Since the much-heralded 3Y LTRO program was envisioned and enacted, we have been clear in our perspective that while this appears to have signaled a removal of downside (contagion-driven) tail-risk for banks (and implicitly to sovereigns), the market’s perceptions are once again short-termist. Missing the unintended-consequence for the sugar high is something that we have seen again and again for the past few years but we worry that this time, given the sheer size of the program, that the ECB has got a little over its skis. By demanding collateral for their bottomless pit of low-interest loans, the ECB has not only reduced banks’ necessary deleveraging needs (and/or capital raising) but has increased risk for all bond-holders (and implicitly equity holders, who are the lowest of the low in the capital structure remember) as the assets underlying the value of bank balance sheets are now increasingly encumbered to the ECB. Post LTRO, Barclays notes that several banking-systems (PIIGS) now have encumbered over 15% of their balance sheets but LTRO merely extends a broader trend among European banks (pledging collateral in return for funding) and on average (even excluding LTRO) 21% of European bank assets are now encumbered, and therefore unavailable for unsecured bond holders, ranging from over 50% at Danske (more a business model choice with covered bonds) to around 1% for Standard Chartered. As the liquidity-fueled euphoria starts to be unwound, perhaps this list of likely stigmatized banks is the place to look for higher beta exposure to the downside (especially as we see EC B margin calls start to pick up).
In a currency collapse, the last thing to go is confidence. Unless TPTB go thru the motions of having standards, following procedures, and enforcing rules, global confidence in their fiat would evaporate. Then it would be game over for them. All they have is each other and they’re trying to show a united, confident front to postpone the moment that it all falls away. They know that when it finally topples, it will be fast and it will be bad. But for now, they have the MSM and large pension & mutual fund managers still listening. There is still a common language with common assumptions, altho they are eroding fast. The big banks won’t lend to each other but they still have confidence in their respective central banks.
Hence, the charade continues. For those of us who have been awake for years, it’s a slow, slow process. I’m torn between gratitude for all this time I have to shore up supplies and prepare to endure a long, cold, hard Depression – and watching these parasites play their game week by week, month by month, year by year, until I want it all to fall apart now before it drives me mad waiting.
In some cases, such as the Scandi banks and their covered (mortgage) bond, the levels of encumbrance are not always a sign of a broken business model – but we have highlighted several names near the top of the encumbrance tables that also rely heavily on repo (a topic have been thought leaders on for some time) as potentially problematic.
In a nutshell, the ECB (or broad collateralized lending liquidity facilities) has taken more and more of the balance sheet of Europe‘s banking system out of the reach of the private debt markets (and real money) – leaving fewer and fewer assets at the bottom of the pyramid and leaving less and less quality collateral available (otherwise why would be seeing ECB margin calls on such a large scale so quickly).
Whether it be their direct actions with Greece (specifically subordinating the world) or their indirect actions with LTRO collateral needs, the systemic risk of Europe’s banking/sovereign credit system is far higher now than it was before (and credit markets have already begun to adjust to this new reality – senior spread decompression, recent sovereign underperformance, and LTRO-Stigma – even if equities remain dumbstruck with the implicit print-fest – though very recently European financial equities have joined the credit drop more closely).
It was my understanding that the ECB took the worst collateral the banks had and gave them good Euros on the face value. If you are worried about encumbering very weak assets by monetizing them and letting the banks make money and build capital, then I am very confused. I thought that was the ultimate purpose of a Central Bank, to provide a backstop and a way to build capital for its member banks. If a by-product of the operation is funding bankrupt countries, well, so much the better.
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