Earlier in the week we began discussing the stigma that would likely be attached to the banks that decide to borrow from the ECB via the LTRO. Many talking heads including Mario Draghi himself, arbiter in chief of all risky collateral in Europe, dismissed this - reflecting back at the compression in credit spreads in the market-place as evidence that all was well and confidence was returning. In the last week our (senior unsecured debt) index of LTRO-ridden banks has underperformed non-LTRO-ridden banks by 23bps to a 75bps differential. This is the largest divergence since the LTRO began and corrects off mid-Summer tight levels of difference as the critical flaw that we also pointed out earlier in the week (that of the implicit subordination of bank assets via ECB's LTRO collateralization). Credit Suisse agrees with us and expounds on 'the flaw' in the LTRO scheme noting that the market is fickle and self-sustaining at times (as we have seen) but over time (and that time appears to be up this week), the market will weigh the liability side of the balance sheet versus the asset side, less haircuts (which implies haircuts will become the de facto capital requirements) and inevitably (given bank earnings potential) reflect this huge differential - most specifically in the senior unsecured debt market. With few shorts left to squeeze, spreads back at pre-crisis levels and financials having dramatically outperformed even large gains on sovereigns, the weakness in senior financial debt in Europe this week is more than just a canary in the coal-mine, it should become the pivot security for risk appetite perception.
“There is no stigma whatsoever on these facilities,” Draghi said at a press conference in Frankfurt yesterday. “Some have made some sort of statements that I would call statements of virility, namely it would be undignified for a bank, a serious bank, to access these facilities. Now let me say that the very same banks that made these statements access facilities of different kinds -- but still government facilities.”
We Disagree (or rather - the senior unsecured debt market Disagrees)
Our indices reflect the average credit risk of six major banks that accepted LTRO loans EULTRO (and hence subordinated their senior unsecured debt holders) and six major banks that did not EUNOLTRO. The lower pane shows that the difference compressed back to pre-crisis levels of the summer and this week, as the reality of the flaw in the LTRO was brought to people's attention, the Stigma of LTRO subordination has appeared writ large in a quite significant underperformance (of almost 50% rise in the spread differential).
Credit Suisse: The Flaw
The market is essentially proceeding on the assumption, as we see it, that banks’ capital requirements can be met organically, through earnings and deleveraging. We want to be very careful about leaning too hard on this; we have insisted for a long time that the banking system needs to shrink, and that the capital markets would grow to match. But this is not a short-term process and cannot be, if it is to remain orderly.
The 2011 consensus range of bank capital requirements was € 100bn to €400bn; the log. average, €200bn, always seemed like a sensible estimate to us. The market is proceeding on the assumption that the need has all but gone away; many estimates now centre on €50bn. Such numbers strike us as ridiculous; the Greek banks alone are absorbing that (see above) and Anglo-Irish absorbed €30bn. This is (yet) another of those cases where a number is small until it is needed, at which point it grows.
But the market has made these moves in thinking despite our long asserting the premise that liquidity cannot cure a solvency issue, and it is liquidity that has been the big change.
Partly, “the paradox of thrift”. Each bank individually can credibly plan to delever, but collectively the system cannot. But even if the inherent contradiction is recognised, it is hard to act on immediately.
Debt is no cure for debt. What it can do is prevent a self-fuelling Fisher-style debt-deflation and it is clear that the LTRO has at least to some extent achieved that. And it can buy time such that, if the basic business model is restored, solvency can be earned. But we are not sure the business model has been restored; far from it. Here again, our caution and outright mistrust needs to be tempered, and at least patient. But the apparent widespread notion that the LTRO is a game-changer simply does not wash in our view, because of our premise. Game-saver (no Fisher); yes. Game-extender, which makes it a potential gamechanger; yes. Outright game-changer; no.
So what’s the flaw?
The flaw is that, even in 2012, we retain respect for markets. Unfettered, they are not the tool of choice for resolving the current situation but we see it as essential to work with them and harness their power, rather than against them, as we discussed in Twelve Steps.
In Greece it is now clear that the process of avoiding a credit event for the past 21 months has been ruinously expensive. Frustrate the markets (again, individuals making rational, fiduciary decisions, not some conspiracy pursuing an agenda) and they will find a way around the frustration, in our view; in the meantime, costs will increase due to the inefficiencies created, as has happened in Greece.
The result that we now expect in the European banking system is in our view rather beautiful.
The Basel Accords have a patchy track record – to put it at its most generous – and the EBA has almost no track record at all and as we see it, even less credibility in the eyes of the market. The market is fickle (and in this situation self-fuelling, so it must be tempered; indeed it has been by the LTRO), so it cannot even trust its own estimates (as stated above, they are all over the map). But it cannot be frustrated in seeking comfort on such an important issue as restoring trust in the biggest banking system in the world, in our view.
In the banking system just as in Greece, the rescue funds are coming in at a senior level.
There are therefore two kinds of bank; those with the market’s full confidence, which will be able to fund at a “senior” but partially subordinated level, and which can repay everything without question (see Flash of 20 January) and those who cannot. The price of time to the latter is ever-further subordination in a self-fuelling circle. Over time, the market will empirically, and with efficient pricing, weigh the liability side of the balance sheet versus the asset side, less haircuts (so haircuts become the de-facto capital requirement), tranche by tranche, maturity by maturity, and see what happens. If there is any insolvency in the European banking system, it will eventually appear, independent of Basel or EBA requirements (which may still becoming binding, of course). But it is hard to see how it appears before some time has elapsed. In this environment, competition for retail deposits, of which the European banking system is chronically short, largely because of its size, will become ever more intense.
Inevitably, due to the mark-to-market nature of repo, the banking system is now even more sensitive to mark-to-market, further baking volatility into the cake.
This reinforces our idea that the ultimate arbiter of bank capitalization is the senior unsecured market.
We suspect that organic earnings retention cannot be the solution.