While hardly news to those who have been following our coverage of the shadow banking system over the past two years, today Reuters has a curious angle on the European "repo" problem: namely, it appears that over the past several months the primary marginal source of cash in the ultra-short term secured market in Europe are not banks, the traditional "lender" of cash (for which banks receive a nominal interest payment in exchange for haircut, hopefully, collateral) but the companies themselves, which have inverted the flow of money and are now lending cash out to banks (with assorted collateral as a pledge - probably such as Italian and Greek bonds), cash which in turn makes its way to none other than the ECB (recall that as of today a record amount of cash was deposited by European "banks" with Mario Draghi). From Reuters: "Blue-chip names like Johnson & Johnson, Pfizer and Peugeot are among firms bailing out Europe's ailing banks in a reversal of the established roles of clients and lenders. One source with knowledge of the so-called repo deals or short-term secured lending, said the two U.S. pharmaceutical groups and French carmaker were the latest to sign up for them." Which intuitively makes sense: as has been well known for years, companies are stuck holding on to record amounts of cash, although what has not been clear is why? Now we know, and it is precisely for this reason: corporate treasurers have known very well that sooner or later the deleveraging wave will leave banks cashless, and corporates themselves will have to become lenders of last resort, especially in a continent in which the central bank is still rather concerned about sparking inflationary concerns.
Naturally, in this environment in which the traditional lender-borrower relationship has been flipped, reading news such the notification that Libor has actually declined, creates nothing but hilarity. Of course this kind of complete lack of credibility is precisely the problem. Unfortunately European financial institutions have none left. What is far more concerning is the question of just how far this practice has spread: have American cash rich companies handed out cash to Euro banks "pledged" with European sovereign bonds (with or without a haircut), and if so what happens when the collateral is found to have far less value than presumed? Once again we go back to MF Global, which blew up precisely for this reason: is the entire Investment Grade space about to get whacked on concerns it has Italian bonds on its balance sheet, via the repo market, instead of actual cash 'and equivalents'?
More from Reuters:
Europe's banks are struggling to secure the cash to fund their day-to-day business and have largely stopped lending to each other for fear Europe's sovereign debt crisis could land any of their peers in trouble.
As a result a group of well-known, cash-rich companies with solid cash flows has stepped in the repo market, which provides a form of lending so far almost exclusively in use between banks, and between banks and central banks.
One market participant said in one key area of lending companies now accounted for 25 percent of these deals.
Oddly enough, once received the cash goes not back into the economy to spur money velocity, but is parked with the ECB:
Repos provide the new financiers with the strict guarantees they need before parting with their cash, answering worries that the crisis has weakened Europe's banks to the extent that they might not be able to pay the money back.
"Companies in the past were ... happy to deposit cash on an unsecured basis to a bank for an interest payment," said Frank Reiss, who oversees some of the repo business at Euroclear, the Brussels-based settlement house owned by a group of banks.
"Now following the crisis, we have seen that companies are engaging in repos secured with collateral against the cash they are lending," said Reiss. Euroclear is the largest administrator of repo trades in Europe.
At the moment the European Central Bank provides the main lifeline for banks and has pumped hundreds of billions of euros of cash into the market.
But the banks are parking most of the money they borrow back at the ECB rather than trusting to lend to each other.
It is time to shift focus from banks and straight to the top of the Investment Grade pyramid:
It is typically these very large companies, with reliable cash flows, that engage in repo deals with banks, Euroclear's Reiss said, though he declined to give the names of any counterparties, because of client confidentiality.
Corporate treasurers are typically extremely wary of talking about their day-to-day cash management, and Johnson & Johnson, Pfizer declined to discuss the matter. Peugeot was not available for comment, while other large companies contacted by Reuters also declined comment.
And while we have covered the topic of shadow banking and repos extensively since early 2010, here is the 30k summary of the relationship:
Regulators cracking down on "shadow banking" -- closed-door deals blamed in part for the 2008 financial crisis -- have expressed worries about how opaque the repo market is, and the U.S. Federal Reserve has set up a working group to suggest reforms.
The rise in repos means more business for companies such as Euroclear and its main rival Clearstream -- owned by Deutsche Boerse (DB1Gn.DE) -- as well as Bank of New York Mellon (BK.N), JP Morgan (JPM.N) and State Street (STT.N).
In a repo trade, one party buys collateral from the other, with the obligation to sell it back at a pre-defined later date and for a slightly lower price -- the so-called haircut. That way, the seller provides cash to the buyer.
When companies rather than banks engage in repo deals they typically rely on a third party for administering the collateral, in what are known as triparty repos.
The triparty market grew at 22.3 percent in the first half of last year, a survey by the International Capital Market Association (ICMA) showed, versus only a modest rise in the overall business, further prove that companies are increasingly accessing the market.
"It shows you that triparty is growing, but ... not the banks themselves," said Richard Comotto, an academic who is involved in drawing up the survey. "I would say triparty is very growing strongly among corporate treasurers."
The European repo market was worth 6.2 trillion euros ($7.88 trillion) in the first half of 2011, according to ICMA's September survey. The vast majority of business conducted was between banks, and banks and central banks.
The biggest concern is that with every passing day increasingly more "good money" is being recycled into the system however collateralized by increasingly worse collateral, until the weakest of all collateral will have to be utilized. This means that the actual value of the currency is also declining as it is backstopped by "assets" that have progressively lower LTV to the cash they pledge. And the biggest threat for Europe, one which we will observe shortly, is that unlike in the US, the bulk of traditional corporate lending is via secured loans, which already have assets pledged as collateral, unlike the US where the bulk of lending is via "guaranteed" loans that are unsecured and thus only have a recourse to corporate cash flow. This means that as more and more cash is needed, absent a wholesale corporate restructuring in which corporate loans are "de-liened", collateral will necessarily have to be of ever spottier quality until the entire shadow banking system implodes once again. Of course, the fact that this is the case does not mean that anything will be done to fix it. For the simple reason that there is nothing that can be done to fix it.
In the meantime, focus on those uber-safe IG companies with "massive" cash hoards. Something tells us the world will be quite surprised to discover it mostly consists of Italian bonds floating around at a 2% haircut somewhere in the multi-trillion repo market.