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The Next Circle Of Spain's Hell Begins At 5% And Ends At 10%

Tyler Durden's picture




 

Three weeks ago we discussed the ultimate-doomsday presentation of the state of Spain which best summarized the macro-concerns facing the nation and its banks. Since then the market, and now the ratings agencies, have fully digested that meal of dysphoric data and pushed Spanish sovereign and bank bond spreads back to levels seen before the LTRO's short-lived munificence transfixed global investors. However, the world moves on and while most are focused directly on yields, spreads, unemployment rates, and loan-delinquency levels, there are two critical new numbers to pay attention to immediately - that we are sure the market will soon learn to appreciate.

The first is 5%. This is the haircut increase that ECB collateral will require once all ratings agencies shift to BBB+ or below (meaning massive margin calls and cash needs for the exact banks that are the most exposed and least capable of achieving said liquidity).

The second is 10%. This is the level of funded (bank) assets that are financed by the Central Bank and as UBS notes, this is the tipping point beyond which banks are treated differently by the market and have historically required significant equity issuance to return to regular private market funding. With S&P having made the move to BBB+ this week (and Italy already there), and Spain's banking system having reached 11% as of the last ECB announcement (and Italy 7.7%), it would appear we are set for more heat in the European kitchen - especially since Nomura adds that they do not expect any meaningful response from the ECB until things get a lot worse. The world is waking up to the realization that de-linking sovereigns and banks (as opposed to concentrating that systemic risk) is key to stabilizing markets.

UBS: A 10% Tipping Point

Greater ECB use defers the point at which a sovereign or bank faces a funding challenge, but accelerates the point at which a return to private market financing is unlikely without external support. We continue to see a level of 10% of funded assets financed at the central bank as a tipping point beyond which banks are treated differently by the market and have historically required significant equity issuance to return to regular private market funding. Spain’s system just passed this figure, reaching 11% with the most recent announcement of ECB drawings

 

 

And a 'bad bank' ahead...

 

We believe that Spain will need an EU program to raise sufficient funds for what we believe needs to be significant further support for its banks and to provide external verification to regain credibility in the resulting financial system. A ‘bad bank’ to deal with the €323 billion in real estate assets is necessary, but not sufficient, in our view: the €545 billion shortfall in domestic savings compared with loans is likely to demand a “funding bank” in addition. We would view the likely loss content of this large headline to be a significant but smaller €100 billion.

Nomura: De-linking sovereigns and banks is key to stabilising markets

The most effective response for Spain would be to de-link sovereigns and their banks, following recent steady accumulation of sovereign debt by peripheral banks, in our view. Reducing the link between Spanish banks and the sovereign remains one of the key aspects for relieving pressure on Spain, whether this be by removing sovereign debt from balance sheets or ensuring sufficient capitalization to absorb losses. Unemployment out this morning at 24.4% shows the fragile state the economy is in, which is likely to keep pressure on Spanish yields. Against this backdrop the effect on the asset side of balance sheets is concerning, with expected weakness in non-core government bond prices coupled with a weak economy decreasing individuals' and corporates' ability to repay

 

If all agencies downgrade Spain to BBB+ or below, the ECB could increase haircuts by 5% on SPGBs

 

The key aspect in terms of the Spanish downgrade(s) is the ECB's LTRO. If all three rating agencies move Spain to BBB+ or below then under the ECB's current framework it moves into the Step 3 collateral bucket which requires an additional 5% haircut across the maturities. In classifying its risk management buckets, the ECB uses the highest of the ratings to determine an asset's position (unlike the sovereign benchmark indices which use the lowest rating, in general). Fitch and Moodys currently rate Spain at A and A3 respectively, with both having a negative outlook in place leaving only a small downgrade margin before Spain migrates to the lower ECB bucket.

 

Italy's position is marginally more precarious in that it shares Spain's A3 rating from Moody's but is rated lower at A- by Fitch, and is similarly outlook negative from both agencies. One would hope ECB pragmatism would prevail and move to be more accommodative on its collateral haircut rules on sovereign debt.

 

The weakness of the eurozone's growth outlook is undermining the efforts of many sovereigns to rein in budget deficits, thereby highlighting the self-defeating nature of the fiscal compact as currently defined. Including the political impact, this has potential to lead to further downgrades

 

 

LTRO funding is not suitable when collateral values are unstable LTRO, like all repo funding, should only have been implemented with quality assets to avoid excessive margin calls. In 2009-10, when the operations were used to good effect, the majority of European sovereign assets were still perceived to be 'risk free'. 5-year SPGBs rallied from 4.95% in mid-2008 to 2.62% in December 2009 and non-performing loans were at roughly half of their current levels. In 2009, despite economic weakness, risk had generally been contained through continued fiscal programs, and with the ECB providing continued cheap funding it was sufficient to allow some normalization. The key difference between then and now is that sovereigns no longer have the ability to utilize the fiscal side. When the ECB announced the twin LTROs at the end of last year the sovereigns were clearly in a different state from 2009.

 

If the ECB believes in the mandated reforms it should be comfortable with warehousing sovereign risk

 

If the ECB believes in the currently prescribed course of reforms and their implementation it should have little issue with holding a major sovereign's collateral on its balance sheet. Taking this a step further, the ECB is generally concerned with moral hazard, which along with subordination, is likely also a reason why we have yet to see the SMP program buying bonds recently. But this is a double-edged sword in that it gives investors little confidence in the sovereigns' recovery prospects if the central bank appears to be in internal turmoil and is showing no action besides utilizing measures that are more suited to a strengthening market. One of our common refrains during the crisis is that moral hazard should not frame the reaction function of central banks. Rather, the over-riding and immediate objective of policymakers during a crisis needs to be avoiding non-linear or dual equilibrium risk. This requires aggressive and bold policies to be enacted. Europe's policymakers have notably failed on this front, and, hence, we have a crisis that has entered its third year.

 

 

The ECB’s discomfort is no comfort to investors, eroding confidence

 

The key question remains in Spain as to who is the marginal buyer of debt beyond the domestic banks and primary dealers. Although the Spanish Treasury has sold a significant amount of its 2012 requirements, as things currently stand the country faces a multi-year funding problem. The extent to which domestic savings filtering through to bond buying is limited given that the general level of savings is likely at its limit. Banks, Santander and BBVA, have also said that they have no more capacity for further sovereign bond purchases given they are at the limit of their risk concentration limits (link), which we think was rather diplomatically put. One risk is that domestic institutions shorten their SPBG holdings and focus more on bills, which would likely be unaffected by any debt restructuring.

 

We will see a worse situation before any meaningful response is produced by the ECB: QE

 

Our view is that things will get significantly worse before any meaningful policy response occurs. From the ECB?s perspective this entails pre-announced QE in a size which is commensurate to the problems faced. If the ECB believes in the actions taken by sovereign governments, which it has largely mandated, then its current responsibility is to stabilize sovereign markets in order to facilitate sovereigns' continued financing. The key inhibitor is the deterioration in the political union and the consequent ability to formulate a political response. Absent a proportional policy response, euro breakup remains more probable than possible at this juncture.

Key takeaways for us are:

  • the 5% haircut that will force margin calls on the most cash-strapped banks;
  • the 10% funding level beyond which the ECB's intervention in the banking system becomes restrictive and self-defeating;
  • LTRO funding is not suitable when collateral values are unstable LTRO, like all repo funding, should only have been implemented with quality assets to avoid excessive margin calls;
  • greater ECB use defers the point at which a sovereign or bank faces a funding challenge, but accelerates the point at which a return to private market financing is unlikely without external support;
  • and finally, the most effective response for Spain would be to de-link sovereigns and their banks, following recent steady accumulation of sovereign debt by peripheral banks, in our view.
 

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Mon, 04/30/2012 - 00:40 | 2384343 derek_vineyard
derek_vineyard's picture

I thought 5-10% was the minimum score to graduate university

Mon, 04/30/2012 - 01:14 | 2384373 Ahmeexnal
Ahmeexnal's picture

question time with Farage:

http://youtu.be/6lE9H2VH_tk

Mon, 04/30/2012 - 03:34 | 2384449 Ghordius
Ghordius's picture

you should add the part where Nigel got some heat from the rest of the panel in a similar discussion in 2010   http://youtu.be/s5LxWwfyHyY

Mon, 04/30/2012 - 00:48 | 2384352 q99x2
q99x2's picture

I hate margin calls.

Mon, 04/30/2012 - 00:49 | 2384353 Ahmeexnal
Ahmeexnal's picture

crisis? cual crisis tio?  joder! a bailar la macarena!

www.youtube.com/watch?v=6IQ0snWgef0

 

Mon, 04/30/2012 - 00:54 | 2384357 chump666
chump666's picture

Take the pain...Spain.

Mon, 04/30/2012 - 00:56 | 2384359 Desert Irish
Desert Irish's picture

Unfortunately the pain in Spain is going to become our pain shortly............

Mon, 04/30/2012 - 03:32 | 2384448 ChrisFromMorningside
ChrisFromMorningside's picture

This feels like Survivor. First Greece got voted off the island, now Spain, soon Italy. 1-by-1 they go.

Mon, 04/30/2012 - 01:00 | 2384364 FinalCollapse
FinalCollapse's picture

Bullish! The price can only go up - as per decree by Keynesian Klowns from FED/ECB. 

Mon, 04/30/2012 - 01:08 | 2384368 Conman
Conman's picture

This can only be market positive, you know since everyone lowering guidance for next quarter is a good thing, all news is good. BTFD, err i guess i should say BTFT(op)

Mon, 04/30/2012 - 02:03 | 2384407 SumSUN
SumSUN's picture

All data I've been seeing points to a future of weak currencies.  Governments will up the ante on austerity, then central banks will step in with their "ammunition".  Then it will be fixed again just before the shit hits the fan.

Mon, 04/30/2012 - 01:57 | 2384404 SumSUN
SumSUN's picture

Watching Bloomberg right now, and apparently, one point something billion just "vanished" in Australia.  Surrrre...  Vanished...  How about evaporated?  Vanished is the new vaporized.

Mon, 04/30/2012 - 02:02 | 2384406 theTribster
theTribster's picture

Spain needs more debt to solve their problems - obviously.

/sarc

Mon, 04/30/2012 - 02:15 | 2384414 l1b3rty
l1b3rty's picture

Spain is Greece

Greece is Spain

Spain and Greece are US

US is Spain and Greece, etc.

http://silvervigilante.com

Mon, 04/30/2012 - 03:04 | 2384432 crawl
crawl's picture

I'm sure the CB will likely pretend the quality of the paper it is willing to receive is AAA+, regardless of the true rating. Avoiding reality is key for the EU to continue, especially the ECB. Special ' investment' vehicles will likely hold the papers that are too toxic to pretend to be AAA+, to limit downside risk. Smoke and mirrors, little fear of downside risk in the markets, sense of security TPTB will intervene can only cause the markets to rally. For now.

Mon, 04/30/2012 - 03:14 | 2384438 DutchR
DutchR's picture

Lol,

"One item on the list of eligible securities of the European Central Bank (ECB) is a Portuguese bond from the year 1943. It will be roughly 8,000 years before this money is due for repayment on Dec. 31, 9999." (http://www.spiegel.de/international/europe/0,1518,766856,00.html)

 

 

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