Since the start of the year, global markets have been apparently buoyed by the understanding that Draghi's shift of the ECB to lender-of-last-and-first-resort via the LTRO has removed a significant tail on the risk spectrum with regard to Euro-banks and slowed the potential for contagious transmission of any further sovereign stress. In fact the rally started earlier on the backs of improved perceptions of US growth (decoupling), better tone in global PMIs, and potential for easing in China and the EMs but it does seem that for now the ECB's liquidity spigot rules markets as even in the face of Greek uncertainty, as George Magnus of UBS notes, 'financial markets are most likely to defer to the ECB's monetary policy largesse' as a solution. Both Magnus and his firm's banking team, however, are unequivocal in their view that the next LTRO will unlikely be the last (how many temporary exceptions are still in place around the world?) and as we noted earlier this morning, banks' managements may indeed not be so quick to gorge on the pipe of freshly collateralized loans this time (as markets will eventually reprice a bank that holds huge size carry trades at an inappropriate risk-weighting) leaving the stigma of LTRO borrowing (for carry trades, substitution for private-sector funding, or buying liquidity insurance) as a mark of differentiable concern as opposed to a rising tide lifts all boats as valuations reach extremes relative to 'broken' business models, falling deposits, and declining earnings power.
They expect a EUR300bn take up of the next LTRO, somewhat larger than the previous EUR200bn add-on - but not hugely so - as the banks face a far different picture (in terms of carry profitability) and yet-to-be-proven transmission to real-economy credit-creation that will make any efforts at a fiscal compact harder and harder to implement as its self-defeating austerity leave debtor countries out in the cold. The critical point is that unless the market believes there will be an endless number of future LTROs, covering the very forward-looking private funding markets for banks, then macro- and event-risk will reappear and volatility will flare.
UBS, European Credit Tracker
The three-year LTRO of December was the latest in a long line of ECB innovations designed to stabilise a rapidly deteriorating environment – in this case, at least in part to reduce the possible need for the Italian banking system to resort to Emergency Lending Assistance (ELA) as the macro and political crisis there intensified, in our view. We believe the upcoming LTRO will not be the last as, like most of the ECB’s actions, the scheme is substituting for durable political conclusions – in this case, Eurobonds.
There is much discussion of the likely size of the end-February LTRO take-up, with the high end of market expectations close to €2 trillion and many commentators expecting €1 trillion. We expect a much smaller figure – around €300 billion – for two key reasons.
1. Bottom up doesn’t meet top down
From a bottom-up perspective, we cannot see how very large figures are something that individual bank managements will feel able to justify. As an example, let’s take Santander, simply reflecting it is the euro area’s largest bank by market value. We believe Santander took €23 billion in ECB financing in December (a figure which, along with several other banks, the company will not confirm, suggesting to us a lack of comfort in its size). The €23 billion would represent a modest 2% of the funded balance sheet, well below the 10% of central bank funding from which companies have historically struggled to return to private sector funding without substantial capital increases.
Possibly a large carry trade…
Compared with the net €200 billion increase in ECB funding in the December LTRO, a net increase of €1 trillion would suggest individual banks taking a multiple in February. What would they do with it? For illustrative purposes, say the bank takes three times as much – in this case €69 billion. Does one buy €69 billion in Spanish government debt to play the carry trade – one that is already much less profitable than it was two months ago (Chart 2) and in a size that would be significantly in excess of the group’s total Spanish government debt holdings pre-LTRO (Chart 3)?
Could the bank reasonably expect to be able to sell that amount of government bonds in the future without disturbing the functioning of the market? Would the equity market not apply a capital requirement to such a large amount of interest rate and credit risk, even if regulators presently do not?
If not the carry trade, substitution or expensive insurance
If not for a carry trade, what would a company be doing with that amount of money? One of two things – substituting for private-sector funding or buying liquidity insurance. We remain unconvinced by the idea that ECB funding is a close substitute for private-sector money over time – a view supported by banks’ issuance activity in January, discussed later in this report. And if one were to be buying liquidity insurance, such a large sum would suggest to the market that the company were fearful of extreme outcomes in the near future.
Practically, therefore, we believe that most banks with the realistic prospect of financing themselves in private markets over time (which naturally includes Santander, a current issuer) will likely limit their take-up of the next LTRO.
2. One more is not enough
The LTRO has been seized on by equity and credit markets as the saviour of economies and banks. It could indeed prove to be so – but only in our view if there are an indefinite number of future LTROs stretching out ahead. As soon as there are none, some macroeconomic risk will appear from the list of Greece, Ireland, Portugal, Spain and Italy to provide a challenge to the financing of the banks – and would be likely to cause a return to the funding concerns prevalent at the end of 2011.
Bank funding markets are very forward looking, as those buying long-dated debt need some reason to believe the borrower will be able to redeem at maturity.
Therefore, as soon as the LTRO window is closed, we are once more counting down to the point at which banks’ funding is challenged – a point which will be accelerated by the macro volatility implicit in trying to run a single currency without socialising the debts of the currency area.
“The Thing”. Or Not
With the SX7E bank index up 17% YTD, the market is in our view discounting that the LTRO has proven a fundamental turning point in the euro area crisis. In Chart 7 we highlight that the reception to the original, “game changing” one year LTRO in 2009 was a rise in the index of 42%, leaving those of us with a sceptical view considerable scope for being wrong in the immediate future – certainly in to the end of the month, as expectations build for the potential size of the upcoming LTRO. However, in what is now a long-lived crisis, there have been many “turning points” thus far and three years on, the index is broadly flat.
Meanwhile, the earnings power of the banks has declined sharply. Chart 8 shows the change in our 2012 forecasts over the last twelve months. As a result, the PE multiple of most euro area banks is higher than a year ago in spite of lower share prices.
To be ‘the thing’, the LTRO needs to catalyse confidence in euro area sovereigns with non-European buyers of sovereign debt, because the current owners of the debt are typically non-domestic and non-bank.
LTRO a partial substitute for the private sector
The LTRO is likely to be different things to different banks in different countries at different times. For example, an Italian bank last December, facing one year sovereign yields of 6%, the complete closure of private sector term financing and the resultant gradual withdrawal of wholesale deposits would in our view be wholly justified in embracing the LTRO to put term back into its balance sheet structure, restoring confidence.
It would also have had an excellent case for buying short-dated government bonds with the proceeds, with risk adjusted returns high. Would the same straightforward picture apply to, say, an Italian investment bank at today’s prices? We believe not. Questions the company would need to ask itself would include:
- What does one characterise the trade as being? Note that some banks (HSBC, JP Morgan, Deutsche) can finance themselves in private markets on an unsecured basis on terms comparable to the secured financing available from the ECB. Therefore, is the trade to fund legacy assets? Being provided with three years to run off these portfolios is an appealing option, but potentially opens the bank to the perception it can't afford to sell them.
- Would the funding be to finance peripheral government bond purchases? What confidence does one have that these are money-good, other than nonbinding political statements? And given the “all in together” Greek experience, what confidence does one have that one is not “encouraged” to roll at maturity if times are tough then?
- One is opening oneself to the political risk associated with making profits from central bank (that is, taxpayer) funding and potentially paying those profits to staff or shareholders.
- A carry trade requires capital for stress loss absorption from the rating agencies, so the profits aren’t free.
- Expanding one’s balance sheet is counter-intuitive heading into a recession, with stressed wholesale markets, regulatory reforms and heightened macro uncertainty.
- If one is substituting for private sector funding, the maths are interesting. As an illustrative example, say a bank with €20 billion in annual maturities finances the next two years (€40 billion) in the LTRO and avoids issuance completely, at significant benefit to the P&L. This means in year 4, it suddenly now has €60 billion in refinancing needs. This is a long-dated problem but not one we believe prudent banks would be relaxed about incurring.
- Finally, while the ECB has stated that there is no stigma to LTRO usage, it is already striking that equivalent schemes in the US, UK, Sweden and Switzerland have been retired. It must be a consideration for bank management that non-euro area investors or counterparties may regard central bank financing as indicative of financial weakness – particularly if several euro area banks do not take the financing, as they don’t need it and don’t want to take on the risks outlined above.
We expect a €300 billion take-up
We believe the take up of the next LTRO will be somewhat larger than the net €200 billion last time – but not hugely so. This reflects the potential constraints imposed by the questions above; and the natural tension between the interests of shareholders and other stakeholders.