Doubling Down

“There is no external savior for a country that doesn’t want to save itself,” Draghi said in a speech in Berlin today.“I will never tire of saying the first response should come from the countries.”  Draghi Says There’s No External Savior for Euro Countries That Fail to Act

I insist that the markets still do not believe this.  If they did, they'd be 30+% lower than they are today.  Articles like this one, Bank of America sees deeper eurozone crisis before ECB rescue, prove my point.

However, that is not the point of my post.  I want to go back to the idea of Bass-Ackwards QE from my last post, as I think this topic is going to be what moves markets in the near term.  What brings me back to this theme is the result of an over-subscribed Spanish bond auction yesterday morning.  "The Spanish Treasury sold €6.028 billion bonds against its target range of €2.5 billion to €3.5 billion of the 3.15% January 2016, 4% April 2020 and 5.50% April 2021 bonds. It received total bids of €11.214 billion, implying a comfortable coverage of the amount sold and allowing the issuer to raise more cash than planned. ... Spain paid an average yield of 4.023% on the January 2016 bond versus 5.276% at its previous auction Dec. 1. The average yield on the April 2020 bond was 5.201% versus 5.006%at the previous sale Sept. 15. The average yield at the April 2021 bond was 5.545% compared with 5.433% on Oct. 20, below secondary market levels."  This morning, we also have generally falling yields in Europe.

The first thing I thought of when I heard of this was that banks are doubling down on their bets. 

As I described in my last post, the ECB has made available a LTRO (Long Term Refinancing Operation) Facility, through which banks can post collateral in order to obtain funds at 1%.  This is not the first time they have done this.  In 2009, the ECB conducted similar programs.  If you read the link at FTAV, you can see that some feel that these programs may have contributed to the banks loading up on high yielding, long dated peripheral sovereigns as part of a carry trade.  Banks borrowed for one year at 1% from the ECB, bought longer dated PIIGS bonds with higher yields (the short dated bonds were not yielding enough at the time), and made the interest spread.  About half of the program's 614 billion euros are estimated to have been invested in sovereign debt, mostly from Greeece and Spain, according to the FT.   What banks did with the bonds once the first LTRO facility closed is an open question, but undoubtedly many remained on the banks' HTM books.

Well, now were at it again.  As popularized by French Whack-Job President Sarkozy, the idea would be that banks can again use this money to gain an interest spread on sovereign debt, thus supporting bond prices. 

French President Nicolas Sarkozy said the ECB's increased provision of funds meant governments in countries like Italy and Spain could look to their countries' banks to buy their bonds.

"This means that each state can turn to its banks, which will have liquidity at their disposal," Sarkozy told reporters at the summit in Brussels. (RT)

 

Next Tuesday, the LTRO will hold its first auction, and markets will be watching closely to see how well the offering is subscribed.   As mentioned, this time the term will be for three years as opposed to one, at a rate of 1%.  This is the just first leg of a three pronged liquidity program.  Secondly, the type of collateral that can be offered to the ECB in return for these loans has been widely broadened, to include non-securitized, non-rated loans.  To quote Draghi, "Our second measure will allow banks to use loans as collateral with the Eurosystem, thereby unfreezing a large portion of bank assets. It should also provide banks with an incentive to abstain from curtailing credit to the economy and to avoid fire-sales of other assets on their balance sheets."  Thirdly, reserve requirements will be halved.  "The third measure we announced last week is to reduce the required reserves ratio from 2% to 1%. This measure frees up liquidity of the banking sector by about 100 billion euro. Along with other measures, this reduction in the reserve requirements should, too, help revive money market activity and lending."  Beyond these announced measures, we also have this little gem from MNI this morning, in which the ECB is advocating for a delay in the implementation of Basel III capital ratios,

So, banks are now given the opportunity to borrow against almost any asset they hold in order to potentially buy sovereign debt, all while reducing reserve pools and avoiding capital raises.  Sounds like doubling down to me.

The big question is - will they take the bait?

In answer, it appears that some already have.  I find it hard to explain the results of yesterday's Spanish auction otherwise.  (If you have an alternate explanation, please post it in comments.)  Some speculate that it will largely be the smaller and medium sized banks that might participate in this Martingale carry trade.  A good article dealing with this question can be found in the FT, titled Doubts over ECB move to boost bond sales.  I won't rehash that here, but highly recommend you read the article.

IF this trade does develop as Sarkozy hopes it will, I can see several potential pitfalls, beyond the obvious one of doubling down on very volatile and risky assets.  Firstly, such a trade would only be attractive to European banks.  This would serve to concentrate risk within the Eurozone, and may present non-European banks with an attractive opportunity to sell remaining European sovereign debt holdings.  Remember, these non-European banks have been tolerating default risk to hold this debt.  Now, they appear to be facing currency risk as wwell.   Secondly, banks would very likely be "encouraged" to buy the debt of their own sovereign.  This could serve to repatriate sovereign debt and compartmentalize risk within individual Eurozone countries, and may not be a bad thing if a dismantlement of the EMU occurs.  On the other hand, such domestic preference could lead to selling pressure from non-domestic EMU banks, in addition to the selling pressure from non-European banks mentioned above.  Finally, what would such a re-leveraging into volatlle assets mean for bank ratings?

ECB repo extension a fillip for sovereigns

You Can Bank on It: European Banks Need Tons of Money

Banks resist European pressure to buy government debt