That European wholesale, and particularly dollar, funding has been "problematic" in past weeks is an understatement. One merely needs to look at the Fed's recent expansion in its transatlatnic swap lines to figure out that someone, somewhere is struggling to meet their USD-denominated obligations. However, is it just one bank, as recent data out of the ECB suggest, or is this merely a symptom of a far more acute underlying cause? Alas, as Barclays' Joseph Abate confirms by looking at the transformation in funding patterns within that most fulcrum of European banking systems - that of France - the threat is far more prevalent than has been speculated. In fact, based on the rapid transition in funding from unsecured to secured lending markets within French banks in general, and one name in particular, it seems that while SocGen stock may have avoided its daily rout courtesy of the extension in the short selling ban, there is a far greater concern for the bank: one of maintaining orderly daily operation funding. And there is little that European stock market regulators can do to restore liquidity, aka confidence, once it starts evaporating. Which it has... although mostly in unsecured markets... for the time being. Should secured funding (ABCP and Repo) wilt next, then it gets really, really bad. To wit: "Bank funding worries have flared up again with the news that the Federal Reserve’s currency swap line with other central banks has been tapped at least twice this month. The trivial amounts borrowed belie significant wholesale funding stresses for some institutions in dollar markets." Let's take a look at what "some" means...
- Total financial CP outstanding is down 15%, or $90bn, since the start of June. Foreign bank outstandings are down nearly 20%, accounting for almost half of the decline in total financial CP over the period.
- WAMs have shortened as issuance piles up in overnights and replaces longer tenor (3m) paper. Average overall daily financial CP issuance has fallen to $3.5bn since June – down more than 50% from the average pace between January and May.
- The reduction in prime money fund holdings of French paper has been comparatively small – about $15bn in July. However, the decline probably accelerated in August.
- Given their confidence shock and the market’s sensitivity to bank funding news, it will probably take some time before prime funds return to unsecured lending markets. Repo and demand for bills (along with AB-CP) should therefore remain robust through the fall.
Step 1 is admitting you have a problem...
Although the pullback in dollar funding for these banks has not reached crisis proportions given their large liquidity cushions, it has likely caused some banks to reduce their activity in dollar markets. Operations such as matched books and securities stockpiling that require access to large amounts of dollar funding are being scaled back.
...Alas, nobody is prepared to do that yet. Which means the dollar will have to do it for them. And it already is, pretty much everywhere, except Libor:
Bank funding markets can’t seem to catch a break. After some calm in 2009, worries about exposures to sovereign credit have flared up several times since 2010. And although the current flare has not pushed LOIS up as dramatically as in early 2010, it has pushed term LOIS about 20bp wider in 2012 (Figure 1). The modest reaction in spot Libor, however, belies significant strains in the market. Indeed, news that the Fed’s currency swap program was tapped at least twice this month for trivial, one-week amounts set off a firestorm of super-heated press coverage. As we have written, these borrowings are expensive and likely represent the actions of small banks completely shut out of dollar funding markets. They are by no means representative of the behavior of large, multi-national global institutions. That said, speculation and concerns are likely to continue in an already-nervous marketplace, but the signs of true financial stress lie elsewhere.
Unsecured funding in the form of non-AB Commercial Paper is now virtually frozen:
While the borrowings from the Fed’s liquidity program have taken center stage, the financial stress experienced by the largest banks has shown up primarily in the CP market, where banks are finding it more difficult to raise dollars. Financial CP outstanding has declined by 15%, or $90bn, since the end of May (Figure 2). And the decline in paper outstanding from foreign institutions has also been acute – down nearly 20%. By contrast, domestic outstandings are down 3% over the same period. (Domestic issuers with foreign bank parents have experienced the biggest decline in outstanding paper – down 24% since the end of May)
It gets better... er, worse.
Troublingly, the decline in outstandings has been accompanied by a sharp change in issuance patterns. Daily issuance has fallen from an average of $7.4bn/day between January and May to $3.5bn/day since the start of June. At the same time, the issuance has become much shorter. Paper with an original maturity of more than three months has declined from 15% of total issuance in May to 10% so far in August. The result is that the WAM of all CP outstanding has contracted two days since the end of July. In effect, investors (typically money funds) are rolling less paper, and at a shorter maturity than earlier this year, reflecting their unwillingness to take on term unsecured bank risk.
Compared with the behavior of the commercial paper market during the first sovereign flare-up in spring 2010, the decline in outstandings has been a bit steeper (Figure 3). Outstanding financial paper declined by nearly 10% in the nine weeks following the April 27, 2010, S&P downgrade of Greek sovereign debt. By contrast, in the nine weeks after June 1, outstanding financial paper has declined by 15%.
Sorry Italy, this time nobody cares about you. It is all about AAA-rated (not for long) France:
In recent weeks, particular attention has been focused on French banks and their access to dollar funding. But how much has their funding declined? The Federal Reserve does not break out the CP data by the origin of the bank’s headquarters. However, the CP figures ignore other sources of French bank dollar funding – particularly Yankee CD issuance, which for most global banks is a much larger portion of their financing, as well as repo. Although imprecise because it ignores other cash lenders, we reckon we can estimate the total amount of French bank dollar funding by examining trends in the money fund holdings.
Four banks (BNP, Societe Generale, Natixis, and Credit Agricole) account for nearly all the money fund exposure to France. As of July 29, total money fund holdings of these banks’ paper – in deposits, repo, and commercial paper – amounted to 8.6% of institutional prime fund balances. By contrast, at the end of June, these banks accounted for 9.0% of prime institutional balances. Fitch puts the money fund exposure to these four institutions at around 11% of its sample of the ten largest prime money funds, mostly unchanged from the end-of-July ratio of 11.2%. The difference between our calculations of prime fund French exposure and Fitch’s estimate reflects the fact that the latter is based on a sample of the largest prime funds, while ours is based on the entire universe. Clearly, the 60% of the funds outside of the Fitch sample hold little to no French paper, so the aggregate holdings (8.6%) are smaller than Fitch’s estimate of 11% from the bigger players.
At first blush, French bank dollar funding from the nearly $1trn prime institutional money fund industry appears to have hardly changed – falling by less than $15bn, to $79bn at the end of July. Our calculation is only $5bn more than the amount of the reduction implied by the Fitch figures. The estimated $15bn reduction across all front-end instruments is smaller than the reduction in foreign bank CP (including domestic banks with foreign parents) during July, which totals $30bn. In other words, the contraction in foreign bank CP outstanding has not been exclusively a French bank story; other banks’ access to unsecured funding has also retreated.
How about second blush?
We believe that the relatively small reduction in money market funding of French banks belies a significant change in the composition of that financing. We split the funding from prime institutional money funds into secured (repo and asset-backed CP) and unsecured (primarily deposits and CP) for each of the four banks in both June and July. The figures reveal that the two largest money fund funders (BNP and SocGen) – kept the level they borrowed from these money funds constant in July (at roughly $25bn each) by shifting from unsecured to secured instruments. For instance, the proportion of BNP unsecured funding from prime funds declined from 76.2% in June to 72.6% in July. Likewise, SocGen reduced its unsecured financing from 95.3% to 83.8%. The remaining institutions, by contrast, did not change their funding mixes, which remain heavily skewed to deposits. Between them, they saw their funding from money funds decline by an average of 36%, accounting for all of the small reduction in French bank CP funding. Thus, the French banks have reacted to market funding concerns mostly by altering the composition of their funding – reducing the amount of deposits and commercial paper they sell to prime money funds while increasing their repo borrowings.
Of course, it may be premature to dismiss a sharper decline in money fund holdings of French banks’ short-dated paper and a deeper contraction in their access to dollar funding. In the weeks since the end of July, foreign bank CP has contracted by an additional $30bn. And it is possible that there has been a further reduction in deposit and repo holdings. However, these updated data will not be available until mid-September. More important, is a reduction in access to front-end financing a significant problem for foreign banks?
So we have an unsecured paper funding crisis. Now what? Why, enter the Fed of course, which again generously bailed out foreign banks with a massive dollar deposit surge as reported first by Zero Hedge. Ah yes, but the nearly 20% drop in USD deposit balances at the Fed is the clearest warning sign that not even the Fed is bailing out Europe's banks properly any longer.
From the perspective of the European banks, the reduction in their money fund financing is significant but not incapacitating. These institutions have so far nimbly shifted the composition of their funding toward more secured alternatives to reduce the effects of the reduction in money market funding. And as many have already noted, non-US institutions have a surplus of dollars – most of which currently reside at the Federal Reserve. Foreign-related banks currently have an estimated $700bn on deposit at the central bank – of which an unknown but large proportion is owned by European banks. The decline in these balances since the end of QE2 in June, however, suggests that the increased difficulty of raising dollar funding may be causing these banks to cut back on operations that require plentiful access to dollar funding – such as their matched books and securities inventories.
This is just the beginning...
These banks are by no means desperate to raise dollar funding. Instead, they appear to be mostly holding the line on borrowing costs, refusing to chase yields higher. This (and their long dollar positions) is a reason the increase in Libor since its mid-June trough has been so mild – certainly compared with the 2010 sovereign flare-up. Of course, no bank – domestic or foreign – can survive for long without access to dollar funding. Instead, their thick dollar liquidity buffers and the winding down of certain dollar-heavy businesses buy banks several months and some flexibility such that the 60bp priced into the December ED contract seems a bit extreme.
As always, Libor is the last to go: first very slowly, then very fast, as the entire French banking system, once one reads between the lines of the above, finds itself in funding limbo, and it last lifeline, that of secured repo funding, disappears. At that point we will be talking not about $500 million in USD swap lines going to rescue French banks, but vicious orders of magnitude greater.
We just hope this latest market realization of facts happens after Labor day: is it too much to ask for at least one week without the world blowing up, please? Plus the higher stocks go up in the interim, the more fun it will be to short from a higher vantage point.
Lastly, we are confident that uncle Warren is currently taking a bath with an atlas of Europe, feverishly trying to come up with his latest Eureka moment.