RUT EOD

Not much to say lately.  This count is my best shot, but my confidence level is less than stellar.

DAILY

10 MIN

A Quick Note on the IIF

The IIF's (Institute of International Finance) MD, Charles Dallara, is heading negotations with the Greek government on PSI.  The total PSI figure is about 200 billion euros.  From Bloomberg,

"Financial firms on the IIF’s private-creditor investor committee, a larger group of 32 members that includes the smaller steering committee, hold more than 47 billion euros in Greek sovereign debt, according to data compiled by Bloomberg from company reports."

47/200 = 23.5% of private bondholders' holdings.

Question:  Just how representative and binding will some type of eventual accord between the IIF and Greece really be?

Ψ Options (UPDATE 1)

The title of this post is the Greek letter Psi, and, of course, I am going to talk briefly about the Private Sector Involvement in writing down Greece's debt.  I already posted about this before, but things have changed quite a bit since then.

As a condition to getting its next bailout tranche to pay a March bond redemption, Greece needs to get private creditors to write down enough of the ~200 billion euros of Greek debt they hold to theoretically allow the country to achieve a debt to GDP ratio of 120% by 2020.  Creditors are willing to voluntarily take about a 69% NPV haircut, for an average coupon of 4.25%.  The troika wants a 3.5% coupon, which is more like an 80% NPV hit.  If they don't come to an agreement, theoretically, Greece defaults - hard.

In my previous post, I spoke of potential blocking positions held by hedge funds.  It seems this may not be as relevant as I thought.  SoberLook has some great work about this issue, and I would refer you to this post and its comments.

So, if the hedgies are not in a position to block, what's the hold up?  I think there are really two answers to the question.  Worries about CDS' being triggered are not one of them.

Firstly, banks realize they hold the upper hand.  A Greek default would cause the realization of losses for taxpayer funded entities, like the EFSF.  So far, there have been no realized losses for governments, and every effort is being made to avoid them for fear of stirring public rage.

Secondly, the IMF has recently been applying pressure for public entities like the ECB to take part in the restructuring.  They are doing this because their October 2011 estimates for 120% debt/GDP by 2020 with a 50% haircut have worsened along with Greece's economy, and that same haircut would now leave Greece with a 135% ratio.  Of course, the ECB publicly is proclaiming that it will not take part in the restructuring, with Germany supporting their position.  But, like nearly everything about this Euro crisis, be careful what you believe.  As I see it, the ECB will take part in the haircut, as it is the single largest holder of GGB's, at an estimated 40 to 60 billion euros.  (Whether that is par value or acquisition value, mostly at ~70 cents, I don't know.)  To not do so would further frighten investors in distressed sovereigns, as the ECB as a super senior creditor would lessen the pool of discountable bonds should PSI be necessary elsewhere - like in Portugal, for example.

What are the ECB's options in this regard?

1.  Retain the bonds and write down them down from par to the acquisition price.  This would be seen, correctly, as debt monetization, and would probably not be enough of a write-down to make a difference.
2.  Retain the bonds and write down them down to well below the acquisition price.  Again, debt monetization, as well as a hit to the ECB's capital.  It could make up the capital hit either through seniorage or a capital call to its shareholders.
3.  Sell the bonds to the EFSF at the acquisition price, which will then do the write-down on its books.  This would lead to the EFSF's first realized losses, and may serve as a wake-up call to its guarantors that this mess may actually cost their taxpayers some cash.
4.  Sell the bonds back to Greece at the acquisition price.  This would give Greece about 15 to 20 billion euros of debt forgiveness, assuming 45 to 60 billion par value GGB's acquired at a 30% discount.  Of course, Greece does not have the money to buy back the bonds, so that would have to come from its bailout package, lowering the amount available for the future.


Of course, this all assumes that the technocratic government in Greece will be able to apply enough sphincter lube to accept the latest set of Troika demands, spelled out here:  Troika spells out its demands

Stay tuned....

Greece, Portugal, And LTRO  (TF Market Advisors)

UDPATE:  "The German government wants Greece to cede sovereignty over tax and spending decisions to a eurozone “budget commissioner” to secure a second €130bn bail-out, according to a copy of the proposal obtained by the Financial Times." (FT)  Now we're talking SERIOUS sphincter lube!

Stand Or Fall

Remember this chart from my early October post?  I used it to make the argument that the top in the DJI had not occurred in May of 2011 because the decline into June was not impulsive.  Well, I still stand by it.

DJI SUMMER 2011

This is now important because the DJI has now exceeded its July high, which I mistakenly called the truncated top of Primary [B].  Obviously, this means that the DJI is NOT in Primary [C]!

So, where might it be?  Three possibilities that come to mind, from most to least bearish.

1.  Still in Intermediate (Z) of Primary [B].

DJI BLUE

2.  In a Primary [X] wave of cycle b or w.  Specifically, in Intermediate (B) of Primary [X], implying a (C) wave down to complete [X].

DJI ORANGE

3.  Finished with Primary [X], and starting Primary [Y] of cycle b or w.  This is a count that I believe Binve is showing, or something like it.  To my eye, it gives us a very foreshortened Primary [X] wave.

DJI GREEN

I really don't know which of these three it might be.  I'd like to go with the blue count, given that the other two counts look a bit ridiculous in the DAX, the MID, and others.  However, the orange and green counts certainly look valid when you look at the SPX and DJI in isolation, and are bolstered perhaps by the contortions one has to go through to make the 2002 to 2007 rally into a five wave impulse.

To illustrate my point, the DAX weekly is shown, with notes on the chart.

DAX WEEKLY

If this count is correct, we should be very close to the top of Intermediate (2) of [C], as shown below.  This chart gives two possible breakouts of (2).  In black, we have a triple three w-x-y-x-z, which would be very close to a top.  In magenta, we have a simpler a-b-c zig-zag, with Minor C of (2) evolving as a potential ending diagonal, as shown by the boundary lines.  This could obviously take longer to resolve, and give us a bearish headfake signal quite soon as it progresses.

DAX 60 MIN

I'm interested in which DJI count you think is valid.  Please record your vote by color with the reaction buttons below.

"An empty face reflects extinction
Ugly scars divide the nation
Desecrate the population
There will be no exaltation

Stand or fall
state your peace tonight
Stand or fall
Let's state it tonight

It's the euro theatre
It's the euro theatre
It's the euro theatre"


Final poll tally:

Blue:  8
Orange:  2
Green:  0

Thanks for voting.

RUT, DAX

Well, here is a chance for me to look like a complete idiot.  My current count has a completed ED in the RUT, with a bit more to go in the DAX.

RUT WEEKLY

RUT 60

RUT 10

DAX 60

I have re-removed the reactions buttons.  If you want to call my counts non-sense, then you are going to have to grow a pair and put in a comment.

More DAX ED "Nonsense"

Whoever checked the "nonsense" reaction button yesterday turns out to have been correct.  Today's spirited rally in the DAX invalidated the ED the way I had it drawn.  But, being possessed of a very hard head, here is another shot at it.

DAX 10 MIN

DAX 60 MIN

From a longer term perspective, many are looking at the action since March 09 as a cycle b or x wave.  As the chart below shows, such a count really does not look plausible, IMHO, for the DAX.

DAX WEEKLY

DAX EOD

I think we may be seeing (v) of [c] resolving as an ending diagonal, especially given the three wave look to i of (v).

DAX 10 MIN

The Credit Suisse Tome

Credit Suisse has outdone itself!  The workhorses in the European Fixed Income Research department have just released a 75 page novel entitled European Public Finances in 2012.

CS European Public Finances 2012

I highly recommend you give it a read!  I am not going to attempt to regurgitate their entire paper here, but did want to make a few cogent comments.

The CS analysts adopt a relatively optimistic view.  They base this on two factors.

•- First of all, the evidence from the first of the ECB’s three-year LTROs is that much needed liquidity is being injected into the euro area financial system, which should ease, but not alleviate many of the sovereign and banking funding pressures; and

•- Secondly, the slowdown in the euro area has, so far, been less acute than we – and other forecasters have anticipated. And the prospects for growth – driven by global developments – look, in the near term, to be slightly more promising than a few months ago.


They also believe that the ECB will massively ramp up its asset purchase program in a Fed/BoE style QE, and I will discuss this in a separate post.

With regard to their first point regarding liquidity, they argue that the first round of the LTRO added a net of 200 billion euros to the banking system.  They anticipate that the late January halving of reserve requirements will add another 100 billion.  Finally, they look for over 200 billion more in the February LTRO auction, at which time changes to collateral requirements will have taken effect.

CS goes on to point out that some of this liquidity is indeed finding its way into the sovereign debt markets, particularly in short duration instruments.  An obvious case in point is the recent Spanish auction, at which Spain was able to sell twice its target amount in three year bonds.  I will concede this point for now, although I think we need to be careful not to confuse bank funding pressures, which have been alleviated for now, with sovereign funding pressures.  It is early to conclude that the LTRO has solved the sovereign issue, and the bond subordination issue I raised in my last post must be remembered, as well as the impending recapitalization challenges banks face (see SoberLook).  The rotation into shorter term debt instruments is also a red flag.  While one could fantasize about the European situation being solved in two or three years, rollover risks are building as debt maturities shorten.  (Risks from ECB debt drip - MacroScope)

 

I won't discuss their second factor - you can read the paper if you're interested.  I will say that page 11 begins an interesting discussion of austerity measures and their fiscal multipliers.  One comment in particular strikes me as patently wrong:

"It is difficult to imagine that the deficit of a country would increase as a consequence of a tax rise and/or expenditure cuts. Such an event would be quite extreme."

 

OK, then how about Greece???

Where I would particularly like to focus is on the discussion on pages 14 and 15, titled "Policy Hurdles."  Here the team identifies three risk factors to their optimistic view.

1. PSI:  I just did a post about this topic, and won't repeat it here.
2. Firewall Construction:  Here the team discusses the EFSF, the ESM, and the IMF.  With regard to the EFSF, their view remains optimistic, but their paper was published prior to the recent S&P downgrade.  It is now quite likely that the EFSF will lose its own AAA rating, and S&P is reviewing the issue currently.  This should finally put a fork in the wacky ideas regarding leveraging this facility.  As to the ESM, the CS team would like to see its implementation moved up into mid 2012 (likely), its firepower increased above 500 bn (unlikely, given the attitude in Germany), its flexibility increased (unlikely, given Finnish and other objections to "qualified majority" decision making), and its senior creditor status abandoned (unlikely, as this superb SoberLook post argues.)  Regarding the IMF, the CS team heralds the recent 150 billion euros put into a special fund by euro area countries as a resource yet to be recognized by the markets.  This may be, but (1) it's chump change, and (2) the BRIC contribution they anticipate seems unlikely.  If it comes about, it will most certainly go to the general fund, and not into the special fund for Europe.  If the IMF General Fund contributes further to the EU crisis, IMF contributing countries will expect senior creditor status, further subordinating existing private bondholders.
3. Fiscal Compact:  Here the CS team refers to the ambitious idea for tighter fiscal rules and balanced budget amendments to EZ country constitutions.  They see implementation of this as critical to paving the way for ECB QE.  Unfortunately, but not unexpectedly, this whole fiscal compact concept is dissolving into a weakly worded mush.  (Eurozone deficit limits flexible under draft).  That, in turn, has evoked the ire of the ECB, which wrote a strongly worded letter condemning the watering down of the original compact.  (ECB raps revisions to draft fiscal pact)  Whether, in the end, this topic would really be critical to the ECB's decision regarding QE is questionable, IMO.

I would conclude that all three of their risk factors look pretty risky about now.

The rest of the paper gives a country by country briefing, focusing on overview, financing needs (net and gross), public finances outlook, risks, and ratings.  I honestly have not read every country's summary, but I certainly intend to, and recommend you do as well.

The Greek PSI

As you know, talks broke down last week between the Greek government and creditors over the terms of a private sector restructuring of Greece's debt.  Greece has approximately 250 billion euros of public debt outstanding, and about 206 billion of this is held in private hands.  October's EU summit set a goal of reaching a near 100% "voluntary" participation rate in haircutting this privately held debt by 50%.  If this could be achieved, we were told Greece would be on a sustainable path, with a debt/GDP ratio of a mere 120% by 2021**.  Furthermore, further IMF/EU bailouts have been made conditional on this level of debt reduction.  As Greece is dependent on an additional tranche of bailout money for a 14.4 billion euro bond redemption on March 20th, the PSI issue is becoming critical.

Greece's creditors include European banks, insurance companies, sovereign wealth funds,  hedge funds, and distressed debt specialists.  We can further divide these groups into:

-- those responsible for their own losses,
-- those who answer to the public for their losses, and
 --those who, while technically responsible for their own losses, will get a bail-out.

I think looking at this way helps predict willingness to accept loss.  Banks, and to some extent insurance companies, are in the third category.  As a result, they are probably more vulnerable to official sector pressure to cooperate, and less concerned with the consequences of a loss.  In fact, in the case of some of the banks, a realized loss on Greek debt might fit very nicely into their recapitalization scenarios as a tax provisioning scheme (think Citigroup).

Hedge funds are another story altogether.  By some estimates, these funds may have control of around 80 billion of the 206 billion total in private hands.  Obviously, these are holders who are solely responsible for their own gains/losses.  Furthermore, many of these funds are relatively new investors in Greek debt, having bought it from delevering European banks over the past year or less.  Given the obvious risks clearly visible in their investments, as well as their late entry into the market, many of these funds have paid quite handsomely for CDS (Credit Default Swap) protection on their positions.  (For the most part, they did not get Greek CDS when they were trading at reasonable rates, although undoubtedly the cleverer ones most certainly did, and the bond purchases were just another facet of their longer term strategy.)  These funds have disincentives to hold out for anything other than either par payment on their Greek bonds or a hard default that triggers payments on their CDS protection.

Sovereign wealth funds are an interesting category.  Obviously, they answer to the public for their losses, and bailouts really don't apply here.  They are interesting because they bring the biggest single hold-out in the Greek restructuring talks out of the shadows.  That hold-out is, of course, the ECB, which is estimated to be the largest single holder of Greek sovereign debt at approximately 45 billion euros.  The ECB has clearly held that it is not in the private sector, and will not be part of the current restructuring.  Obviously, sovereign wealth funds make a similar argument - their bonds should be pari passu with the ECB.

So, what pressure can Greece bring on its creditors to cooperate?  The answer comes in the form of retro-active collective action clauses (CAC), a measure which is currently under consideration in the Greek Parliament.  The presence of these clauses could force the hand of any restructuring hold-outs - as long as they remain a minority.  However, CAC's, and particularly retro-active CAC's, raise other issues.

1. CDS related:  While the enactment of a retro-active CAC would not be a triggering event, almost certainly its enforcement would be.
2. ECB related:  In a sovereign default, all bondholders are supposed to be pari passu.  This is a principle that dates back to the first Paris Club restructuring in 1956.  While the current effort to get private holders to voluntarily restructure could spare the ECB, a forced restructuring via a CAC would be legally much trickier unless all remaining bondholders were involved - to include the ECB.  In this sense, the ECB is in a tough spot.  If it partakes in restructuring it realizes losses against a highly leveraged 80 billion euro capital base and will likely have to make capital calls to its already strapped shareholders.  If it insists on immunity from restructuring, it makes it crystal clear to holders of EU sovereign debt that, in the event of a future restructuring, haircuts will be larger based on the ECB's non-participation.  Holders of Spanish and Italian debt will realize that they were effectively subordinated by the ECB's large SMP purchases in August, and may demand yields that reflect this increased exposure.  Of course, the December EU summit declaration made some cleverly worded promises about PSI being unique to the Greek situation, while paradoxically putting CAC's into all future EU sovereign bond issuances.  I was certainly not convinced, nor was Standard and Poors, as their downgrade statement makes clear:

            "As we noted previously, we expect eurozone policymakers will accord ESM de-facto preferred creditor status in the event of a eurozone sovereign default. We believe that the prospect of subordination to a large creditor, which would have a key role in any future debt rescheduling, would make a lasting contribution to the rise in long-term government bond yields of lower-rated eurozone sovereigns and may reduce their future market access."  (S&P)

            Obviously, this issue of ECB purchases subordinating other holders would be a huge issue in the event of a large scale QE program by the ECB.

**Since those estimates were published, the Greek situation has deteriorated considerably. "J.P. Morgan warned in October that based on a 75 billion euros write-off and its expectations of a long recession, debt could reach 190% of GDP."  (WSJ)

References:

Dealing with Greece’s biggest holdout (FTAV)

The Threats to Greece’s Debt Deal (WSJ)

No Finale for Greek Debt Drama (WSJ)

Awaiting a Greek Payout (NY Times)

Greece Will Wipe Away The Draghi Magic (WSJ)

UPDATE 5-Debt talks falter, Greeks warn of disaster (Reuters)

Hedge Funds Try to Profit From Greece Debt Swap (Bloomberg)

Euro Checkers: Guide to Greek PSI (WSJ)

Credit FAQ: Factors Behind Our Rating Actions On Eurozone Sovereign Governments (S&P)

Vega Threatens Lawsuit Over Greek Debt Talks (FINAlternatives)

Hedge Funds Complicate Greek Bailout (FINAlternatives)

Greece’s creditors seek end to deadlock (FT)

Greece: Disagreement Everywhere, Rift in the Troika (Testosterone Pit)

I still plan on doing a post about possible ECB QE, but am finding the time to do so in short supply.

Fascinating Factoid:

Apple Computer; 30,000 people; Yearly Revenue $100 Bil
Greece: 11 million people, Yearly Revenue $300 Bil

An Approaching Top?

The question is - of what?  The RUT is showing some divergence on the hourly chart, and is in the process of testing its 200 DMA.

RUT 10 MIN

RUT 60 MIN

The DAX is the strongest of the big Eurozone indices at the moment, and the hourly chart points out some important differences between it and the French CAC, as well as the Spanish IBEX and Italian MIB.

DAX 10 MIN

DAX 60 MIN

Bigger picture, the blue and the magenta counts give you an idea of the debate going on in my brain.  I think much depends on whether or not the ECB launches a QE operation or not.  I intend to revisit that issue in my next macro post, but am waiting to see what happens with the ECB's interest (repo) rate on Thursday.  A move toward QE would probably be heralded by a cut in the benchmark rate to 0.75%, perhaps even 0.5%.  More on this later...

MID WEEKLY

TARGET2 Imbalances: Causes And Consequences

TARGET2 is the European System of Central Bank's (ESCB) balance of payments mechanism.  The acronym stands for Trans-European Automated Real-time Gross settlement Express Transfer system.  The purpose of TARGET2 is to provide a mechanism for the real-time gross settlement of cross-border interbank and customer payments.  The system allows for intra-day finality, which
insures that transactions will not be unwound if one of the parties fails to settle.
TARGET2 has recently been the subject of much attention given large imbalances that have appeared between net creditor NCBs (National Central Banks), such as the Bundesbank, and net debtor NCBs, such as the Bank of Ireland.  Some have claimed that these imbalances are a "stealth-bailout" of the periphery by the core.  Others claim that these imbalances are leading to restricted liquidity and possibly the need to sell NCB assets in the creditor nations.  I shall humbly attempt to address these issues and explain how TARGET2 works.  At the end, I will raise what I feel are concerns stemming from the existence of these imbalances.

How does TARGET2 work?

The system itself is rather complicated, and an understanding of it demands knowledge of what represents a bank asset versus a bank liability.  For a non-bank commercial corporation, an asset is obviously something it owns, like plant, equipment, inventory, etc.  The corporation's liabilities are things which it owes, like loans, payroll, pension obligations, etc.  For a bank, the situation is reversed.  A bank's liabilities are things it owes to others, such as demand deposits, while its assets are those things which are owed to it, such as loans.

With that background, let's look at an example of a funds transfer from a Spanish commercial bank (Bank "A") to a German commercial bank (Bank "B").  This transfer could either be a payment from one of the Bank A's account holders to a German corporation with an account at Bank B, or it could be the transfer of one of Bank A's demand deposit accounts to Bank B.

TARGET2 performs this transfer by debiting the Spanish bank's account at the Bank of Spain, and crediting the German bank's account at the Bundesbank.  Note - the transfer occurs at the NCB level.

The Bundesbank now has a liability to the German commercial bank, in that the German bank can be thought of as holding a demand deposit at the Bundesbank.

On the other side of the transaction, the Bank of Spain debits the account of Spanish commercial bank (Bank A) for the amount of the funds transfer.  This requires that the originating commercial bank have a sufficient credit balance in its central bank account.  If it does not, then manner in which the bank pays for this debit will prove crucial in our discussion to follow.

THE CRUX OF THE MATTER

The Bundesbank's liability to Bank B is matched on the asset side of the balance sheet in the form of a claim on the Bank of Spain, just as the Bank of Spain's credit from Bank A is matched by a liability to the Bundesbank.

At the end of the transaction, the two NCB's positions are as shown below.

However, at the end of each business day, these NCB positions are assigned to the ECB.  In this particular case, this leaves the Bundesbank with a claim on the ECB, and the ECB with a claim on the Bank of Spain.

It is important to remember that both legs of the transaction - the one that occurred in Spain, and the one that occurred in Germany - were settled independently of each other via the NCB's.  It is only at the end of the day that positions are netted, and that takes place between the ECB and the NCBs.  This is a characteristic of a gross settlement system versus a net settlement system, in which the failure of one party in the system can bring the entire settlement process to a halt.

So, that's how the system works.  Now we will examine why the imbalances have arisen.

Why So Much Imbalance?

Imbalances in a gross payment system like TARGET2 are nothing unusual.  In the past, NCBs usually displayed non-zero TARGET2 balances vis-à-vis the ECB, but the balance tended to be neutral on average. However, in the last few years some countries have seen their TARGET2 liabilities increase (and conversely others have seen their TARGET2 claims increase) up to six-fold or more.  This chart from a MUST-READ note by Credit Suisse (CS) illustrates the problem as of Q3:2011.

To understand why this has occurred, let me take you back to that transaction I highlighted above (labeled as "The Crux of the Matter"), in which the Bank of Spain debits the account of the Spanish commercial bank - Bank A.  In years past, that Spanish commercial bank, as well as most other banks in peripheral Europe, had ready access to private funding, often on an unsecured basis.  That funding came from US Money Markets, direct investments, and interbank loans - often from commercial banks in the surplus countries of Europe, like Germany.  Access to this private, largely unsecured funding is what allowed peripheral banks to pay off their liabilities to their respective NCBs. 

However, starting in mid-2010 with the first stirrings of the Greek crisis, investors and depositors began to differentiate between the perceived risks of banks in the periphery versus the core, and this trend has done nothing but accelerate since.  According to Fitch, US money market funds (MMF) reduced their exposure to European banks by over 45% in this year alone, and the remaining financing has migrated to much shorter duration instruments. 

Additionally, the nature of the MMF funding has changed.  MMFs have reduced their unsecured lending, partially replacing it with secured repo financing against collateral.  (FT) 

Furthermore, German banks have drastically cut their lending to the periphery, as is shown in the graph below, from the Bundesbank.

Finally, to add insult to injury, not only is private capital inflow to the periphery at a standstill, but we are also witnessing massive capital outflows in the form of depository flight from the periphery to the core, as illustrated in this CS graph.

 

In summary, we now have a situation in which the interbank market is dysfunctional, cross border loans have decreased and deposits are flowing out of the crisis countries.  As a result, these net capital outflows settled through the national central banks result in the respective NCBs accumulating TARGET2 liabilities on their balance sheets, while the countries receiving the flows (e.g. Germany) accumulate TARGET2 claims.   Peripheral banks can no longer fund themselves through the private markets, and it is the peripheral NCBs that now provide the funding in the form of secured loans against collateral.

To explain further, I find it hard to do better than quoting directly from the Credit Suisse paper.


"Due to the flight of liquidity from banks in the periphery, the ECB has stepped in and provided the liquidity, in the form of unlimited provision of funding to the banks against collateral – i.e., through MROs and LTROs.  

For that reason NCBs’ balance sheets that show increased TARGET2 liabilities vis-à-vis the ECB, generally also display increased liquidity provisions through lending operations on the asset side. The ECB stepped in to play the role of liquidity provider when there was limited flow of private funds to crisis countries and increased TARGET2 liabilities largely reflect that.

The extent to which TARGET2 reflect these imbalances in liquidity needs across the euro area is demonstrated by Exhibit 5. It shows the refinancing operations (MROs and LTROs) on the balance sheet of the Bundesbank and the NCBs of the five peripheral economies. TARGET2 imbalances became increasingly noticeable not during the 2008-2009 crisis, when both Germany and the periphery required liquidity, but after 2010, when German liquidity needs sharply dropped away and the needs of the periphery continued to increase. This is shown clearly in Exhibit 6, which charts the difference between the value of the refinancing operations in the periphery and Germany against Bundesbank TARGET2 claims.

So the underlying factor driving the expansion of TARGET2 liabilities in the periphery is that capital outflows have intensified since the crisis, while the willingness of the private sector to finance these flows has decreased. This can be shown in Exhibits 7 and 8, which chart the behavior of the current account and TARGET2 imbalances in the periphery and Germany. Exhibit 7 shows that between 2007 and 2011 the periphery’s current account deficit has more or less been maintained, but the source financing this has switched from the private sector to ECB financing."

Hopefully, you now understand how these imbalances have arisen.  I would also hope that it is clear that these imbalances are NOT the result of a deliberate stealth bailout of the periphery by the surplus NCBs.  Instead the imbalances are a reflection of the funding difficulties in the periphery and are more driven by the actively derived negative balances of the peripheral NCBs than by the passively derived positive balance of the Bundesbank.  (An important and related aspect of TARGET2 is that, while an NCB can place a credit limit on the TARGET2 balance of a commercial bank or other MFI, it cannot place such a limit on one of its fellow NCBs.)

Is There A Limit to TARGET2?

The short answer here is no.  However, from a practical standpoint, the amount of eligible collateral that peripheral commercial banks can pledge to their NCBs is limiting.  This is one of the main reasons the ECB recently relaxed collateral rules, expanded collateral eligibility, reduced reserve requirements, and expanded repo operations.  Should losses be realized in the TARGET2 system as a consequence of a country default or exit, we could see positive balance NCBs (like the Bundesbank) demand a re-tightening of collateral eligibility rules, as well as the imposition of TARGET2 credit limits on some commercial financial institutions.

What are the Risks?

Let's start with the case of the Bundesbank, as they hold the largest TARGET2 credit position, by far.  As of November 30, 2011, the balance was 495,164.155 Euros!  The graph below charts its progress, and has undoubtedly shown explosive growth since the late December LTRO by the ECB.

It is critically important to remind ourselves that the Bundesbank's credit balance is held directly against the ECB, not against other NCBs.  This is as a result of the end-of-day netting procedure in TARGET2.  To date, no losses have been borne via TARGET2 imbalances.  However, losses could potentially be realized in the case of default or exit from the Eurozone by a member country, but those losses would be borne and shared according to the ECB capital share of the remaining NCBs.  In the case of the Bundesbank, that is currently 27%, but would obviously rise to some extent after the departure of the defaulting member.  In the extreme case of a Eurozone collapse, losses to the Bundesbank obviously would be much more severe.  Many claim that the desire to avoid realizing TARGET2 losses is one of the factors holding the Eurozone together, and preventing Greece from being allowed to default.  When combined with issues regarding CDS, currency convertibility, social unrest, political turmoil, etc, I would agree.

Besides default risk, there is also a risk of the Bundesbank losing control over monetary policy in Germany.  This is highlighted and explored in a paper entitled "TARGET2 Unlimited:  Monetary Policy Implications of Asymmetric Liquidity Management with the Euro Area" from the University of Leipzig.  Quoting from the abstract, the paper "analyses the implications of a continued divergence of TARGET2 balances for monetary policy in the euro area. The accumulation of TARGET2 claims (liabilities) would make ECB’s liquidity management asymmetric once the TARGET2 claims in core countries have crowded out central bank credit in those regions. Then while providing scarce liquidity to banks in countries with TARGET2 liabilities, the ECB will need to absorb excess liquidity in countries with TARGET2 claims. We discuss three alternatives and its implications to absorb excess liquidity in core regions: (1) Using market based measures might accelerate the capital flight from periphery to core countries and would add to the accumulation of risky assets by the ECB. (2) Conducting non-market based measures such as imposing differential (unremunerated) reserve requirements would distort banking markets and would support the development of shadow banking. (3) Staying passive would lead to decreasing interest rates in core Europe entailing inflationary pressure and overinvestment in those regions and possibly future instability of the banking system."  It also addresses the faulty claim by Sinn and others that the Bundesbank would need to sell its gold reserves and other assets in order to continue to amass TARGET2 credits.  I do not wish to delve into these very important issues here, but highly recommend those interested read the paper.

Moving beyond the isolated case of the Bundesbank, what are the risks TARGET2 imbalances imply for the Eurosystem in general?  (I choose the phrase "imply for" versus "pose to" very deliberately.  TARGET2 imbalances are more a symptom of the disease than its cause.)

One of the greatest risks, IMHO, is further asset encumbrance.  I have posted about this previously.  Remember, these TARGET2 imbalances represent the substitution of collateralized central bank funding of commercial banks for the unsecured funding that existed prior to Europe's sovereign debt crisis.  As such, each central bank repo operation ties up evermore of the collateral available to commercial banks.  We saw the ECB act to expand eligible collateral lately, but will it be enough?  Are some banks now reaching encumbrance limits, as Dexia did?

Collateral quality is another risk, and we can already see some very transparent gamesmanship in this regard.  Peter Tchir of TF Market Advisors speaks of Portugal guaranteeing a 3 year debt issuance by one of its commercial banks, who, in turn, gave the debt as collateral in an ECB repo operation.  Zero Hedge relates that Greece, Italy, and others have been doing this for quite a while.  Jens Weidmann, the Bundesbank President, told Bloomberg news on Dec 13 that he was more concerned with the quality of collateral than with the quantity.  From the article, he is quoted as saying “In a situation like the current one, where we are providing solvent banks with liquidity, for me the size of the Target2 balances is less important than the risks we are taking on. It is my concern that we limit these risks as much as possible.”

Other Implications

Given the need to offer collateral in order to obtain NCB funding, it is not surprising that the ECB's 3 year LTRO offering in December saw such strong demand.  The February offering will probably be similar.  By that time we should have data to confirm that LTRO funding is being taken up disproportionately by peripheral banks.  We should also be able to confirm the further widening of TARGET2 imbalances that would be the result of that disproportionality.

Regarding the sovereign debt and implications for the "Sarko" carry trade, we have seen relatively strong demand for short term Spanish and Italian debt leading up to the LTRO and since.  However, longer term issuances, particularly in Italy, remain under pressure with little, if any, improvements in yield.  Why might this be?  My theory revolves around the collateral preferences of capital constrained peripheral banks.  If you have 500 euros with which to buy sovereign debt that you intend to use as collateral with your NCB, would you rather:

• buy five 100 € lower yielding short term issues that have a 5% haircut, giving you  475 € of collateral, or
• buy ten 50 € higher yielding longer term issues that have a 10% haircut, giving you 450 € of collateral?

If my theory is correct, longer term sovereign debt in Italy and Spain should remain under pressure and we should gradually see a decline in duration, meaning more volatility, more debt rollovers, and greater difficulty in arriving at an exit strategy for the ECB.  It may also mean that the ECB, through its Securities Markets Program (SMP), will hold a greater share of longer term Spanish and Italian debt than it currently does.

It must also be remembered that European banks face massive rollovers of their own debt in 2012.  This makes it highly unlikely that a large portion of the proceed that they gain from ECB repos are going to be used to buy sovereign debt.  Instead, schemes like the one I described above of having their respective governments guarantee bank debt for use as repo collateral may predominate.  One could easily imagine the sovereign issuing those guarantees could demand some degree of quid pro quo with respect to sovereign debt purchases, but banks' own refunding requirements will be constraining.  Furthermore, these bank debt guarantees should rightly show up as a new contingent liability for the sovereign issuing the guarantee, thereby worsening their sovereign debt situation further.  Whether EUROSTAT will treat these guarantees as on balance sheet sovereign liabilities remains to be seen.

Finally, Wolf Richter has a recent post up regarding Germany's continued economic outperformance.  To a great degree, this has been a direct result of the capital flows facilitated by the TARGET2 system. 

Conclusion

TARGET2 imbalances are a reflection of ECB efforts to provide liquidity support to peripheral financial institutions that are no longer able to obtain their own private funding.  They are not a stealth bailout, they do not constrain liquidity in countries with positive TARGET2 claims, and they are not an immediate threat to any NCB, to include the Bundesbank.  However, they are a clear indication of the greater dependence on central bank financing in peripheral Europe.  As the repo operations that give rise to these balances require quality collateral from capital constrained banks, they give rise to further asset encumbrance and continued competition for high quality collateral.

Are TARGET2 operations a game changer for Europe?  I would say distinctly not, although they may keep the teams on the field for longer.

For Further Reading

**Missing the Target (Credit Suisse)**

The implications of intra-euro area imbalances in credit flows (CEPR)

Central Bank Imbalances in the Euro Area (FRBNY)

Goldman's Take On TARGET2 And How The Bundesbank Will Suffer Massive Losses If The Eurozone Fails (Zero Hedge)

Should We Worry About Target 2 Imbalances? (Nordea)

The fuss about TARGET2 (Reszatonline blog)

TARGET2 imbalances and the money supply disparity (Sober Look)

TARGET2 and the collateral imbalance - diagram (Sober Look)

TARGET2 Unlimited: Monetary Policy Implications of Asymmetric Liquidity Management with the Euro Area (Leipzig University)

The ECB’s stealth bailout (Sinn)

ECB and Hans-Werner Sinn on Target2 (??)

Eurozone Crisis, Act Two: Has the Bundesbank reached its limit? (Tornell, Westermann)

No, the Bundesbank has not reached its limit (Karl Whelan)

Germany’s Hidden Risk: Bloomberg Businessweek Opening Remarks

DAX, RUT Update

My take on today's decline in the RUT was that it marked the end of an expanding ED for a c wave of (iv) of [c].  A break below today's lows would obviously change that view.

RUT 10 MIN

The DAX still appears to be consolidating, as opposed to declining.  I am unable to see anything impulsive/motive looking about the decline off the magenta top, although my confidence in my ability to recognize a first wave declines by the minute.  I think the French and EFSF bond auction results today have given some near term relief.  We'll see what Italy and Spain bring next week.

DAX 10 MIN

Do any of you have any interest in my doing a post about TARGET2 imbalances and their meaning?  There is already a lot of stuff out there on the subject, so I hesitate to waste my time unless there is some genuine interest.

Big DAX Day

The DAX was up a full 3% today on light volume.  Unfortunately, it still does not resolve the dilemma between the two counts I presented on 29 Dec.  The DAX is currently very close to an important lateral resistance level, so what happens here should help us figure out whether we double top near 64xx or truncate badly near present levels.

DAX WEEKLY

DAX DAILY

At a significant .618 fib of the entire [B] wave, and a hypothetical channel line.

DAX 60 MIN

DAX 10 MIN

Divergent RSI - so far...