THE ECB IS MAKING THE BANKS AN OFFER THEY CAN’T REFUSE
By Walter Kurtz, Sober Look
If you are the ECB and you are not legally permitted to purchase outright material amounts of eurozone bonds (at least not now), what options do you have left to stabilize the eurozone? One option that has been kicked around is you would lend to the IMF, who in turn would buy the bonds. But that’s tricky to implement and would run into all sorts of opposition.
An alternative is to have the eurozone banks load up on more sovereign debt, but the trick is to incentivize them to do so. What ultimately brought down MF Global when they held sovereign bonds was a funding squeeze. They held these bonds via a short-term repo and the counterparties refused to roll the repo loans.
Keenly aware of this issue, the ECB is making banks an offer the can’t refuse – term funding via 3-year loans at 1%.
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| ECB Benchmark Rate |
Now the banks don’t have to worry about financing by purchasing bonds with maturities under 3 years and locking in the spread. Of course the worry is still default risk. But it is fairly certain that Spain for example is not going to default in the next six months. At 3-4% the Spanish 6-month bills now look attractive as the banks would be locking in 200 – 300bp with no capital usage (the 1-3-5 rule: borrow at 1% lend at 3% and be on the golf course by 5.) In fact the bills could be used to satisfy the banks’ liquidity ratio requirements as well.
So the only risk remains is a significant downgrade of Spain within the next six months, making Spanish debt ineligible as collateral at the ECB. The AA- can and probably will drop at least a notch. But no worries – should Spanish debt get downgraded to junk, the ECB will simply waive the rating requirement as it did with Portugal.
In response, the Spanish six-month bill yield is down 300bp from the peak.
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| Spanish 6-month bills yield (Bloomberg) |
This solves two problems for the ECB:
1. It gets banks to buy material amounts of eurozone sovereign debt where the ECB is unable to do so.
2. It also slowly recapitalizes the eurozone banks by giving them an opportunity to make significant amounts of money over time without much capital usage.
* Walter Kurtz is a credit specialist at a NYC based hedge fund.
Exactly. Brilliant piece. Although in this ZIRP world, the usual phrase of 3-6-3 rule has somehow morphed into 1-3-5.
Who the hell wants to wait until 5 pm to get on the golf course?
maybe just on the practice?
Well then. Problem solved! Get out there and buy!
Eye opener of a piece. Thanks for posting this Cullen. This reeks of an undercover QE in europe, which means it may be time for some risk on.
I think it’s more subtle than Cullen’s explanation.
No expert, but I believe that if you want to draw the three year facililty, you have to post collateral of at least three year’s maturity. A three month Spanish bill won’t cut it. But there are other, existing, facilities for those bills.
So what has changed ? The new facility is not really new, it just has a longer maturity.
If you hold the expanded form of eligible collateral, of three years maturity or more, you can use this new (extended maturity) facility to prefund (for example) debts falling due in 2012. And meanwhile park it in short-term bills issued by Spain. For a spread of 1.5 % pa and, since it’s short-term, no problem with Basle III.
Provided you have the three year collateral. Why wait to prefund if you are being paid 1.5 % pa to go for it now ?
Discussed on FTAlphaville. Hope it’s okay to give them credit – they credit this site when due – but delete if it goes against the rules here, and apologies. But hopefully everyone is friends.
+1
I’ve been trying to learn about this angle of the crisis via FT Alphaville and have been left scratching my head more often than not, due to my own ignorance as opposed to their explanations.
However, their opinion seems to be that the LTRO isn’t funding some massive carry trade like this piece suggests.
Warren had some comments on this as well.
Oops,
Not a Cullen thread. Apologies to Cullen and all others.
Yes, this is Walter’s article. He’s excellent and deserves the credit.
Here’s a good piece for anyone confused. I am not quite sure this is the panacea some think it is. A help, but a fix? I am skeptical…. http://blogs.wsj.com/marketbeat/2011/12/20/ltro-will-help-short-term-funding-but-backdoor-qe-it-probably-is-not/
Cullen,
Sarkozy as quoted by Reuters on Dec 9th:
http://www.reuters.com/article/2011/12/09/eurozone-idUSL5E7N900120111209
“But French President Nicolas Sarkozy told reporters the ECB’s move to provide unlimited three-year funds to cash-starved European banks would be more effective, by enabling them to continue buying government bonds.
“This means that each state can turn to its banks, which will have liquidity at their disposal,” he said.”
Why do you think it took so long for the market to recognize the impact of this idea?
What this article is stating was pretty much what was known two weeks ago. I just find it odd that the information dissemination would be so inefficient.
Thanks.
Seems a great example of how investor sentiment can make a supposedly ‘efficient’ market look downright dozy. For a while there, players just couldn’t see beyond the negative. Will they now mistake the ECB’s policy for a ‘European QE’ and overreact to the upside?
I don’t think the market actually believes this is a fix….Will banks really load up on sov debt for a mere carry trade if there is still default risk? I can’t imagine they will….
No panacea. The panacea has to come from the governments.
So long as the ECB is the major player, I think it’s safe to assume that nothing has changed – ie the political will is absent.
There is potential for this to help prolong the Euro until some real political solution, but it’s not a panacea. For one thing, Euro banks were already in the process of selling down their PIIGS exposure, so at best this reverses the new trend enough to stabilize yields, at worst it only slows the trend, with yield spreads still widening, but at a more gradual rate.
Also, the idea that Euro banks can flip a “risk-on” switch and start levering their balance sheets with PIIGS debt seems far-fetched. There are investment committees and risk officers galore that will have to be placated, both of which are staring down the barrel Basel III next year.
Finally, the “risk-free” spread involved in this ECB concocted trade is dependent on yields stabilizing and solvency fears fading into the background. Without a political resolution, i.e. dismemberment of unification, this seems like a short-term phenomena at best.
This can work, if the ECB is willing to adopt the Fed’s mantra of A) allowing 100%, Grade A dogsh*t to be pledged as risk-free collateral B) ensuring Euro banks won’t be stressed with new capital requirements that actually risk-test their balance sheets, and C) ensure Euro banks don’t have to actually mark their PIIGS assets at market, or at the very least are allowed to do so at their leisure. If the ECB will play along they could technically push off their LOLR responsibilities onto the Euro banks, but it’s a risky proposition, and in no way does it fix the underlying problems within the EMU.
More risk-free money for banks, yay!
Meanwhile the people of Europe have to go through masochistic austerity begging for money.
Oh this system… we now live under pure fascism, and still there is people who thinks this is worth saving ‘just because it could be worse’. Coward, cynical or both?
Walter, this is a great post, and I thank you for it. As another reader said, this could be one of the main “reasons” for today’s big rally.
Cullen and all you readers, do you think it is possible that this will turn into a strong monster rally that will carry through to the end of this year? Will the fund managers of underperforming funds feel impelled to chase this rally?
I think this has a good chance of turning into a moonshot or even a multi-month uptrend, but as a technical guy I’ll be keying off the S&Ps 200-day moving average just above here before I place any major bets.
There’s also the fair probability of a false breakout to the upside, one which rockets up fast enough or grinds higher long enough to suck the remaining players in. If after that point complacency and optimism return, if ECRI maintain their recession call while facing increasing ridicule, and if Europe finally disappears from the front pages having presumably ‘dodged a bullet’, that’s when I’ll be cashing in my chips.
@OnTheMoney, thanks. And the S&P500 200 day moving average is currently at 1260, not very far away from today’s close of 1241. Could be a good trade if the market can make it through this resistance level that has stopped it before. I have heard more than one person argue we could be in for a blow-off top some time in the next few weeks. Then perhaps the bear resumes. I like the odds for your possibility of a false breakout.
I don’t pretend to understand the details of LTRO, but it seems to me that if banks are allowed to buy sovereign debt, then use it as collateral for LTRO loans, then use those loans to buy more sovereign debt, use it to borrow more from LTRO and so on, that would imply a huge amount of money creation by the ECB.
Wouldn’t that imply a lot of inflation?
I don’t see how it is different from allowing the ECB to buy sovereign debt directly (except that LTRO allows banks to pocket the interest spread). Are there any limits on how much debt can be purchased by LTRO?
This is a recapitalization of Eurozone banks via a carry trade that is bulletproof, because the ECB will renew the three year duration of the program so that all but the weakest banks can rally. The high yield sovereign debt that is the carry will catch a nice bid so that the GIIPS can get some air. Monti is a smart guy; what we have is a slow motion, partial bailout of the GIIPS via the banks, and a recap of the banks via the ECB using GIIPS sovereign debt as the carry.
Jon Corzine must have known that this was in the bag. Monti is a fellow Goldman alumnus. Unfortunately for Jon and MF Global, his timing was a little too early-he got greedy. RISK ON!
It’s working in getting yields down and will give the politicians time to come up with something.
Is there a limit to which the banks can load up on soveriegn ???
Why are you skeptical Cullen ????
Reasons for being skeptical were given by @Mountaineer above:
“the idea that Euro banks can flip a “risk-on” switch and start levering their balance sheets with PIIGS debt seems far-fetched. There are investment committees and risk officers galore that will have to be placated, both of which are staring down the barrel Basel III next year.
Finally, the “risk-free” spread involved in this ECB concocted trade is dependent on yields stabilizing and solvency fears fading into the background. Without a political resolution, i.e. dismemberment or unification, this seems like a short-term phenomena at best.
”
Euro banks will do this in the short term and to a limited extent. But they don’t want to go to far in this direction, as it can bring them even closer to insolvency if political events and GIIPS sov bond prices turn against them.
Credit to Mountaineer.
Given intermediate MtM risk borne by banks in this carry trade it will only help the short end of the curve
+2
This is shock & awe. Apparently, it isn’t just Italy that has to roll over a lot of debt in Q1 CY 2012. So do a lot of banks. Carry trade, huh????
http://www.moneynews.com/Headline/European-Banks-ECB-Loans/2011/12/21/id/421701
The only comment I have here is re mention of techincials like 200ma etc etc and of course refs to will it work. Thin market ,moves little to do with macro this side of the New Year so leap if you like ,but over this period it’s pretty meaningless because it’s ‘Little Johnny’ in play and ‘he’ tends to get sent to the corner as soon as the teacher returns post the New Year anyway.
Behind all of this stuff we still have a slowing global growth trend and policy which promises to be too tight in Europe especially so whatever ‘kick’ sovs and rollover of bank debt get’s in the Qtr1 2012 it’s hardly likely to get that growth trend turning around. By that I don’t see big hedgies and corps treasurers reversing the moneyflow they have been making on the strength of this manouver.They’ll want a lot more convincing than this in terms of polictical certainty.As for the consumer my suspicion is they are bagging forward and will be conspicuous by their absence in the New Year anyway.
So they are enticing the banks to do QE for them. Nice that they can share in the profit, the banks really deserve a break being the good citizens they are.
1) The 3Y-LTRO is NOT fixed rate. The rate paid is the average rate of the MRO during the operation’s lifetime. ECB is not a rate setter on such long maturities. So the banks do carry interest risk.
2) ECB does margining with collateral market value. If collateral market value falls, the banks will have to post more of it. As a result the operations are nothing compared to QE but just an extended maturity LTRO.
The big news is basically the collateral relaxation. Moreover, the NCB’s have a say on collateral value (the also assume the risk in such a case), so Greek/Irish banks should be able to get substantial liquidity from the ECB for 3 years instead of the overnight ELA mechanism.
More in the ECB bulletin: http://www.ecb.europa.eu/pub/pdf/mobu/mb201112en.pdf