Thursday, December 22, 2011

The ECB Lending - Folly or Fantabulous

When the tap finally opens, banks (whether they needed the money or not), stretched out their palms. Much like the experience during the subprime rot when the Fed lent out money at zero rates. As one can see, the yield on government bonds in Italy and Spain did not fall, but actually moved higher. So banks are hoarding again to prettify their balance sheet and maybe capital adequacy ratio, or just having a standby line while they can still access funds because if the Euro crisis gets any deeper, the whole money market could shrivel up.

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The good thing is that at least money is moving, the risk of a major bank run has been thwarted somewhat. So, anyone who says that the ECB lending is not a positive thing is looking at much too high expectations. This is precisely the stopgap fear removal. The persistent fear is that dwelling deeper into how to revitalise troubled EU government's finances would eventually lead to extreme pessimism, which will result in people and funds fearing the most, extreme fear will eventually give in to panic if left to simmer - panic will mean massive bank runs all over Europe, thats the last thing you want.

Hence I am reasonably positive that markets will view the development as quite essential in putting the path of recovery on the map. What EU has to contend with most of all is fear and pessimism, fear that collectively they cannot come up with a truly viable and effective solution, pessimism that causes one and all to rein in spending and investment of any kind. Hence, its a vital and crucial move to release the funds, instead of just talks and summits. It won't lower government bond funding cost overnight, that will take some months before the whole thing right itself.
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Read further on the excellent article on ECB lending by Simone Foxman:

Early today 523 banks requested an unprecedented €489 billion ($640 billion) in super-cheap funding from the European Central Bank.

But the massive lending operation has garnered only a tepid response from markets, with short-term government bond yields rising in Italy and Spain, and markets virtually unchanged on the day.
So what happened? In general, initial investor reaction suggest that this was not the back-door bailout some were hoping for, and that expectations were simply too darn high.
A few early conclusions:
  • Banks took advantage of access to much needed liquidity. This was the real aim of this funding operation, and clearly the stigma against borrowing from the ECB is gone.
  • Easily accessible liquidity is positive for the markets. This counteracts tightening credit conditions in the euro area, at least on a temporary basis, and will also make it easier for banks to meet the 9% capital requirement they'll have to adhere to by mid-2012.
  • Ideas that banks would make bank on a carry trade—purchasing sovereign bonds to take advantage of relaxed collateral standards and low funding costs and profit from high yields—were probably overzealous. The reversal in bond yields after the operation and the continuing elevation of Italian yields suggest this is not the case.
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In general, reactions from Wall Street have been positive, but unimpressed. However, they generally suggest that a similar 3-year LTRO operation in January could have a bigger impact.
Citi's Todd Elmer synopsizes this attitude concisely:
The EUR 489bn was in the EUR400-500bn range that our economists were expecting but somewhat stronger than published consensus that was more in EUR300-400bn.  That said, the fat tail was clearly to the right and there were indications that many expected a much larger number than the consensus.
The next question is what is done with the money...Whether the money will be used to buy sovereign debt (the secret wish), or be lend out to businesses (the stated wish) is unclear. There is plenty of liquidity in the system not doing much of anything, so the auctions at the beginning of 2012 will be scrutinized carefully to see if the carry trade is being reignited. 
Goldman's equity research analysts waxed even more positive about the move's effects on banks:
The amount distributed is large and equals 165% of total European bank bond maturities for 1Q2012 and a full 63% for the entire 2012. This amount will grow further still, through the February 28 auction, in our view. European banks seem firmly on their way to fully pre-fund all bond maturities for 2012 (and possibly 2013) through the ECB, in our view.
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But Morgan Stanley outlined expectations that the move was probably not as significant as bulls had prayed it would be:
With this in mind, we therefore welcome the first 3-year LTRO this week, as we see this as a necessary step to reduce risk in the system of “disorderly deleverage” and even possible bank failure...To be clear, we don't think the LTRO and other bank funding support will stop banks from shrinking entirely and our concerns over 1.5-2.5tr bank delevering remain uppermost in our minds...This may not be the reduction of tail risk at the sovereign level that we might have hoped for, but we certainly welcome the tightening impact on sovereign spreads that it is causing, especially across 2/3 years’ maturities.
All told, the ECB measures did exactly what everyone expected they'd do before the hubbub about a bank bailout flared up last week. They lowered sovereign bond yields temporarily and they will prove a temporary sigh of relief from what has been escalating market pressure on the euro area.
Even so, that's not necessarily a good thing. We've seen lots of reforms by the Italian government recently as the country faces steepening sovereign borrowing costs. But analysts have suggested (specifically, research teams Goldman Sachs and Bank of America) this breath of fresh air might reverse that trend, not to mention increasing activism from the ECB.
Again from Morgan Stanley:
Whether the Governing Council will see a need for outright asset purchases next year will depend on the pace of deleveraging in the banking system and the repercussions on the availability of bank loans to private sector. In our view, the ECB is still too optimistic on growth next year and is likely to revise its estimates down meaningfully in the coming months.
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In sum, the liquidity measures were just as successful as anyone could have realistically hoped they would be. The crisis is not "over" and the downward trend of worsening economic conditions probably will not be truly be alleviated, but there are clearly positive immediate repurcussions for the European banking sector.


ronnie said...

This babe is gorgeous

ProfitsOn said...

Great point!

The euro (stocks) should decline further in the first part of 2012.

However, the longer-term picture is still bullish for eur/usd.

Since 1972, D-Mark/Usd has topped in 1980 and 1995 (15 years). From bottom to top the uptrend lasted for 12/10 years (1968-1980) and (1985-1995). The actual bear market of the dollar started in 2002.

Of course, past performance is not indicative of future results.