Following yesterday's €489 billion LTRO there are few things we know with certainty, primary among them is that the net proceeds from the 3 year refi operation are really €210 billion, due to the rolling of various other duration facilities which are already in use into the LTRO as discussed yesterday. What we do not know, is whether the net proceeds of €210 billion have been used by banks to purchase sovereign debt or as Peter Tchir suggested, are actually used in a reflexive ponzi whereby banks use the explicit ECB guarantee to buy their own debt. Perhaps the best evidence that the LTRO was an epic failure when it comes to subsidizing the peripheral bond market is the fact that hours after its completion the ECB was forced to jump into the secondary market and buy up billions in Italian and Spanish bonds: an action that was supposed to be conducted by the banks themselves. But let's assume that the entire €210 billion form the first LTRO (and there certainly will be more) is used to fund carry trades: what then? Well, luckily UBS has performed a mathematical analysis which looks at how much paper profit banks can extract from said trade and juxtaposes it with the most recent €115 billion capital shortfall calculated by the EBA in its most recent stress test (not to be confused with the second to last stress test which saw Dexia pass with the highest marks possible). The result: woefully insufficient . In other words, anyone who believes that the LTRO will be used by banks as a source of carry "profits" is massively deluded. If anything banks will find creative loophole to prop up their balance sheets and issue more of their own debt instead of chasing pennies in front of the bond vigilante rollercoaster by loading up on more sovereigns. Because the last thing Italian banks can afford is another late Novemeber blow out in yields which brought the system to within hours of imminent collapse.
Below we present the hypothetical analysis from UBS Atsushi Ito, which was conducted before the final allocation was known. Keep in mind that UBS assumes an amount of €320 billion is used for full carry allottment. Instead we know that the most currently available is €210 billion or 66%. In other words, take all the numbers, notably "profits", from the analysis, and haircut them by a third.
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..
Summary - max profits thru the stress test deadline in a non-hypothetical situation €4.1 billion when there is a €115 billion hole to be plugged? And in reality, for a €210 billion carry trade the maximum profit is... €2.7 billion!? And the market ramps on this?
So can we please move on from the LTRO as the Deus Ex du jour now?