So, what it is asset encumbrance? In its simplest definition, encumbrance is a claim against an asset by another party. In relation to banks, encumbered assets are assets of the bank which have been pledged as collateral to back a secured loan or covered bond.
The degree of asset encumbrance is a real issue for European banks, as almost all interbank lending and bank financing is now being done via secured lending or the issuance of covered bonds. The unsecured senior debt market has been pretty much frozen for all but a few European banks since the summer. Looking at Dexia, the following excerpt from an October 29th FT article tells the story:
"Just three months ago, Dexia announced it had €88bn ($121bn) of quality assets on its balance sheet. With the European Central Bank offering funding for the region’s troubled financials against such collateral, this sum should have been enough to stave off disaster at the Franco-Belgian bank.
Except for one problem: less than a quarter of that €88bn was actually free to be used as ECB collateral.
Some €68bn of the assets had been already tied up, or “encumbered”, in the bank’s various funding programmes, including tapping the ECB for extra money – a factor that helped precipitate Dexia’s move into government arms this month.
With more and more banks resorting to so-called “secured funding” – or financing that is backed by specific pools of a bank’s own collateral – concerns are rising over the growing levels of such asset encumbrance."
As unsecured lending has disappeared in Europe, banks have been scrambling to obtain the highest quality collateral, which partially explains the penalizingly low yields on German and Dutch short term paper. Of note, these yields have declined even further since Wednesday's LTRO auction, just as Spanish and Italian yields rose, with the Italian 10 year bond popping back up over the ominous 7% level. (Spanish Bonds Fall After ECB; German Note Yields Drop to Record Bloomberg) Essentially, traders are willing to take a loss in order to obtain the safest securities as collateral. This does not bode particularly well for the "Sarkozy" carry trade.
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| GERMAN 2 YR |
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| DUTCH 2 YR |
ITALIAN 10YR
Note: the pre-LTRO improvement is almost completely erased.
SPANISH 10 YR
Note: The LTRO effect is holding, but watch that recent reversal.
The much heralded LTRO resulted in a net new issuance of about 210 billion euros of liquidity from the ECB. However, and this is an important however, that liquidity is in the form of collateralized loans that are marked to market. Hence, from a different perspective, the 3 year LTRO newly encumbered approximately 210 billion euros of bank assets for a much longer term. Furthermore, assets rolled from shorter term facilities into the new three year facility are also obviously tied up for a considerably longer period. The risk here is "that unlimited ECB liquidity provision, by taking collateral out of the market, is undermining private secured lending which typically recycles collateral. It is a particularly perverse liquidity trap in which central bank loosening can precipitate a credit crunch." (FT) This phenomenon has already led to broad downgrades for the credit ratings of most European banks' senior unsecured debt. BTW, this is the same thing that is occurring in the sovereign bond market. As super senior secured creditors, such as the ECB and IMF, take larger positions in a sovereign's bond market, private sector bondholders are pushed further down the ladder in case of default, notwithstanding any EU bullshit ambiguously worded promises about PSI (private sector involvement).
A key indicator of the degree of the stress in the European interbank secured lending market is a measure known as the EUREPO. (A HUGE hat tip to SoberLook for an excellent post on this subject, which can be found here.) This is a measure of the haircut applied to collateral offered to secure a repurchase agreement. The higher the EUREPO, the greater value given to the collateral. The lower the EUREPO, the less the value given to the collateral. In a low EUREPO environment, a much larger amount of collateral has to be pledged (or encumbered) in order to obtain an equivalent amount of funding. Obviously, the perceived risk of the collateral itself also plays a big role, and banks would have to offer considerably more Spanish or Italian debt than German debt if they were seeking repo funding. Again, this does not bode well for the Sarkozy carry trade. The graph below tells the story.
3 MONTH EUREPO
A picture is worth a thousand words....
Another indicator to watch is the spread between EURIBOR and EUREPO. EURIBOR measures the interest rate banks charge one another for unsecured lending. As SoberLook and I point out, there is hardly any unsecured lending occurring in the European Interbank market, so the quote here is somewhat misleading. Nevertheless, the spread between the three month unsecured EURIBOR lending rate and the secured EUREPO of similar maturity is now at 127 points. These are levels not seen since December of 2008. I do not have the peak level for three month rates, but the peak spread for 12 months was at 230 on October 31, 2008. The 12 month spread is currently at 175.6, which is the highest it has been since 2008 as well.
3 MONTH EURIBOR
The recent sharp drop is a result of the 0.5% benchmark rate reduction from the ECB
ITRAXX EUROPE FINANCIALS
Finally, the last stress indicator to watch is the use of the ECB's Overnight Deposit Facility. Banks place funds here when they basically can find no better, or safer, use for the money. The use of this facility has been making new record highs on a regular basis now, and just made a new record on Thursday - after the LTRO. From the WSJ:
The high deposit level also suggests markets aren't fully convinced that the ECB's massive long-term loan allotment is enough to fortify the currency bloc's banking sector.
ECB OVERNIGHT DEPOSIT FACILITY USAGE
What could the ECB do about all of these interbank stresses? It has already take some steps, to include reduction of reserve requirements from 2% to 1%, freeing up about 100 billion euros as possible collateral. It also dramatically broadened the assets it will accept as collateral to now include unsecuritized loan portfolios and lower rated sovereign assets. It did stop short of accepting dry cleaning receipts, for now anyway. And, of course, the biggie was the repo facility itself. However, as I have tried to show, the more banks repo with the ECB, the greater the degree of asset encumbrance they generate. As assets become more generally encumbered, accounting can give the illusion of greater financial strength and liquidity than may actually be the case, as we learned from Dexia. Of course, banks know this, which has led to a high degree of mistrust in the interbank markets and a much greater degree of dependency on the ECB. Creditors also know this, which has led to a freezing of unsecured lending to banks. The second round of LTRO, scheduled for February, is likely to exacerbate this situation further.
Other measures that could be undertaken would be lowering haircut rates for collateral, thus allowing less collateral to obtain funding from the ECB. Such a measure would certainly make Bagehot roll over in his grave, but I have to think he must be on about his tenth roll by now anyway. Allowing the use of non-Euro denominated securities, such as US Treasuries, to be used as collateral at the ECB could also be done, but this could backfire and increase selling pressure on weak European sovereigns.
So, why should you care about all of this stress in the European Interbank market?
Firstly, it is highly indicative of an ongoing and escalating credit crunch in Europe. This is already having contractionary effects on the private sector, as detailed in this article from Reuters:
"The stresses from banks are already spilling into the wider economy, as banks take a harder line on their lending.
French media and telecoms group Vivendi has been forced to raise the pricing on a 1.5 billion euro loan refinancing and Danish brewer Carlsberg is also meeting resistance from banks for a new loan.
A stark retreat in areas like project finance, shipping finance, aviation and infrastructure, as banks get rid of assets funded by U.S. dollars, may be less politically sensitive than cutting lending to small businesses, but it will slow economic growth.
The shipping industry, for example, is facing a major storm from the banks' retreat, with shippers cancelling or delaying orders as owners get strapped for cash.
The situation may get worse: analysts at Morgan Stanley estimate Europe's banks could shed up to 3 trillion euros in the next 2-3 years and up to 4.5 trillion euros in the next 5-6 years as the full extent of the financial crisis becomes clear."
Secondly, it is creating a much greater degree of symbiosis between the central bank and private banks, raising serious questions about eventual exit strategies. Gillian Tett has an interesting perspective on this in the FT, and I highly recommend it. The issues she raises are worth are post in of themselves.
Thirdly, it has strong implications for the Sarkozy carry trade. This is the idea that banks will use large portions of their LTRO borrowing to prop up sovereign debt. Let me set the stage...
European banks have 725 billion euros of maturing debt in 2012, with 282 billion due in the first quarter alone. US money market funding of European banks is in full retreat, with exposure to French banks cut by 68% in November alone. US money market funding to Europe in general has decreased by 45% since May, according to Fitch. The unsecured lending market in Europe is frozen. The secured repo environment - one of the few fund sources available outside of the ECB - is demanding overcollateralized deals with only the highest quality collateral, as evidenced by EUREPO rates. This secured lending is also resulting in a worrying degree of asset encumbrance. The ECB is applying haircuts on its lending, and marking collateral to market. In this environment, obtaining a given quantity of repo funding using Italian bonds as collateral would require a bank to pledge/encumber a much larger amount of its assets than it would if it pledged German bunds. It would also expose the bank to more MTM risk down the line.
This train of thought can lead us to a potential conclusion regarding the recent strong improvement in short term Spanish paper. This could very well have been due to banks scooping up cheap collateral that only the ECB would accept, and may not continue. We may very well see another spate of this in the run up to the February auction, although this could be muted if banks either suffer MTM collateral calls or run up against asset encumbrance regulatory limits in the interim.
Fourthly, and finally, increasing asset encumbrance through securitized borrowing could lead to bank failures ala Dexia and Bear Stearns should bank counterparties demand more collateral from banks than they are able to produce.
I'll leave you with a reading recommendation for a brilliant article by John Glover on Bloomberg entitled "Bonds Stop Flowing as Collateral Gets Stuck at ECB: Euro Credit." This article was the inspiration for this post, and I strongly recommend you read it.
Merry Christmas to all!
28 Dec Update WSJ is catching on to this story: Europe's Banks Face Pressure on Collateral
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