While today's rumor of a massive QE program by the ECB to be announced tomorrow has temporarily stopped the sovereign spread widening, we are skeptical that it will achieve much in the mid-term. As in all other recent cases of CB intervention, the half life of this particular involvement will likely have short-term benefits at best. So what happens when the leakage resumes? The first immediate response will be a hike in various repo margins by LCH. Clearnet, as was the case with Irish bonds. Goldman's European Equity Research provides an overview of the key milestones and trigger events in LCH's methodology as it evaluates who may be affected next.
If the Irish case is to go by, the spreads on Spanish government debt would need to widen further, towards the 450 bp over Bund mark, before additional LCH.Clearnet (LCH) margin requirements would be triggered, in our view. Whilst the spread on Portuguese government paper is close to this mark, there is substantial additional room for Spanish (we estimate it at more than 190 bp) or Italian (more than 270 bp) spread widening. Additional margin requirement would create headlines and – we believe – shift repo volumes to the ECB. Whilst the funding costs would increase by some 10-30 bp to 1% ECB rate, the access to volume of funding would not be affected, in our view.
In October, the Spanish banks cut their reliance on the ECB by €40 bn or by 36% compared with the previous month. In our view, the bulk of this should be attributed to use of central clearing through LCH. Introduced as late as August 2010, centrally cleared REPOs on Spanish government bonds allowed banks to achieve better terms than those offered at the ECB (1%). Decline in the usage of the ECB facility, and the increase in LCH REPO usage is therefore driven by economic benefit, in our view. Similarly, we expect that were a cost of a centrally cleared REPO to rise above that offered by the ECB, the volumes at the ECB could “snap back”.
Typically, the cost a bank faces to fund a sovereign bond portfolio, through a tri – party repo transaction, consist of: (i) the funding rate (“repo rate”) for the duration of the repo and applied to the market value of the bonds REPOed; (ii) additional funding cost, mostly in the form of the haircut / margins required by the Central Clearing House as a collateral. The higher the haircut / margin level and the marginal funding cost, the higher the cost of the borrowing, which becomes ineffective when it exceeds the cost of ECB repo facility (1% repo rate + haircut funding cost).
The Irish case: margin requirement increased when the spread exceeded 450 bp threshold
In November, LCH increased the margin level on Irish sovereign bond repos (from the original level of 1-3%) in 3 stages, which we outline below:
- November 10: increased margin requirement for Irish sovereign bond REPO by 15%;
- November 17: an incremental 15% increase, citing a spread “consistently over 500 bp”;
- November 25: an incremental increase of 15%.
Thus, the current total margin requirement stands at around 46%-48%, depending on the maturity. This is taken from both parties involved in a REPO transaction (i.e. LCH is nearly 100% covered by margins in the event of Irish default, even excluding proceeds from sale of the collateral).
Potential implications for other markets
While the LCH does not state any specific rule or guideline for margins definition, general comments can serve as an indication of what could materialize in similar instances:
- 450 bp spread over benchmark a key level. LCH’s Risk Management Framework states that “we would generally consider a spread of 450 basis points over the 10-year AAA benchmark to be indicative of additional sovereign risk and LCH may materially increase the margin required for positions in that issuer”.
- Definitional flexibility remains, as the AAA benchmark is not specifically defined; it is highlighted that CDS levels, credit ratings and discretion are applied during the process.
The above suggests that current widening of sovereign bond spreads, were it to continue, could trigger additional margin requirements at central clearing houses. The focus now is clearly on Portugal, Spain and Italy.
- Portuguese 10-year bond yields are currently at around 7.0% or 410 bp above German Bund, just 40 bp shy of the potential “450 bp trigger level”.
- Both Spain and Italy, however, still maintain a reasonable buffer to the trigger level, with Spanish 10-year yield at 5.4% (190 bp below the trigger level) and Italian at 4.6% (270 bp).
Since margin hiking creates a toxic spiral of increasing weakness, we are confident that these levels are a key indicator kept track of by JC Trichet's posse.