As Spanish CDS surge and bonds shrug off the very recent gloss of a 'successful' Italian debt auction, the sad reality we pointed out this morning [11] is the increasing dependence between Spanish banks, the sovereign's ability to borrow, and the ECB. As ING rates strategist Padhraic Garvey notes this morning, the bulk of the LTRO2 proceeds were taken down by Italian (26%) and Spanish (36% of the total) and the latter is even more dramatic given the considerably smaller size of Spanish banking assets relative to Italy. The hollowing out of the Spanish banking system, via encumbrance (ECB liquidity now accounts for 8.6% of all Spanish banking assets), is a very high number - on par with Greek, Irish, and Portuguese levels around 10% where their systems are now fully dependent on the ECB for the viability of their banks. His bottom line, Spain is not looking good here and while plenty of chatter focuses on the ECB's ability to use its SMP (whose longer-term effectiveness is reduced due to scale at EUR214bn representing just 3% of Eurozone GDP), consider what happened in Greece! The ECB did not take a Greek haircut and so the greater the amount of Greek debt the ECB bought, the greater the eventual haircut the private sector was forced to take. By definition, every Spanish bond that the ECB buys in its SMP program increases the default risk that private sector holders are left with. Only outright QE, a promise not to default and a willingness to expand the ECBs balance sheet with ownership of the entire stock of Spanish debt if necessary (in the extreme) would be enough to cause a material positive effect from ECB intervention but it is clear from the massive compression in German yields (and weakness in Spain) that the market remains nervous amid an ongoing preference for core. Of course the cycle of crisis, as BNP noted, from crisis to complacency is becoming more chaotic and less sustainable.
[12]
ECB dilemma / Bank liquidity
Latest central bank data (which comes out with a lag) shows that the 2nd 3yr LTRO was dominated by Spanish and Italian banks. Specifically we estimate that Spanish banks took down 36% and Italian banks took down 26% of the total. The larger takedown of Spanish banks here is significant as the size of its banking assets are lower than those of Italy, hence in proportional terms Spanish banks have shown the greatest need for 3yr LTRO cash.
On an on-going basis Spanish banks now take down some 316bn of ECB liquidity, which represents 8.6% of its banking assets. This is a very high number. By way of comparison Greek, Irish and Portuguese banks take down some 10% to 12% of their banking assets in ECB liquidity, and these systems are basically fully dependent on the ECB for the viability of their banks. Spanish banks are not far behind on this metric. The next worst are Italian banks with the liquidity takedown of 6.5% of their banking assets.
Bottom line, Spain is not looking good here. There has also been a warning shot aimed at Ireland from the ECB's Asmussen, who asserts that the current amount of liquidity support extended by the ECB and through ELA (additional liquidity support through the Irish Central Bank) "needs to be substantially reduced over time". He also warns that Ireland should be very careful on any deviation from the original promissory notes agreement, suggesting that any restructuring here should be preceded by reduced bank reliance on emergency liquidity assistance.
At the other extreme, Dutch banks take down a mere 0.4% of their banking assets in ECB liquidity, and latest data show German banks taking liquidity to the equivalent of 0.6% of their assets. We estimate that German banks took down 8% of the 2nd LTRO while the Dutch take down was significantly small. The French need for ECB liquidity is higher, with total ECB takedown running at 147bn, which represents 1.7% of its banking assets, and we estimate that French banks took down 12% of the 2nd 3yr LTRO.
In the past three weeks there has been evidence that the beneficial effects of the two 3yr LTROs are largely behind us, with spreads under widening pressure again. In the meantime there has been no evidence of ECB bond buying through its SMP program. While the SMP may be resumed and would have a positive impact, it could ultimately risk making things worse. Why? Consider what happened in Greece. The ECB did not take a Greek haircut. So greater is the amount of Greek bonds that the ECB bought, the greater was the size of the private sector haircut required in order to get to the 120% medium-term debt/GDP target.
A baseline assumption is that the same could happen in the future i.e. if there had to be, say a Spanish, restructuring (albeit unlikely) at some point in the future that the ECB would not share in the pain. By definition then, every Spanish bond that the ECB buys in its SMP program increases the default risk that private sector holders are left with. The SMP program has survived the Greek default event because the ECB did not take a haircut, but that action in itself has impaired the effectiveness of the SMP. Only outright QE, a promise not to default and a willingness to expand the ECBs balance sheet with ownership of the entire stock of Spanish debt if necessary (in the extreme) would be enough to cause a material positive effect from ECB intervention.
A more positive gloss has taken hold in the past few days, coinciding with Italy getting paper into the market yesterday amid a strong convergence theme for peripheral spreads to core. However, the fact that 2yr Schatz trade close to a single digit and that the 5yr area is trading so rich to the curve tells us that this market remains very nervous amid an ongoing preference for core.