First off, it should be stressed that in spite of the adverse reaction in 'risk' markets to the ECB announcement yesterday, the ECB has in fact taken very significant steps designed to bring the liquidity gusher to bear and ease the banking system's funding pressures.
First of all, there is of course the 25 basis points rate cut, which immediately sent all key Euribor rates down sharply.
However, far more important were the decision regarding the provision of new long term refinancing operations (LTRO's) and the decision to further ease collateral eligibility requirements.
In terms of LTRO's, the ECB has – as expected – announced an extremely long term facility. While ECB president Mario Draghi was eager to stress the 'temporary nature' of this measure, there can be little doubt that all these 'temporary' liquidity support measures are slowly but surely becoming ever more enshrined and are taking on a quasi-permanent character. Whenever an attempt is made to take these measures back, crisis immediately results. Draghi may not yet be fully cognizant of this, but we are looking at an essential feature of the fractionally reserved fiat money system here. It needs to continually inflate, or it dies.
“In its continued efforts to support the liquidity situation of euro area banks, and following the coordinated central bank action on 30 November 2011 to provide liquidity to the global financial system, the Governing Council today also decided to adopt further non-standard measures. These measures should ensure enhanced access of the banking sector to liquidity and facilitate the functioning of the euro area money market. They are expected to support the provision of credit to households and non-financial corporations. In this context, the Governing Council decided:
First, to conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months and the option of early repayment after one year. The operations will be conducted as fixed rate tender procedures with full allotment. The rate in these operations will be fixed at the average rate of the main refinancing operations over the life of the respective operation. Interest will be paid when the respective operation matures. The first operation will be allotted on 21 December 2011 and will replace the 12-month LTRO announced on 6 October 2011”
Again, the effect of this measure should not be underestimated. One of the main obstacles faced by euro area banks as they scramble to obtain funding and attempt to deleverage in order to reach the mandated new tier one capital ratios (which – according to the latest worthless EBA 'stress test' results - is a less onerous exercise than was hitherto assumed), is that liquid banks and investors have withdrawn unsecured funding from the banks considered to be experiencing liquidity and quite possibly solvency problems.
In many cases it has turned out that selling assets is far easier said than done, as the prices that are likely to be paid will invariably lead to the recognition of significant losses that can only be hidden as long as such assets are neither sold nor written down voluntarily. Thus the banks have been forced to obtain funding in bilateral deals on ever more onerous terms, in most cases requiring very large haircuts (or over-collateralization) and have found it very difficult to engage in strategic long term planning as there are currently only very few buyers of their unsecured long term bonds. In addition, the interbank funding market has dried up as well, with liquid institutions preferring to park their excess reserves with the ECB rather than lending them out, as counterparty risk perceptions remain in red alert territory. So a very long term ECB funding facility certainly removes a lot of pressure.
Secondary Media of Exchange and the Re-Hypothecation Chain
Due to the above mentioned fact that assets pledged to obtain funding are often subject to vast haircuts, a collateral shortage has developed in the euro area banking system, a problem which we have first discussed several weeks ago. This developing collateral shortage put paid to ECB board member Lorenzo Bini-Smaghi's full-throated assurances of a few months ago that 'there is plenty of eligible collateral in the euro are banking system'. In fact, it appears that an amount of € 14 trillion in eligible collateral thought to be available at the time has quickly shrunk to next-to-nothing. Of course this has been further egged on by the Fed's and BoE's 'QE' operations, which permanently remove 'safe collateral' from the marketplace, as well as the constant stream of credit rating downgrades, which make collateral previously regarded as 'safe' decidedly 'unsafe'. In the sovereign bond space in Europe alone, trillions in debt collateral have been pushed into the 'unsafe' category. The effect is that haircuts and margin requirements are constantly increased. In the meantime, more color on this problem has emerged, via the '2012 Global Outlook' recently published by Credit Suisse.
A chart of the shrinking pool of 'safe assets' in the global financial system – click for better resolution.
As the FT Alphaville blog reports, commenting on the above chart:
“It shows how the world’s outstanding stock of safe haven assets denominated in either dollars or euros has evolved, adjusted to account for the Fed’s purchases of US Treasuries and other assets in recent years as part of quantitative easing. You can see just how impressive the decline has been since 2007, and we’d also note that if Credit Suisse had been feeling uncharitable, they would have been justified in excluding French sovereigns.
The chart helps explain much of what’s happening in global financial markets now, especially in Europe (not on its own, mind you — we said “helps” explain):
– Begin with the ongoing collateral crunch, and how the decline of safe assets is directly tied to the dramatic fall in the availability of high-quality collateral in European lending markets. So much of it is now encumbered via direct bilateral funding agreements or by sitting at the central bank drawing liquidity.
Now, if you’ve read your Manmohan Singh (or your Izzy Kaminska or your ), you’ll know that this availability is the first of two parts of the collateral shortfall effect. The other part is the shortening of “re-pledging chains”, otherwise known as a reduction in the velocity of collateral.
Regarding the 're-pledging' or 're-hypothecation' chains, it is worth mentioning that the demise of MF Global and the associated disappearance of a good chunk of its customer's funds has lately attracted the attention of many observers to the unregulated shadow-banking re-hyopothecation cesspool in the London market. More on this follows further below, but let us first consider the above mentioned 'velocity' effect.
Alphaville quotes Manmohan Sing on the matter:
The “velocity of collateral”—analogous to the concept of the “velocity of money”—indicates the liquidity impact of collateral. A security that is owned by an economic agent and can be pledged as re-usable collateral leads to chains. Thus, a shortage of acceptable collateral would have a negative cascading impact on lending similar to the impact on the money supply of a reduction in the monetary base. Thus the first round impact on the real economy would be from the reduction in the “primary source” collateral pools in the asset management complex (hedge funds, pension and insurers etc), due to averseness from counterparty risk etc. The second round impact is from shorter “chains”—from constraining the collateral moves, and higher cost of capital resulting from decrease in global financial lubrication.When you hear concerns that the ECB has lost some control over monetary policy because of a liquidity-starved credit channel — or indeed when you hear Draghi himself say that he’s cognizant of the “scarcity of eligible collateral” – this is why. As was perhaps inevitable, the decline in safe assets has come at a time when investor demand for these assets has only climbed for them and as the deep freeze in European unsecured lending has meant a big shift towards collateralised lending. Hence the widening discrepancy in repo prices for different types of collateral (also noted by Draghi) and, in particular, the negative spread between Libor and the secured repo rate, on which Izzy superbly elaborates. For all but the strongest banks, i.e. those with surplus cash reserves, the ECB is increasingly the only shop still open.”
We encourage readers to follow the links provided in the above excerpt for more details on how the plumbing of these funding markets operates and how the collateral crunch impacts them, especially Izabella Kaminska's 'The ECB as pawnbroker of last resort'.
We would note to the above that in these repo markets, collateral operates in a manner that suggests that it can be regarded a 'secondary medium of exchange' as described by Mises. Therefore, instead of talking about the 'velocity of collateral', which is a slightly misleading concept since someone always holds the collateral, we would be inclined to rather speak of the 'supply of and the demand for collateral' in a sense similar to when we speak of the supply of and the demand for money.
As regards secondary media of exchange, below is a passage from Human Action that explains the concept. Money is the economic good with the highest marketability, so there obviously exists a gradation of the marketability of various economic goods. Goods that have an extremely high degree of marketability, this is to say, can be expected to be readily exchangeable into cash, can therefore function as secondary media of exchange.
“Thus the size of a man's or a firm's cash holding is influenced by whether or not he owns a stock of goods with a high degree of secondary marketability. The size of cash holding and the expense incurred in keeping it can be reduced if income-producing goods of a high degree of secondary marketability are available.
Consequently there emerges a specific demand for such goods on the part of people eager to keep them in order to reduce the costs of cash holding. The prices of these goods are partly determined by this specific demand; they would be lower in its absence. These goods are secondary media of exchange, as it were, and their exchange value is the resultant of two kinds of demand: the demand related to their services as secondary media of exchange, and the demand related to the other services they render.
The costs incurred by holding cash are equal to the amount of interest which the sum concerned would have borne when invested. The cost incurred by holding a stock of secondary media of exchange consists in the difference between the interest yield of the securities employed for this purpose and the higher yield of other securities which differ from the former only in regard to their lower marketability and are therefore not suited for the role of secondary media of exchange.”
Today the secondary media of exchange commonly used are:
1. Claims against banks, bankers, and savings banks which- although not money-substitutes – are daily maturing or can be withdrawn on short notice.
2. Bonds whose volume and popularity are so great that it is, as a rule, possible to sell moderate quantities of them without depressing the market.
3. Finally, sometimes even certain especially marketable stocks or even commodities.
Of course, the advantages to be expected from lowering the costs of holding cash must be confronted with certain hazards incurred. The sale of securities and still more that of commodities may only be feasible with a loss.”
It is the latter point emphasized above that has become a big problem – the collateral used a 'secondary media of exchange' in the repo markets has now become victim to the hazards Mises mentions: its sale is only feasible at a loss, which in turn means that its value as collateral in the chain of hypothecation and re-hypothecation has commensurately declined.
Therefore, the second important decision the ECB has announced yesterday was a further relaxation in its 'collateral eligibility rules'. Instead of lending only against collateral of impeccable quality, it sounds as though the ECB will possibly soon accept everything from beanie-babies and comic book collections upward (as long as they are securitized). In this it has adopted the methodology employed by the Fed in the 2008 crisis: it is relieving the banking system of assets of rather dubious quality. Here is the pertinent passage from the statement:
“Second, to increase collateral availability by reducing the rating threshold for certain asset-backed securities (ABS). In addition to the ABS that are already eligible for Eurosystem operations, ABS having a second best rating of at least “single A” in the Eurosystem harmonised credit scale at issuance, and at all times subsequently, and the underlying assets of which comprise residential mortgages and loans to small and medium-sized enterprises, will be eligible for use as collateral in Eurosystem credit operations. Moreover, national central banks will be allowed, as a temporary solution, to accept as collateral additional performing credit claims (namely bank loans) that satisfy specific eligibility criteria. The responsibility entailed in the acceptance of such credit claims will be borne by the national central bank authorising their use. These measures will take effect as soon as the relevant legal acts have been published.”
You can bet that the 'national central banks' in the euro system will make liberal use of their discretion. Also, the lower quality asset backed securities (ABS) the ECB is now prepared to accept are often securities the banks have created with the specific intent of pawning them off to the ECB – they would be completely illiquid in the secondary market.
Now to the trail of MF Global's business, which financial journalists have lately followed and which has led to increased scrutiny of the 're-pledging chains' in the so-called 'shadow banking system'. What is most remarkable about this is that investment banks and brokers can use the assets belonging to their customers held in margin accounts without their customers' assent in any way they deem appropriate (or rather, the situation is that customers must sign a blanket assent when opening an account – thereafter they have no control whatsoever over the manner in which securities that belong to them are used).
These third party assets are then pledged and re-pledged in a sheer endless chain of hypothecation that is obviously only as strong as its weakest link. Moreover, the relatively low margin requirements involved make this a form of fractional reserve banking using secondary media of exchange. This means that although the so-called 'shadow banking system' can not by itself create money from thin air, it can still create an enormous amount of systemic leverage by employing secondary media of exchange in these operations. We have to leave a more detailed discussion of MF Global's specific trades for a future post, in the meantime we would however like to point readers to an article at Thompson-Reuters that gives a detailed account of the shadow banking system's activities in London's unregulated repo markets. It should be obvious from this that a 'collateral shortage' impinges greatly on systemic liquidity and hence on asset prices. This also explains why the ECB's continued refusal to finance euro area governments with a form of 'QE' has led to a sharp sell-off in 'risk assets' yesterday.
Here is the article at Reuters by Christopher Elias, entitled 'MF Global and the great Wall Street re-hypothecation scandal'. An excerpt:
“With weak collateral rules and a level of leverage that would make Archimedes tremble, firms have been piling into re-hypothecation activity with startling abandon. A review of filings reveals a staggering level of activity in what may be the world’s largest ever credit bubble.
Engaging in hyper-hypothecation have been Goldman Sachs ($28.17 billion re-hypothecated in 2011), Canadian Imperial Bank of Commerce (re-pledged $72 billion in client assets), Royal Bank of Canada (re-pledged $53.8 billion of $126.7 billion available for re-pledging), Oppenheimer Holdings ($15.3 million), Credit Suisse (CHF 332 billion), Knight Capital Group ($1.17 billion),Interactive Brokers ($14.5 billion), Wells Fargo´($19.6 billion), JP Morgan($546.2 billion) and Morgan Stanley ($410 billion).
Nor is lending confined to between banks. Intra-bank re-hypothecation is also possible as evidenced by filings from Wells Fargo. According to disclosures from Wachovia Preferred Funding Corp, its parent, Wells Fargo, acts as collateral custodian and has the right to re-hypothecate and use around $170 million of assets posted as collateral.
The volume and level of re-hypothecation suggests a frightening alternative hypothesis for the current liquidity crisis being experienced by banks and for why regulators around the world decided to step in to prop up the markets recently. To date, reports have been focused on how Eurozone default concerns were provoking fear in the markets and causing liquidity to dry up.
Most have been focused on how a Eurozone default would result in huge losses in Eurozone bonds being felt across the world’s banks. However, re-hypothecation suggests an even greater fear. Considering that re-hypothecation may have increased the financial footprint of Eurozone bonds by at least four fold then a Eurozone sovereign default could be apocalyptic.
U.S. banks direct holding of sovereign debt is hardly negligible. According to the Bank for International Settlements (BIS), U.S. banks hold $181 billion in the sovereign debt of Greece, Ireland, Italy, Portugal and Spain. If we factor in off-balance sheet transactions such as re-hypothecations and repos, then the picture becomes frightening.
As for MF Global’s clients, the recent adoption of an “MF Global rule” by the Commodity Futures Trading Commission to ban using client funds to purchase foreign sovereign debt, would seem to suggest that it was indeed client money behind its leveraged repo-to-maturity deal – a fact that will likely mean that very few MF Global clients few get their money back.”
No wonder then that the ECB continues to implement 'extraordinary measures' and remains committed to its quest of becoming Europe's biggest 'bad bank'. Its balance sheet accordingly continues to grow by leaps and bounds.
The ECB/euro-system's balance sheet (asset side), via Cumberland Advisors (data provided by Austria's central bank) – click for better resolution.
Assets of the 'G4' central banks – the Fed, ECB, BoJ and BoE combined – click for better resolution.
Putting the 'Fraction' Into Fractional Reserves
The third 'extraordinary measure' we already briefly discussed yesterday, was the decision to lower the reserve requirement for customer deposits at euro area banks. This has now been cut from an already ridiculously low 2% to a mere 1%.
“Third, [it was decided] to reduce the reserve ratio, which is currently 2%, to 1%. This will free up collateral and support money market activity. As a consequence of the full allotment policy applied in the ECB’s main refinancing operations and the way banks are using this option, the system of reserve requirements is not needed to the same extent as under normal circumstances to steer money market conditions. This measure will take effect as of the maintenance period starting on 18 January 2012.
Fourth, to discontinue for the time being, as of the maintenance period starting on 14 December 2011, the fine-tuning operations carried out on the last day of each maintenance period. This is a technical measure to support money market activity.”
As we have mentioned many times, the amount of uncovered money substitutes in the euro area's banks relative to covered money substitutes is already frighteningly large. A mere € 209 billion out of a total of € 3.917 trillion in money substitutes are actually covered in the sense that there exists standard money that is backing them. The rest – € 3.708 trillion – are fiduciary media, a.k.a. 'money from thin air', for which no standard money currently exists. This situation will be made even more precarious by the further lowering of reserve requirements. As a rough estimate, we would guess that this measure will 'free up' an additional € 100 billion in liquidity in the euro area banking system.
As an aside to this, obviously the euro area banking system is highly vulnerable to a run on deposits.
Something that may have escaped people's attention is the innocuous looking remark about the 'discontinuation of fine-tuning operations'. As far as we are aware from the ECB's 'ad hoc communications' page, the only 'fine tuning operation' that is regularly undertaken every week is the sterilization of the SMP. Is the ECB suggesting that it will no longer sterilize the SMP? If so, then this is a momentous decision, with the ECB taking a big step into the realm of 'QE' ('quantitative easing' or better, 'money printing on a grand scale').
We are however not quite sure if we really understand this correctly, as Mario Draghi continued to stress during his press conference that the SMP remains fully sterilized. Alas, what else can this mean? There simply are no other 'fine tuning operations' that we can find or are currently aware of.
In summary we would say that the market seems to greatly underestimate the importance and likely impact of the measures the ECB has announced yesterday. As far as we can tell, these measures amount all in all to a truly gigantic inflationary push.
The euro area's true money supply (TMS), via Michael Pollaro. The mountain of uncovered money substitutes dwarfs covered money substitutes and currency – click for better resolution.
Mario The Party Pooper
As always, the ECB press conference was quite interesting and well worth watching. It can be seen here, on the ECB's web-casts page.
The most important part of the Q&A was when Mario Draghi was (repeatedly) quizzed regarding his statements to the European parliament, which were hitherto interpreted as indicating that the ECB was prepared to intervene more heavily in sovereign bond markets once the new 'fiscal compact' was decided upon by the euro-group's political leaders.
We have also speculated on the meaning of Draghi's remarks in his address to the EU parliament and concluded that in some shape or form, a 'clever formula' (to paraphrase Irish finance minister Noonan) was being cooked up to allow the ECB to begin monetizing the bonds of Italy, Spain and others. Of course this would be fraught with considerable problems, not the least of which is that ECB interventions in sovereign bonds immediately create two classes of creditors, with the ECB's claims enjoying seniority over the claims of the private sector. As has been seen in the case of Greece, this can utterly destroy the bond market of the country concerned, as the private sector gets burdened with an ever greater proportion of the eventual 'haircut'. Of course the eurocrats assure us that Greece will remain an 'exceptional case' - a one-off never to be repeated. The problem with this is that they have irretrievably lost all credibility on this particular topic.
Newsflash to the naïve: governments lie. They do it all the time, as a matter of course. Sometimes they are even candid and brazen enough to admit it, as the prime minister of Luxembourg, Jean-Claude Juncker, has famously done a few months ago.
Anyway, regarding the financing of government deficits with the help of the ECB, Draghi was at pains to dispel all speculations to this effect, which apparently triggered the big sell-off in stocks and commodities yesterday. He stressed once again that the ECB's statutes and EU treaties make clear that such activities are not legal, and that these statutes have been drawn up in the spirit of the long-standing prohibition of government financing enshrined in the German Bundesbank's statutes.
Draghi also noted that there was no question of finding a 'clever formula' to circumvent these prohibitions: not only the letter of the law should be respected, so Draghi, but its spirit. And quite clearly, the monetization of government debt is not in the spirit of the treaty.
However, Draghi seemingly left a small door open with regards to lending money to the IMF. While stressing (we are paraphrasing) that 'the ECB is not an IMF member' and therefore 'can not lend to the IMF' and can also 'not give money to the IMF for the exclusive purpose of buying euro area government bonds', as this would once again violate the spirit of the prohibition – he noted also that there were 'complex legal questions' involved and that there was a need to quickly implement a rescue mechanism aside from establishing a new 'fiscal compact'. There was evidently a hint there regarding the notion that the national central banks of the euro system can in fact lend to the IMF in bilateral agreements. To this it should be noted that even Germany's Bundesbank now seems open to the idea – while likewise stressing that any bilateral loans to the IMF must go to the IMF's 'general account' in order to avoid the appearance that financing of euro area government deficits is enacted by the region's national central banks. As Reuters reports:
“The Bundesbank is open to it and other euro zone national central banks providing credit lines to the International Monetary Fund as part of a package of measures to tackle the debt crisis, a Bundesbank source told Reuters on Thursday.
"We must look at the precise details," the source close Bundesbank President Jens Weidmann added. "The money must go to the general IMF account, a special account for euro zone countries would equate to a financing of member states."
Euro zone countries are likely to agree to lend 150 billion euros ($200 billion) to the IMF via bilateral loans from their central banks, a senior euro zone source told Reuters earlier on Thursday, hours before the start of a crucial EU crisis summit.
So clearly there are efforts underway to actually set in motion what Draghi says won't be done, namely the implementation of the aforementioned 'clever formula' to enable more forceful ECB intervention in euro area government bonds via the IMF detour.
Draghi of course remains very 'conscious of the Bundesbank's perspective' as this Reuters article notes, and is careful 'not to alienate Jens Weidmann'.
Lastly, leaked proposals from the the euro-group summit seemed to indicate that the idea of giving the ESM a banking license remains on the table. While quickly denied by Germany ('we won't agree to this') there remains the feeling that Germany is merely holding out in order to ensure that the new 'fiscal compact' is accepted. It will have to offer something in return and surely even Merkel and Schäuble are aware that they risk a volatile, non-linear market dislocation if they continue to balk at these rescue ideas (yesterday, euro area government bond yields ex Germany's once again shot up sharply). In short, a number of cherished Teutonic principles are likely to be thrown overboard in the end. And needless to say, the ECB's latest policy moves already indicate that money printing on a grand scale is about to get underway – counterbalanced to some extent by the continued deleveraging efforts of the banking system and other private sector economic actors in the euro area.
ECB president Mario Draghi: the spirit of the law must be respected – no government deficit financing by the ECB is possible.
(Photo via Reuters)
The German Übermutter and little Nicolas – will they be able to 'deliver' this time?
(Image via FreakingNews.com)
Charts by: Michael Pollaro, Cumberland Advisors, Haver Analytics, Credit Suisse, Federal Reserve Research
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