Wednesday, December 21, 2011

LTRO, Maasichism, and the Future of Europe in 2012

December has brought another acronym to the rescue kit of European policy makers in the form of the ECB’s Long Term Refinancing Operations (LTRO), the arrival of which has been heralded by at least some market observers with a sense of cautious optimism and hope.  So, with a full allotment of €489.2bn to 523 bidders, clocking in at the upper range of analyst expectations, where do we stand today as we look forward to 2012?    

In sum, it is my view that those looking for LTRO to accomplish what the summit of December 10th did not are likely to be disappointed.  Before reviewing the specifics of LTRO and the extent to which it changes the situation of the European financial infrastructure, let’s briefly discuss the other avenues through which relief may or may not be possible:

While the headline €750bn figure highlighted by the Euristocrats in their presentation of the summit agreement is at first glance impressive the substance of the program is highly problematic.  What was needed was enough money to credibly demonstrate that Europe could buy itself the time necessary to make some very difficult decisions.  Having wasted earlier opportunities, the commitment required has likely grown after countless 'final solutions'.  A a number above €1trn (and probably closer to €2trn by some estimates) would perhaps have signaled that Europe has the intention and the ability to defend its financial system for at least the coming year.  In the end, a sizeable chunk of the committed capital would likely prove to be unnecessary but the important task of halting the reflexive self-fulfilling collapse of confidence would have been accomplished.  Instead, we have for the time being an amount unable to cover even a fraction of the sovereign issuance that is on the table for 2012.  Even had the financial commitment had been credibly adequate, the ultimate success of such a response remains contingent on timely, genuine structural reform of the European system.

These people have something to say about structural reform
Although not without its fair share of massive real estate busts (including a healthy side portion of US mortgage exposure slung at dim-witted European financials by people like this man)Europe’s problem is at root one of human capital misallocation.  Un and under-employed youth drift between their parents’ basements and temporary, dead-end jobs while overpaid, underworked and superfluous bureaucrats join arms with rent-seeking unions to put a ceiling on economic success and divide the spoils between themselves.  Making the necessary fundamental changes will require that a lot of the dead weight is cut and that will mean the end of what had hitherto been for many a relatively carefree and comfortable lifestyle.  This is not easily resolvable at the national level and even more challenging on a pan-European basis, even should the worrying market headwinds be kept under control. 

Having briefly touched on what might have been, we now proceed to what we are left with:
The current generation ESM & EFSF are of barely adequate size to credibly contain a bond market crisis among just the small periphery nations.  Germany continues to draw the line at a €500bn ceiling, effectively signaling that there is no willingness among Northern creditors to stand behind Europe’s bond markets should worse actually come to worse.  When you have a fiat currency without a sovereign willing to stand behind it, it is not surprising that markets have slowly been losing their confidence in the European experiment.
Setting aside the apparent inadequacy of the €110bn handed to lowly Greece, with <€250bn left in the EFSF kitty and the exact details of the ESM not fully sketched out, the near term firepower of European crisis managers remains worryingly thin.  The additional €200bn of IMF funds is also fairly underwhelming, assuming that everyone can be encouraged to participate.  Ignoring the problematic feature in common with the ESM that almost ¼ of the committed funds come from Italy and Spain (and a further ~20 % from a ‘I Can’t Believe Its Not AA-‘ France), there is a serious problem with the IMF solution that those who have been observing the political theater of crisis should by now be well aware of.  IMF money cannot and will not be shoved out the door in the rapid, credibly reckless fashion necessary to halt a bond market collapse.  It will require separate, painful negotiations with individual sovereigns, who will be loathe to seek IMF funds until the domestic situation has clearly moved beyond the limits of their own control.    While shifting the onus to the IMF may have reduced the immediate political burden on Euroistocrats, it has not endowed a first-responder capable of unilaterally and decisively acting to prevent the situation at hand from spiraling out of control.

This was the great hope of markets with respect to the ECB; not that the ECB would singlehandedly solve Europe’s problems, but that it would stake a claim as the definitive lender of last resort able to take action in a crisis situation where others would not.  In this role it would serve as a credible catalyst for greater sovereign action by being able to dictate to politicians the urgency and scale of the problems at hand.  With significant funding needs looming, the first six months of 2012 will be critical for Europe.  Protected by only remaining EFSF funds and an unwilling ECB likely to be readily available in the first half of the year, the situation is worrying.

Having discussed why the current trifecta of bailout packages is of dubious adequacy in its current form, divided as it is between authorities and with its availability stretched out over time, we now turn to LTRO.

There has been much discussion of the so-called ‘Sarkozy Trade’:
“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. 
To an extent, similar shenanigans had already been possible, as described by Peter Garber at Deutsche Bank in a pretty good report on the now-infamous TARGET system, dating from last December:
“Similarly, a euro-zone government could, if it had to, continue to finance itself via the ECB even if it could not sell new bonds to the market because of fears of default. Under this scenario, a government might sell its bonds to a local bank, which draws funds from the ECB through its NCB, depositing the new securities as collateral at the NCB. The government could then use the funds to pay private creditors in other countries who are not rolling overexisting debt. The ECB then effectively replaces the old creditors of the sovereign and the lender for ongoing deficits—indirectly via the collateral at the NCB. This is how a sovereign debt crisis in one of the euro-zone sovereigns can become a problem for the euro currency and a risk that might overwhelm the capital of the ECB. This is especially so if a sovereign crisis is allowed to fester long enough that the ECB ends up with a significant direct or indirect claim on the sovereign before a default occurs.”
In fact, there is even some evidence that Greece has taken advantage of this unfortunate but necessary corollary of a unified currency zone and payment system, having upped its short term bill issuance to domestic banks in recent months, albeit on a fairly innocuous scale thus far.

In any case, as this helpful chart courtesy of the FT suggests, the bank re-financing needs were always something of a sideshow:

Now, put yourself in the butter-soft calfskin shoes of a senior European banking executive.  The European Banking Authority has arrived at the tidy sum of €115bn as the precise sum of money that will insure that the European banking system is fully protected against any possible act of god, lazy underwriting, or systemic insolvency of the financial system.  As Dexia investors might recall, these figures may or may not be moving targets.  The language of the EBA’s statement is itself suggestive of the absurdity of the capital requirements:
“These buffers are explicitly not designed to cover losses in sovereigns but to provide a reassurance to markets about the banks’ ability to withstand a range of shocks and still maintain adequate capital. The sovereign capital buffer is a one-off measure and, once the deployment of the new EFSF’s capacity becomes effective in addressing the sovereign debt crisis by lifting sovereign bond valuations from today’s distressed prices, the EBA will reassess the ongoing need for and size of capital buffers against banks’ sovereign exposures. “
Seems a bit like trying to close the door after the horse is gone, does it not?  

Perhaps this will be accomplished by raising equity capital.  Or, perhaps not:  

The above is a chart of European financial issuance over the past 5 years.  Since then, there have been 44 primary and secondary equity offerings with a value above €1bn.  Excluding the non-bank financials (primarily insurers with some closed-end funds and property developers) we are left with 27 deals for a total of €98.4bn.  Not bad, but when we look at 2011 and 2010, the results are far less thrilling - 2011 saw 15.4bn raised against 11.6bn in 2010..  In 2011 there were only two deals of real size, the ~€3bn IPO of Bankia, the Spanish roll-up of busted cajas (a less than satisfactory resolution strategy favored during the US S&L crisis) and a 1.7bn secondary from the Swedish Nordea.  Its worth noting the absence of Southern issuers among the bigger deals- indeed, the only large deals completed by periphery banks (aside from the aforementioned Bankia) were in 2006, with BBVA, Dexia, and Erste issuing a combined €5.2bn of shares.

Given the recent developments, it seems that equity markets will be unable to provide the necessary funds.  What about credit markets?  Well, as the need for LTRO suggests and interbank spreads seemingly confirm, there is little appetite for lending to European banks.  Although the swap spread is dangerously elevated, try to imagine what this would look like if you substituted EURIBOR for an accurate index of inter-bank repo rates:

De-leveraging, accordingly, seems to be the order of the day.  European banks have already been selling assets like Nicholas Cage and further credit contraction is likely. The EBA's insistence comes along-side to what amounts to the German re-tooling of the Maastricht criteria that will impose an enormous penance of fiscal austerity, provided that anyone bothers to adhere to it.  The new 'fiscal compact' arrived at at the beginning of the month will require austerity from almost all of the parties involved, not the least of which is Germany, unable to meet the newly stringent and rigid criteria they themselves have set.  The painful impact of across-the-board austerity (or, as one colleague termed it- "massichism") in a land where the government is frequently 40-50% of the (formal) economy is not difficult to imagine.  The mounting impact of the status quo policy and the insistence on the critical importance of made-up capital requirements from regulators has more or less insured further contraction in 2012 with worrying implications for the sovereign debt markets. 

Italy "can live with interest rates over 7% for years"-
"Italy should be given the chance to show it can carry out"
its fiscal reforms'.  Reuters, quoting Bundesbank president
Jens Weidmann
In light of the disappointing performance of Euro politicians, the stronger private hands seem likely to stand aside and do what little they can to disconnect themselves from whatever possible contagion may arise from the continuation of the crisis.  The idea that European banks, newly awash in central bank liquidity, will step in to prop up the bond markets is wishful thinking and ignores an obvious collective action problem.  Without a truly credible government policy response banks are likely to be very reluctant to unnecessarily expose themselves.  Who wants to the one to face their board and tell them why they felt it was prudent to load up on dodgy sovereign assets in the midst of an unresolved fiscal crisis?  If worse comes to worse as long as you're not one of the first few to bust out you might be able to maneuver some sort of bailout package and keep your job.  In any case, in light of the situation at MF Global I have my doubts that EU banks will be willing to meaningfully expand their sovereign exposure, not least because of the deleveraging demands being imposed by their supra-national and local regulators (Setting aside, of course, ratcheting down by gaming RWA and starting to keep 2 sets of 'books').  There is already plenty to suggest that this is the case.  Even if there was a compelling reason for individual bankers to further expose themselves to a slowly crumbling market seemingly propped together by vague hope and ECB SMP, it is hard to imagine that the Bundesbank et. al. would permit the expansion of LTRO on a scale sufficient to finance meaningful bond purchases.  

If you're like me and are similarly concerned about the possibility of Chinese blow-up, the outlook is potentially even worse.  Germany's economic strength has been given a flattering boost: not only from a euro that likely is significantly weaker than where an independent Deustchemark would trade but also by the enormous growth of emerging Asia (particularly China) and the attendant demand for German capital goods.  A helpful chart from the Gildemeister annual is suggestive:  

A similar situation is visible in Germany's flagship auto industry.  

With political demands driving a process of cognitive economization among Northern leadership and an apparent sense of complacency emanating from Germany, policymakers seem likely to continue to push on with the status quo until markets once again force them to reconsider.  LTRO is in many ways a doubling down of the current approach, hoping that by opening one new outlet it will unjam credit and allow insolvent banks time to recuperate.  With an ever shortening collateral chain threatening the shadow system and the prospect of capital flight looming, the European banking system and the sovereigns that stand behind it are dangerously exposed, demanding a degree of innovative conviction in policy as yet absent in the current dialogue.  On the current path we may be only a further haircut induced fire sale away from yet another devastating systemic crisis.     

Full disclosure: I am currently and have been intermittently short the euro/dollar cross since the mid-1.40s

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