covered bonds, accounting for 40% of debt issuance in 2011. The LTRO exacerbates this trend. Post LTRO, several banking systems now have encumbered over 15% of their balance sheets.
Declining bondholder recovery rates keep funding costs high: Bondholders face increasing subordination from this balance sheet encumbrance, reinforced by depositor preference laws (in some countries) and imminent legislation on bail-in bonds. Combining these factors suggests that unsecured funding cost for banks will remain high – potentially too high for some business models to make economic sense.
What can the banks do?: If funding costs can’t come down to economic levels, banks will either have to look for other sources of funding, or shrink. Alternative funding sources could include further covered bond issuance (encumbering balance sheets further) or aggressive growth of deposit franchises (thereby shrinking lending margins).
What can policymakers do?: One offset to lower recovery rates is to reduce the probability of default. It is unclear whether Basel 3 compliance does enough to re-assure funding markets. If not, we may need further ECB measures to support banks now that the precedent of the 3-year LTRO has been set. This increases the perception of the ‘nationalisation’ of funding structures.
Encumbered assets % of Total Assets (excluding derivatives) EURmm...
In some cases, such as the Scandi banks and their covered (mortgage) bond, the levels of encumbrance are not always a sign of a broken business model - but we have highlighted several names near the top of the encumbrance tables that also rely heavily on repo (a topic have been thought leaders on for some time) as potentially problematic.
In a nutshell, the ECB (or broad collateralized lending liquidity facilities) has taken more and more of the balance sheet of Europe's banking system out of the reach of the private debt markets (and real money) - leaving fewer and fewer assets at the bottom of the pyramid and leaving less and less quality collateral available (otherwise why would be seeing ECB margin calls on such a large scale so quickly).
Whether it be their direct actions with Greece (specifically subordinating the world) or their indirect actions with LTRO collateral needs, the systemic risk of Europe's banking/sovereign credit system is far higher now than it was before (and credit markets have already begun to adjust to this new reality - senior spread decompression, recent sovereign underperformance, and LTRO-Stigma - even if equities remain dumbstruck with the implicit print-fest - though very recently European financial equities have joined the credit drop more closely).