March 27, 2012 8:21 pm
European finance: A leaning tower of perils
By piling on funds to save banks, the monetary authorities may initiate a renewal of the euro crisis
.
A drug. A pyramid scheme. Strikingly for an initiative that is credited with saving the eurozone and financial markets from disaster, those are just two of the undignified epithets that some in the financial markets now hurl at the European Central Bank’s provision of cheap three-year loans to eurozone commercial banking groups.
The ECB’s “longer-term refinancing operation” has sparked a big rally in global equities and has lowered borrowing costs for Italy and Spain, viewed as the countries whose fortunes will determine whether the crisis in the 17-nation single currency area intensifies again.
.
The €1tn-plus, two-stage action by the Frankfurt-based monetary authority – taken in December and late February as the first big policy move by Mario Draghi, its new president – has demonstrably eased fears of an imminent collapse either of a European bank or even of the euro itself.
But there is a dark side to the LTRO. Critics are increasingly concerned that by helping to save banks and governments now, the ECB may unwittingly be sowing the seeds for the next escalation of the crisis. That would shatter the calm in global markets of the past few months and cause renewed soul-searching about the continent’s single-currency project.
“Financial markets have certainly been impressed. But this isn’t really solving anything and in some respects it is actually worsening the intricate and nepotistic relationship between banks and sovereigns,” says George Magnus, senior adviser to UBS, the Swiss bank. He describes claims by some European politicians that the crisis is over as “myopic”.
.
Concerns over the LTRO are several, ranging from the question of banks becoming dependent on artificially cheap funding to fears about the structure of their balance sheets. But one of the main charges is that the sheer cheapness of the funds has prompted banks to go on another credit-fuelled binge, similar to what preceded the global financial crisis but this time snapping up the debt of their own governments.
.
Their bond buying has brought bond yields down for the likes of Italy and Spain but it has also caused the fates of banks and countries to become even more inextricably linked. “There is a risk it’s like tying two drowning people together in the hope they will float,” says Benedict James of Linklaters, the law firm.
.
In total, UBS analysts think Italian banks have taken about €260bn from not just the LTRO but other liquidity schemes from eurozone central banks. Spanish banks in turn took €250bn, well ahead of the next biggest users, French banks, with €150bn.
.
While banks have used the money for a variety of purposes including refinancing their debt, they have also clearly stocked up on state paper. Spanish banks, for example, increased their holdings of Madrid’s state bonds by 29 per cent in December and January combined, the last two months for which data are available, to reach €230bn. Italian banks boosted their domestic purchases by 13 per cent over the same period to €280bn.
.
The effect on government bond yields has been dramatic, particularly in short-dated maturities, which have tumbled. Conversely, this demand has strengthened bond prices, which move inversely to yields. Under the so-called carry trade, banks get the money at 1 per cent from the ECB and invest in higher-yielding securities. Two-year yields for Italy have fallen from 4.6 per cent to 2.5 per cent and for Spain from 3.4 per cent to 2.5 per cent so far this year.
Debt auctions have also gone well for the two Mediterranean countries. Spain has raised 44 per cent of its target while Italy is more than a fifth of the way to its 2012 goal, according to UBS credit analysts. But the buying in auctions and secondary markets has been overwhelmingly by domestic buyers, with international investors largely staying on the sidelines. One senior European investment banker, with perhaps only a little exaggeration, says some auctions have drawn buyers of which 95 per cent were domestic.
Describing it as a “Ponzi scheme”, Marc Chandler, currency strategist at Brown Brothers Harriman in New York, says simply: “Weak banks are buying weak sovereigns.”
. . .
Concern is focused more on Spain than on Italy, largely because the former’s banking system is viewed as more fragile. Unlike Italy, Spain experienced an enormous housing bubble and many investors fret that the cleaning up of Spanish banks’ balance sheets has only just begun.
.
As government bond yields fell, and correspondingly bond prices rose, banks were making a tidy paper profit on the carry trade. But in recent weeks Spanish, and to a lesser extent Italian, market interest rates have started rising again. Spain’s benchmark yields had risen 48 basis points from their lows earlier this year to 5.35 per cent by Tuesday.
If yields continue upwards, some analysts worry that banks may have been pushed into buying the bonds at exactly the wrong time. “You are encouraging banks to buy at potentially the peak. Banks are going to have to mark to market and post more collateral if bond prices decline meaningfully,” says Graham Secker, equity strategist at Morgan Stanley. He describes Spanish and Italian banks’ approach as in some respects “the proverbial all-in at poker”.
Policy makers are not oblivious to the dangers. ECB officials insist the LTRO was necessary to relieve market tensions, especially about the possibility that one or more eurozone banks could collapse because of funding difficulties.
.
But they also acknowledge that there are risks to the scheme. Jens Weidmann, the president of Germany’s Bundesbank, has gone further, warning in a speech in February that “too generous a provision of liquidity will open up business possibilities for banks that could lead to greater risks for the banks” and thus jeopardise financial and price stability. The German central bank did not try to block the LTRO, unlike its resistance to other recent ECB policies, but it would have preferred less-favourable terms to have been set.
.
A second big problem that many see is that the LTRO lessens the pressure on both banks and sovereign borrowers to reform. In essence, the ECB loans have bought three years for banks to reform themselves and for the southern countries in Europe to rekindle economic growth.
.
But some wonder whether enough will be done now the immediate heat has been turned down.
.
“There’s a fine balance to be struck between providing the market with a sufficient level of optimism and at the same time keeping a certain level of fear so that progress is genuinely delivered,” says Richard Ryan, a senior credit fund manager at M&G Investments.
.
Alastair Ryan, banking analyst at UBS, argues that banks should be looking different from how they did before the financial crisis, both in terms of capital and the size of their balance sheets. But while UK banks have been forced to alter their structure – by boosting capital heavily, selling assets, raising liquidity and reducing their reliance on wholesale funding – “if you look at French, Spanish and some Italian banks not very much has changed at all”.
.
He frets that the Spanish banks are now “chronically dependent on the ECB” and the sector no longer has an incentive to carry out reforms. Weak funding and capital positions in turn limit the ability of banks to lend to the real economy, hurting the country’s growth prospects.
.
It is a widely feared addiction. “Like any drug, there will be side effects. It is just we don’t know what they are at the moment,” says Nick Gartside of JPMorgan Asset Management. Europe still has too many banks – 460 from Germany alone tapped the second LTRO – and the loans could lessen incentives to consolidate as well as to change broken business models.
. . .
.
Of worry to many is what happens in three years when all this bank debt comes due at the same time. The hope is that economic growth will have picked up by then, giving banks a healthy backdrop against which to issue debt on their own.
But plenty of people in the market believe institutions in some of the “peripheral” countries in southern Europe at least are likely to struggle for longer than three years, raising the prospect of their becoming “zombie banks”. Peter Sands, chief executive of Standard Chartered, the UK-based emerging markets lender, says the amount of liquidity pumped in by central banks risks “laying the seeds for the next crisis”. He adds: “It is not clear what the exit strategy is. What happens in three years’ time when it needs to be refinanced?”
.
Within the ECB’s 23-strong governing council there is also widespread concern that by relieving financial market tension and helping subdue bond yields in what some have dubbed “backdoor quantitative easing”, pressure on governments for fiscal and structural reforms has lessened. Some in Frankfurt have already been alarmed by Spain’s defiance over its fiscal targets this year after dramatically breaching them in 2011.
.
LTRO critics reject suggestions they are being churlish, given that markets have undergone a remarkable stabilisation this year compared with the dark days at the end of 2011. Concerns that the next few months could have been highly tricky for banks in terms of funding have dissipated, they agree, as has the “tail risk” – marketspeak for an event that could disrupt markets’ central muddling-along scenario – of a lender going bust.
.
But many remain worried about just what the LTRO will end up achieving. Banks remain under pressure to shrink their balance sheets, a process known as deleveraging, even if the LTRO has eased the strain somewhat. As UBS’s Mr Ryan asks: “What is LTRO? Is it a useful tool to manage deleveraging, quantitative easing via the back door, or a convenient way to avoid restructuring?”
.
.
Capital structures: Relegation of the bondholders
.
For an investor, holding bonds in banks or governments used to be fairly straightforward. Your place in the capital structure was clear, meaning that if any entity went bust you knew where you stood in terms of payment.
.
The financial and sovereign debt crises have changed that. Bondholders are now much more subordinated to other creditors. This is perhaps starkest among holders of eurozone bank bonds. In 2007 they typically accounted for more than 80 per cent of a bank’s capital structure, research by Citigroup shows. Now it is about 10 per cent, with a swath of other interests ranked ahead, among them deposits, covered bonds and arrangements with the European Central Bank.
.
There has also been a marked change in government bonds as the Greek debt restructuring showed. Private sector bondholders suddenly found that they were ranked lower in payment terms – not just, as expected, to the International Monetary Fund but also, for political reasons, the ECB and the European Investment Bank.
.
Citigroup reckons the subordination could be worse in other bail-outs. After expected refinancings in Portugal and Ireland, private holders would respectively represent just 40 per cent and one-third of total debt.
.
At the similar stage in Greece before its restructuring this month, they held about two-thirds. “One of the lessons of the financial crisis is that there has not been enough focus on the capital structure,” says Andreas Utermann of Allianz Global Investors. “It is becoming very political.”
.
The worry is acute for banks where the ECB’s longer-term refinancing operation is adding to worries about institutions tying up assets to raise money. This results in so-called balance sheet encumbrance as banks pledge their assets either to obtain cheap ECB money or to use in transactions, such as covered bonds.
.
Some argue that this leaves banks with less collateral. It would also make the cost of funding for unsecured debt – that not backed by assets – less attractive, prompting banks to cut lending and shrink. Alberto Gallo of RBS says the LTRO has helped banks to refinance debt. “But we believe the price for liquidity today is bondholder subordination tomorrow.”
.
Additional reporting by Ralph Atkins
A drug. A pyramid scheme. Strikingly for an initiative that is credited with saving the eurozone and financial markets from disaster, those are just two of the undignified epithets that some in the financial markets now hurl at the European Central Bank’s provision of cheap three-year loans to eurozone commercial banking groups.
.
The ECB’s “longer-term refinancing operation” has sparked a big rally in global equities and has lowered borrowing costs for Italy and Spain, viewed as the countries whose fortunes will determine whether the crisis in the 17-nation single currency area intensifies again.
.
Click here to enlarge
The €1tn-plus, two-stage action by the Frankfurt-based monetary authority – taken in December and late February as the first big policy move by Mario Draghi, its new president – has demonstrably eased fears of an imminent collapse either of a European bank or even of the euro itself.
But there is a dark side to the LTRO. Critics are increasingly concerned that by helping to save banks and governments now, the ECB may unwittingly be sowing the seeds for the next escalation of the crisis. That would shatter the calm in global markets of the past few months and cause renewed soul-searching about the continent’s single-currency project.
“Financial markets have certainly been impressed. But this isn’t really solving anything and in some respects it is actually worsening the intricate and nepotistic relationship between banks and sovereigns,” says George Magnus, senior adviser to UBS, the Swiss bank. He describes claims by some European politicians that the crisis is over as “myopic”.
.
Concerns over the LTRO are several, ranging from the question of banks becoming dependent on artificially cheap funding to fears about the structure of their balance sheets. But one of the main charges is that the sheer cheapness of the funds has prompted banks to go on another credit-fuelled binge, similar to what preceded the global financial crisis but this time snapping up the debt of their own governments.
.
Their bond buying has brought bond yields down for the likes of Italy and Spain but it has also caused the fates of banks and countries to become even more inextricably linked. “There is a risk it’s like tying two drowning people together in the hope they will float,” says Benedict James of Linklaters, the law firm.
.
In total, UBS analysts think Italian banks have taken about €260bn from not just the LTRO but other liquidity schemes from eurozone central banks. Spanish banks in turn took €250bn, well ahead of the next biggest users, French banks, with €150bn.
.
While banks have used the money for a variety of purposes including refinancing their debt, they have also clearly stocked up on state paper. Spanish banks, for example, increased their holdings of Madrid’s state bonds by 29 per cent in December and January combined, the last two months for which data are available, to reach €230bn. Italian banks boosted their domestic purchases by 13 per cent over the same period to €280bn.
.
The effect on government bond yields has been dramatic, particularly in short-dated maturities, which have tumbled. Conversely, this demand has strengthened bond prices, which move inversely to yields. Under the so-called carry trade, banks get the money at 1 per cent from the ECB and invest in higher-yielding securities. Two-year yields for Italy have fallen from 4.6 per cent to 2.5 per cent and for Spain from 3.4 per cent to 2.5 per cent so far this year.
Debt auctions have also gone well for the two Mediterranean countries. Spain has raised 44 per cent of its target while Italy is more than a fifth of the way to its 2012 goal, according to UBS credit analysts. But the buying in auctions and secondary markets has been overwhelmingly by domestic buyers, with international investors largely staying on the sidelines. One senior European investment banker, with perhaps only a little exaggeration, says some auctions have drawn buyers of which 95 per cent were domestic.
Describing it as a “Ponzi scheme”, Marc Chandler, currency strategist at Brown Brothers Harriman in New York, says simply: “Weak banks are buying weak sovereigns.”
. . .
Concern is focused more on Spain than on Italy, largely because the former’s banking system is viewed as more fragile. Unlike Italy, Spain experienced an enormous housing bubble and many investors fret that the cleaning up of Spanish banks’ balance sheets has only just begun.
.
As government bond yields fell, and correspondingly bond prices rose, banks were making a tidy paper profit on the carry trade. But in recent weeks Spanish, and to a lesser extent Italian, market interest rates have started rising again. Spain’s benchmark yields had risen 48 basis points from their lows earlier this year to 5.35 per cent by Tuesday.
If yields continue upwards, some analysts worry that banks may have been pushed into buying the bonds at exactly the wrong time. “You are encouraging banks to buy at potentially the peak. Banks are going to have to mark to market and post more collateral if bond prices decline meaningfully,” says Graham Secker, equity strategist at Morgan Stanley. He describes Spanish and Italian banks’ approach as in some respects “the proverbial all-in at poker”.
Policy makers are not oblivious to the dangers. ECB officials insist the LTRO was necessary to relieve market tensions, especially about the possibility that one or more eurozone banks could collapse because of funding difficulties.
.
But they also acknowledge that there are risks to the scheme. Jens Weidmann, the president of Germany’s Bundesbank, has gone further, warning in a speech in February that “too generous a provision of liquidity will open up business possibilities for banks that could lead to greater risks for the banks” and thus jeopardise financial and price stability. The German central bank did not try to block the LTRO, unlike its resistance to other recent ECB policies, but it would have preferred less-favourable terms to have been set.
.
A second big problem that many see is that the LTRO lessens the pressure on both banks and sovereign borrowers to reform. In essence, the ECB loans have bought three years for banks to reform themselves and for the southern countries in Europe to rekindle economic growth.
.
But some wonder whether enough will be done now the immediate heat has been turned down.
.
“There’s a fine balance to be struck between providing the market with a sufficient level of optimism and at the same time keeping a certain level of fear so that progress is genuinely delivered,” says Richard Ryan, a senior credit fund manager at M&G Investments.
.
Alastair Ryan, banking analyst at UBS, argues that banks should be looking different from how they did before the financial crisis, both in terms of capital and the size of their balance sheets. But while UK banks have been forced to alter their structure – by boosting capital heavily, selling assets, raising liquidity and reducing their reliance on wholesale funding – “if you look at French, Spanish and some Italian banks not very much has changed at all”.
He frets that the Spanish banks are now “chronically dependent on the ECB” and the sector no longer has an incentive to carry out reforms. Weak funding and capital positions in turn limit the ability of banks to lend to the real economy, hurting the country’s growth prospects.
.
It is a widely feared addiction. “Like any drug, there will be side effects. It is just we don’t know what they are at the moment,” says Nick Gartside of JPMorgan Asset Management. Europe still has too many banks – 460 from Germany alone tapped the second LTRO – and the loans could lessen incentives to consolidate as well as to change broken business models.
. . .
.
Of worry to many is what happens in three years when all this bank debt comes due at the same time. The hope is that economic growth will have picked up by then, giving banks a healthy backdrop against which to issue debt on their own.
But plenty of people in the market believe institutions in some of the “peripheral” countries in southern Europe at least are likely to struggle for longer than three years, raising the prospect of their becoming “zombie banks”. Peter Sands, chief executive of Standard Chartered, the UK-based emerging markets lender, says the amount of liquidity pumped in by central banks risks “laying the seeds for the next crisis”. He adds: “It is not clear what the exit strategy is. What happens in three years’ time when it needs to be refinanced?”
.
Within the ECB’s 23-strong governing council there is also widespread concern that by relieving financial market tension and helping subdue bond yields in what some have dubbed “backdoor quantitative easing”, pressure on governments for fiscal and structural reforms has lessened. Some in Frankfurt have already been alarmed by Spain’s defiance over its fiscal targets this year after dramatically breaching them in 2011.
.
LTRO critics reject suggestions they are being churlish, given that markets have undergone a remarkable stabilisation this year compared with the dark days at the end of 2011. Concerns that the next few months could have been highly tricky for banks in terms of funding have dissipated, they agree, as has the “tail risk” – marketspeak for an event that could disrupt markets’ central muddling-along scenario – of a lender going bust.
.
But many remain worried about just what the LTRO will end up achieving. Banks remain under pressure to shrink their balance sheets, a process known as deleveraging, even if the LTRO has eased the strain somewhat. As UBS’s Mr Ryan asks: “What is LTRO? Is it a useful tool to manage deleveraging, quantitative easing via the back door, or a convenient way to avoid restructuring?”
.
.
Capital structures: Relegation of the bondholders
.
For an investor, holding bonds in banks or governments used to be fairly straightforward. Your place in the capital structure was clear, meaning that if any entity went bust you knew where you stood in terms of payment.
.
The financial and sovereign debt crises have changed that. Bondholders are now much more subordinated to other creditors. This is perhaps starkest among holders of eurozone bank bonds. In 2007 they typically accounted for more than 80 per cent of a bank’s capital structure, research by Citigroup shows. Now it is about 10 per cent, with a swath of other interests ranked ahead, among them deposits, covered bonds and arrangements with the European Central Bank.
.
There has also been a marked change in government bonds as the Greek debt restructuring showed. Private sector bondholders suddenly found that they were ranked lower in payment terms – not just, as expected, to the International Monetary Fund but also, for political reasons, the ECB and the European Investment Bank.
.
Citigroup reckons the subordination could be worse in other bail-outs. After expected refinancings in Portugal and Ireland, private holders would respectively represent just 40 per cent and one-third of total debt.
.
At the similar stage in Greece before its restructuring this month, they held about two-thirds. “One of the lessons of the financial crisis is that there has not been enough focus on the capital structure,” says Andreas Utermann of Allianz Global Investors. “It is becoming very political.”
.
The worry is acute for banks where the ECB’s longer-term refinancing operation is adding to worries about institutions tying up assets to raise money. This results in so-called balance sheet encumbrance as banks pledge their assets either to obtain cheap ECB money or to use in transactions, such as covered bonds.
.
Some argue that this leaves banks with less collateral. It would also make the cost of funding for unsecured debt – that not backed by assets – less attractive, prompting banks to cut lending and shrink. Alberto Gallo of RBS says the LTRO has helped banks to refinance debt. “But we believe the price for liquidity today is bondholder subordination tomorrow.”
.
Additional reporting by Ralph Atkins
Copyright The Financial Times Limited 2012
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