Deflation Bogey Invoked To Enable Skirting Of The Rules
As a result of the out-of-control advance in euro area sovereign bond yields, pressure on the ECB to intervene continues to increase. One point well worth considering in this context is that at the current juncture, the ECB must begin to fear for its own survival.
Garri Schinasi, a former IMF official, puts it very succinctly:
„With the market pressure on Italy unrelenting, Schinasi said the ECB needed to drop its objections to quantitative easing.
"From a philosophical point of view, they should not touch it but they have no choice," he said. "They could have to step outside the boundaries of their statutes and their credibility will be damaged. But the risk of not doing so is being blown out of existence. If the euro breaks up there is no longer an ECB.“
People are constantly dreaming up new ways of how the ECB could in theory justify going 'beyond its remit'. The latest idea has been summarized by Nomura economist Jens Sondergaard thusly:
„Backed into a corner, the least bad option for the ECB may be to expand its bond-buy program and only partially 'sterilize' the purchases by taking an equivalent sum in from the market. By doing so, it would embark on a policy of quantitative easing, as already employed by the U.S. Federal Reserve and the Bank of England.
At present, the ECB sterilizes its bond buys by conducting weekly liquidity absorbing operations equal to the cumulative size of its debt purchases, ensuring it does not directly increase the money supply. If the ECB did not fully sterilize the purchases, it would be embarking on quantitative easing.
Germans, historically scarred by their experience of hyperinflation in the 1920, are loathe to take this road. An economic slowdown and the threat of deflation could, however, provide the bank the cover it would need to sell a policy of quantitative easing to its German constituency.
ECB President Mario Draghi said earlier this month euro zone inflation was likely to fall below 2 percent next year and the economy likely to grow less strongly than previously thought. A deterioration in the economy late this year and early next is likely as forward-looking indicators paint a grim picture.
"Then by spring there is a clear case for significantly expanding the ECB balance sheet but doing it under the cover of monetary loosening to save the economy, or save the euro area from deflation," said Nomura economist Jens Sondergaard. "If the economy continues to deteriorate, there will have to be some more creative solutions which involve the EFSF in combination with the ECB's balance sheet," he added, suggesting the two could work in tandem.
The ECB could continue to justify its bond purchases as a means to smooth the transmission of monetary policy, while additional buying by the EFSF could raise the aggregate downward pressure on borrowing costs, Sondergaard said.
In other words, there is no need to even invent new and tortured justifications for the ECB if it wants to break its own rules. All it needs to do is invoke the deflation bogey!
The groundwork for this is being laid as we write. As the same article notes, some members of the ECB's governing council are beginning to consider becoming more 'creative':
„In the interim, the ECB is ready to innovate if needed, say experts familiar with the bank's operations.
Some ECB policymakers beyond the German-led core have already given signs of being ready to be creative. Marko Kranjec, chief of Slovenia's central bank and, like Weidmann, a member of the ECB's 23-member Governing Council, told Reuters on Saturday Italy's austerity reforms go in the right direction and the ECB was willing to support sovereign borrowers as long as it does not put price stability at risk.
"We are flexible," Kranjec said. He declined to comment in detail on the ECB's bond purchases but said they would go "as far as needed."
The ECB stepped in again to buy Italian government bonds on Thursday, traders said, as the yields on 10-year Italian debt traded above the 7 percent threshold seen as unsustainable for the highly indebted country.
The crisis' grip on Italy has left in tatters an October deal on more aid for Greece and new powers to enhance the EFSF, in the assessment of one senior EU diplomat, and the eyes of Europe's leaders are once again turning to Frankfurt.
"Italy has changed the picture," the diplomat said.
Weidmann has forcefully rejected the idea of the ECB acting as lender of last resort for governments, lending directly to the International Monetary Fund or targeting specific interest rates for individual countries.
Softer options remain, however, such as the ECB increasing its bond purchases, as well as the possibility of the EFSF leveraging up its war chest by tapping the central bank's refinancing operations. French Finance Minister Francois Baroin repeated Paris's view on Wednesday that the EFSF should have a banking license, something Berlin opposes. Such a move would allow the fund to borrow from the ECB, giving it extra firepower. A more flexible use of the ECB's bond-purchase program remains a possibility.
The tactics of how to use this tool are determined on a daily basis by the ECB's six-member Executive Board. Stark is a strong voice on the board but he is quitting the ECB this year in what sources say is a protest at the bond-buy program. He will be replaced by Joerg Asmussen, a self-styled pragmatist. This personnel change coincides with the growing political pressure from France, and beyond the euro zone, for the ECB to do more to fight the crisis.“
We don't doubt it would be possible for the ECB to justify a bout of 'quantitative easing' (colloquially known as 'money printing') by asserting that it needs to fight a 'deflation threat'. In fact, money supply deflation is indeed in evidence in several peripheral euro-area countries, although not yet in the euro-area as a whole. As we have previously pointed out, the main reason for the eruption of the crisis at this point in time is the fact that true money supply inflation in the euro area as a whole has slowed to a mere 1.3% year-on-year – the slowest growth in the region's money supply since the euro came into existence. In a fractionally reserved banking system based on fiat money, a mere slowdown in the growth of the supply of money and credit is all it takes to bring the economy to the point of crisis. Essentially what is happening is that the many malinvestments in the economy have been unmasked and are in the process of being liquidated. The associated economic downturn has worsened the fiscal outlook of a great many governments, as their tax revenues are set to decline. The markets are therefore reassessing the creditworthiness of the governments concerned. In the absence of a national central bank that can print currency for an over-indebted government at will, the probability of a direct default on its obligations rises strongly.
By contrast, the US and UK governments, to name two pertinent examples, are in the process of defaulting on their debts via the indirect route of inflation. The markets are therefore giving them more rope to hang themselves – not least because there is an erroneous assumption that the inflationary policy will one day be stopped or reversed. This is however nigh 'impossible', as it would immediately lead to economic crisis as well. As a result, it is to be expected that the crisis will arrive in these countries with a considerable lag, but will be all the more forceful. If the ECB relents and adopts quantitative easing as well it will likely avert the imminent default of a number of euro area governments, but the euro area will then be in a very similar situation – the crisis will have been postponed, at the price of a bigger crisis that will erupt at a later stage.
In this context, it is quite amusing that the BoE's governor Mervyn King – the serial money printer who is currently presiding over a 1970's type stagflation in the UK – recently expressed his 'understanding' of the ECB's reluctance to go down the same path. You couldn't make this one up.
As to Germany's opposition to ECB money printing, one observer noted that German opposition to a lot of things has broken down in the course of the crisis:
“Even as skepticism grows about the EFSF plan, euro zone officials say no alternatives are being considered and that it is too early to declare failure.
"The demand (for participation in a CIF) has not been tested yet. The discussions (now) are on design, not on participation," a third official said.
The perceived flaws in EFSF leveraging and the difficulty of rushing the plan through quickly puts the ECB firmly back in focus, economists and policymakers say. French calls to make the EFSF a bank, with ECB funding, could be reconsidered. Although intensely resisted in Germany, the Frankfurt-based ECB is the only euro zone institution with the funds to buy Italian, Spanish and potentially French bonds in sufficient size to give markets pause for thought.
"I don't think we should assume that option of the EFSF as a bank is ruled out," said Alastair Newton, an analyst at Nomura.
"Back in September, both German Chancellor Angela Merkel and Finance Minister Wolfgang Schaeuble said there was no question of leveraging the EFSF. Yet a month later, Europe's leaders approved the leveraging," he said.”
Indeed, the likelihood that the 'leveraged EFSF' will flop is increasing by the day. We called it 'DOA' on the day it was announced and so far the market is agreeing with us. Consider the price of existing EFSF bonds depicted below:
The price of existing EFSF bond continues to plummet – click for higher resolution.
The eurocrats meanwhile aver that investors have told them that 'if confidence in euro area sovereign bond markets increases, then they would be perfectly willing to co-invest with the leveraged EFSF'. Alas, if 'confidence in euro area sovereign debt increases', a leveraged EFSF won't even be needed anyway, so this once again demonstrates that a bunch of financially illiterate amateurs is at work here. As Reuters reports on this circular argument:
"A very large majority of people are considering that one or both options of the leveraging would make sense for them," the official said. "They want to know more on technicalities, but the first reaction was clearly positive. It is too soon for them to commit a number or give any figure," the official said.
"If there is a good signal that would bring the confidence back to the markets, then probably the two options would be a very positive and very efficient leverage. They (investors) would go back, potentially massively, to the market," the official said.
"What they all want, and this is common to all investors, they want the confidence to come back," the official said. "A large amount of money is ready to go back as soon as they are confident that the volatility of the market is ready to fall."
In short, if market conditions improve to the point where we really don't need a leveraged EFSF, then we can actually get one off the ground. We're saved!
ECB president Draghi is apparently well aware that events have once again overtaken the eurocracy's latest plans. He bemoaned in a speech yesterday that not even decisions that were taken more than a year ago have been implemented. He used the same speech to also lay the groundwork for more ECB activism, by (effectively) noting that the economy is sliding into recession.
“Draghi expressed exasperation at the slow progress made by euro zone governments in getting the European Financial Stability Facility up and running.
He pointed out that European Union leaders had decided to launch the EFSF more than a year and a half ago, subsequently decided to make the full EFSF guarantee volume available, and decided to leverage the resources of the fund four weeks ago.
"Where is the implementation of these long-standing decisions?" Draghi asked in a speech to the European Banking Congress in Frankfurt.
"We should not be waiting any longer," he added in the text of his speech, although he did not actually say that line.
The ECB president, an Italian, repeated the central bank's assessment that downside risks to the economic outlook in the euro area have increased and said the weaker degree of activity would moderate price, cost and wage pressures.”
Regarding Germany's current stance, one idea that occurred to us – an idea that seems increasingly supported by circumstantial evidence – is that Germany's government is in principle prepared to relent, but wants to first extract a price from the rest of the euro area.
In brief, this amounts to: 'we'll agree to letting the ECB loose, but only if we get to dictate everybody's fiscal policy in the future'. This is what the push toward 'closer integration' of the EU and of the euro area specifically is very likely about from the German point of view - the Germans want to ensure that a truly effective mechanism for keeping government deficits in check is installed.
Obviously the original 'growth and stability pact' has completely failed at this task. However, as we have previously pointed out, it is Germany itself that was one of the first nations to fall afoul of the Maastricht treaty limits on deficits and cumulative public debt. It is not in possession of the moral high ground on this particular issue. Moreover, we think this proposal is even more DOA than the EFSF at this point, but nonetheless, Germany's political leadership probably feels it is necessary to be able to present a quid pro quo to its electorate if it is to relent on the ECB intervention question.
Bank Funding Drama Escalates
As readers may recall, we wrote in late October about the growing problem euro area banks are facing with respect to eligible collateral that can be used to obtain funding from the ECB (see 'The Euro Area Crisis May Be Coming To A Head' for the details).
In addition to this problem, banks are also faced with grave challenges regarding their long term funding requirements. In short, no-one wants to buy their bonds, but they actually need to roll over hundreds of billions in maturing debt next year. As the FT reports on this point:
“The worsening sovereign debt crisis in Europe has alarmed investors in eurozone bank debt. Many have simply backed away from funding the region’s lenders, stoking fears of a self-fulfilling funding squeeze. Even run-of-the-mill depositors – who historically have acted as a ‘sticky’ or safe form of funding for banks – are becoming more fickle.
Unicredit’s plea to the ECB in Frankfurt, on behalf of Italy’s banks, is “a sign that there are significant funding difficulties for European banks and they are escalating,” says Suki Mann, Société Générale credit strategist. He says that European banks have raised just €10.5bn of euro-denominated debt since July, a fraction of their usual financing needs.
With public markets effectively closed or prohibitively expensive for many European banks, lenders are having to look at different financing options. These include issuing more secured debt, such as covered bonds, or striking private funding deals. Banks can also attempt to increase their deposits, or tap the ECB for fresh loans.
The scale of refinancing is immense. Europe’s banks have raised about €295bn in the capital markets so far this year, according to Dealogic data. At the same time, the banks have €485bn of debt due to mature next year, meaning Europe’s lenders will have to scramble simply to replace their bonds.”
European authorities have also recognised the problem, promising to come up with a fix for the region’s funding woes at last month’s European Union summit. An EU-wide guarantee for bank debt might help thaw the market. But the EU has yet to announce details of its proposed plan and co-ordinating any such programme is likely to be difficult.
With investors backing off, Europe’s banks are left with two other options. They can turn to the ECB for funding or simply shrink their balance sheets; cutting unprofitable lending or exiting some businesses altogether.
A chart depicting the financing needs of euro area banks, via the FT – click for higher resolution.
We would add to this that the 'they can turn to the ECB' option runs into the problem that the 'striking of private funding deals' has denuded the banks of unencumbered assets they can pledge to the central bank. In spite of the fact that eligibility rules for collateral have been relaxed considerably, it has become increasingly evident that the assets still available for this purpose may not suffice to see the banks through. This means that 'shrinking their balance sheets' will soon remain as the sole alternative. A massive credit crunch is thus preordained. As to the fact that the “EU has yet to announce details of its proposed plan”, this is par for the course. There isn't a single plan in the context of the current crisis for which 'the details' have been hammered out yet. The only things that seem to be moving forward at a fast pace are various obstacles aimed at restricting financial market activity, such as the just passed 'naked CDS' trading ban.
As the WSJ reports, the scramble for collateral is beginning to take on potentially dangerous facets:
“Sometimes the end really is near. As the Journal’s David Enrich reports in this A1 story, European banks are resorting to liquidity swaps of dubious value to come up with the billions of euros worth of assets they need to pledge as collateral to secure ECB loans. This mad dash for collateral highlights how traditional sources of funding have dried up on concerns that lenders are sitting on “huge piles of risky government bonds and loans to shaky borrowers,” Enrich reports. It’s gotten so bad that, in a case of man bites dog, some corporate borrowers are balking at doing business with their banks.
And the U.K.’s Financial Services Authority has ominously warned that liquidity swaps have the potential to “create a transmission mechanism by which systemic risk across the financial system may be exacerbated.”
As we have pointed out yesterday, euro basis swaps have moved to new crisis wides, plunging below a previous shelf of support. The dollar swap agreement between the Fed and the ECB allows the banks to tap the ECB for dollar funding, however most have so far refrained from making use of this facility for two reasons, namely the stigma associated with it and more importantly, the price attached to this funding avenue. The ECB is charging the Fed Funds rate plus 100 basis points for dollar funding. Hence, as long as euro basis swaps remained at a level that was below the cost of the ECB's dollar funding facility, it made no sense to tap it – except for banks that are completely shut out from the wholesale and interbank funding markets.
This is now changing with the break of euro basis swaps to new wides, so we can likely expect an explosion in ECB dollar funding for euro area banks in coming weeks, especially if the situation in the swaps market worsens further. According to Reuters:
“The dollar funding issues for European banks have been well publicised over the past few months. Fearful of the worsening Eurozone crisis, vital sources of dollar liquidity like US money market funds reduced their exposure to European banks in the third quarter. Many European banks reacted by selling dollar assets and entering into secured funding transactions to alleviate their funding stress. At the same time, coordinated central bank action announcing the introduction of new dollar swap lines in mid-September helped to significantly ease markets.
However, signs of dollar funding stress have returned over the past fortnight, as the Eurozone crisis once again stepped up a gear. The three-month EUR/USD basis swap is currently trading at 129bp below Euribor, compared to around 103bp below three weeks ago.
"The way that the market is going, pressure is increasing for people to start tapping the ECB dollar line, both because the FX forward markets and the cross currency markets are drifting in the wrong direction making it more expensive to roll funding in the open market through the FX forwards, and because the banks themselves in Europe are under increased funding pressure as time goes by," said Nick Hallett, head of cross currency swaps at Barclays Capital.”
Meanwhile, Jonathan Weil has published an interesting observation in the wake of Unicredit's recently announced huge loss. As Weil notes, there is a good reason why bank stocks trade at a huge discount to their stated book value. Their books values are vastly overstated by accounting items that have little bearing on tangible value. Among those there are large 'deferred tax assets' (which only are of value if one actually makes a profit) and generous dollops of 'goodwill'. In the case of Unicredito the numbers are staggering, but the same is true for many other banks – including US banks:
“About 12 billion euros, or 23 percent, of UniCredit’s equity consisted of . Basically, this number represents the money UniCredit believes it will save on taxes in the future, assuming it will be profitable. Trouble is, in a crisis, those assets are pretty much useless.
On top of that, UniCredit’s balance sheet still showed 11.5 billion euros of the intangible asset known as goodwill, even after the bank wrote this down by 8.7 billion euros last quarter. Goodwill isn’t a salable asset. It’s the ledger entry a company records when it pays a premium price to buy another. The asset exists only on paper. (For what it’s worth, European banks are allowed to count deferred-tax assets as part of their regulatory capital, unlike goodwill.)
Add up the goodwill and deferred taxes, and that’s 23.5 billion euros of junk assets right there, which is more than the company’s market capitalization.
Hence, the problem: The numbers don’t make sense, at least not in the real world. And this is from a bank that would seem to be a beacon of candor by European standards, considering that no one else reported such huge third-quarter losses at a time when Europe is on the verge of disaster.
The French lender Credit Agricole SA, for instance, showed 19 billion euros of goodwill as of Sept. 30. That’s 7.4 billion euros more than its current market cap. Dexia SA (DEXB), the French- Belgian lender, took a government bailout in October, only three months after passing European regulators’ stress tests. Lack of faith in big banks’ numbers isn’t strictly a European problem, either. In the U.S., Bank of America Corp. shows $70.8 billion of goodwill, about $11 billion more than its market cap.
In so many words, all these banks are really worth zilch. Anyone buying their shares is an incurable optimist. This underlines an observation of Murray Rothbard's, who once noted (paraphrasing) that 'fractionally reserved banks are always teetering on the edge of insolvency'.
As an aside to the above, Unicredito has announced that it plans to raise € 7.5 billion in new capital. Consider in this context that the bank has assets valued at € 950 billion.
Meanwhile, in today's trading, government bond yields of Italy and France came in a little bit following a successful French bond auction and more (rumored) ECB intervention in Italian bonds. However, Spanish bond yields have continued to shoot up and sit at 6.77% at the time of writing, still influenced by the after-effects of yesterday's disastrous auction, in which the government had to agree to pay yields of almost 7% – causing Spain's prime minister Zapatero to plead for 'immediate action to stem the crisis' from the ECB. “That’s why we transferred to them a great part of the powers of each central bank,” Zapatero said.
The press has lately taken note of the deep troubles faced by Spain's banks – something we wrote about in great detail many months ago already (scroll down to 'The Accounting Tricks of Spain's Banks' for details). Bloomberg now reports that Spain's banks are under threat from 'unsellable real estate':
“Spanish banks, under pressure to cut property-backed debt, hold about 30 billion euros ($41 billion) of real estate that’s “unsellable,” according to a risk adviser to Banco Santander SA (SAN) and five other lenders.
“I’m really worried about the small- and medium-sized banks whose business is 100 percent in Spain and based on real- estate growth,” Pablo Cantos, managing partner of Madrid-based MaC Group, said in an interview. “I foresee Spain will be left with just four large banks.”
Spanish lenders hold 308 billion euros of real estate loans, about half of which are “troubled,” according to the Bank of Spain. The central bank tightened rules last year to force lenders to aside more reserves against property taken onto their books in exchange for unpaid debts, pressing them to sell assets rather than wait for the market to recover from a four- year decline.
Land “in the middle of nowhere” and unfinished residential units will take as long as 40 years to sell, Cantos said. Only bigger banks such as Santander, Banco Bilbao Vizcaya Argentaria SA (BBVA), La Caixa and Bankia SA are strong enough to survive their real-estate losses, he said.”
It is becoming difficult to keep track of the many fires that are now burning in the euro area's banking landscape. Not surprisingly, EU president Barroso now speaks of a 'systemic crisis' being faced by the euro-area.
Euro Area Credit Market Charts
Below is our customary collection of CDS prices, bond yields, euro basis swaps and several other charts. Both charts and price scales are color coded. Prices are as of Thursday's close. The plunge in euro basis swaps continues and our proprietary euro-bank CDS index is at a new high. CDS on Greece have exploded into the blue yonder.
5 year CDS on Portugal, Italy, Greece and Spain – a new all time high for CDS on Greece, which now clock in at an unbelievable 7,900 basis points. Whoever it was that 'bought the dip' following the haircut agreement has made a huge profit – click for higher resolution.
5 year CDS on France, Belgium, Ireland and Japan – CDS on France and Belgium continue to be at levels that can not be reconciled with their current credit ratings – click for higher resolution.
5 year CDS on Bulgaria, Croatia, Hungary and Austria – click for higher resolution.
5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – several new highs here as well – click for higher resolution.
5 year CDS on Romania, Poland, Slovakia and Estonia – click for higher resolution.
5 year CDS on Germany, the US and the Markit SovX index of CDS on 19 Western European sovereigns. The SovX is off just a tiny bit from a recent all time high – click for higher resolution.
Three month, one year and five year euro basis swaps – the plunge continues following the recent break of support – click for higher resolution.
Our proprietary unweighted index of 5 year CDS on eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito) – a new all time high!
5 year CDS on Austria's Erstebank and Raiffeisen Bank (based to 100 as of August) – also still rising – click for higher resolution.
10 year government bond yields of Italy, Greece, Portugal and Spain – Spain's yields continue to play catch-up with Italy's – click for higher resolution.
10 year government bond yield of Austria, the 9 year government bond yield of Ireland, UK Gilts and the Greek 2 year note.
10 year government bond yield of France - a slight dip – click for higher resolution.
10 year government bond yield of Spain - new high (today it increased further, to 6.77%) – click for higher resolution.
10 year government bond yield of Portugal – consolidating in its recent trading range. This is one that needs to be closely watched – we think Portugal may yet turn into the next Greece, although a recent 'troika' assessment confirmed that the country's fiscal plans remain on track. Alas, the economic downturn may yet alter that happy situation in coming months – click for higher resolution.
Italy's 10/2 spread remains very tight and close to inversion – click for higher resolution.
Germany's vice chancellor and economy minister Philip Rösler has come up with a great idea: end the bull market in emergency meetings.
As the WSJ reports:
"German Economy Minister Philipp Roesler has had a fantastic idea that should help us out of the euro crisis swamp. Europe needs stronger political integration, he said Thursday. The common currency needs common rules, he said. Some sovereign rights may have to be relinquished, he added.
That’s all well and good.
But his best idea, indeed probably the best proposal put forward by any European official so far, is this: Limit the number of crisis summits. Note: not the number of crises. Just the number of summits.
It’s tough to see how this could work. Should the eurocrats stand back when the flames are licking at their feet, and do nothing to reassure markets? Or is Mr. Roesler indirectly affirming what we all already know: The summits somehow seem to make everything worse?"
Indeed, the track record of these emergency summits isn't very good so far. As a side effect, cutting down on them would save tax payers a nice bundle as well, both directly and indirectly.
Charts by: Bloomberg, Financial Times
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