Watching the Euro

There is a fascinating article from Bronte Captial about the Euro Fix.

The story so far, if you’ve forgotten: the ECB can’t be a lender-of-last-resort to governments, because it isn’t allowed to (from memory, the Krauts say No). But in a transparent fix, it is allowed to lend to banks, if those banks put up suitable collateral. And it has said, lo, government debt, that is good collateral. And so 500 bn has been loaned.

Why, as a bank, would you want to buy shonky govt debt? Because dodgy Italian debt yields 6% or so at the moment, and lord knows what the Greek stuff provides. But the ECB loans are at 1%. With the difference yielding 5% pure profit risk-free (ahem), hooray. The downside, of course, is the long-term capital risk.

The Bronte article is speculating on the likely conflicts between the banks’ traders – who can presumably see the short-time huge bonuses coming out of the short-term profits, all sanctioned by the Euro-governments desperation to get the banks to buy the debt – against the Risk Dept., who probably don’t want to touch it with a bargepole.

Refs

* Britain and Europe
* It has to get worse before it can get better
* Greek PM drops trousers
* Eurozone: It’s Working, the Carry Trade is Working, Euro Saved!

Comments

  1. #1 Alexander Ač
    2011/12/23

    William, regarding the Euro and those 500 bn injection, another relevant comment can be found at the Automatic Earth by Ilargi:

    “The ECB claims that it “hopes” the banks will use the money to purchase peripheral debt, but the ECB knows they won’t (and what sort of €489 billion deal depends on “hope” only?). It knows, because the ECB itself, along with other parties, has refused to guarantee that debt.

    It may be presented as a good deal, but borrowing at 1% to get a 5% return is not all that attractive when you have a 50% chance of an 80% haircut. Or something along those lines.”

    ETC…. http://theautomaticearth.blogspot.com/2011/12/december-21-2011-forest-feels-denser.html

    Alex

    [I think that comment is wrong. The ECB isn't allowed to guarantee that debt; "refused" doesn't come into it. The ECB has, howeer, been very clear that it is perfectly happy to accept as collateral for the loans that debt that it itself won't / can't guarantee. But of course, yes, there is the capital risk -W]

  2. #2 sharper00
    2011/12/23

    ” because it isn’t allowed to (from memory, the Krauts say No).”

    Correct. The Germans are deathly afraid of inflation which is perhaps not unjustified given semi-recent history

    It’s very difficult to say what would work best in the Eurozone – if the ECB could simply invent the needed money would Italy or Greece reduce their spending? I have to think not. The only workable way we have the ECB be the lender of last resort is if individual governments have strict limits on how much they can borrow, obviously efforts to achieve this are underway but in the usual odd way Europe tends to do things.

  3. #3 grypo
    2011/12/23

    Keep in mind that any loan from IMF or ECB must be paid back FIRST in case of default on loans and liquidation of assets of any sovereign or bank. It means that the international investor market still won’t get anything if they continue to buy debt of a soon-to-be-defaulted country or bank. This move doesn’t actually fix anything, it kicks the can down the road. It’s the same measure the Obama/Geightner team used to get liquidity back into the banks, which helped the banks mightily and propped up a failed system in early 2009, but did nothing to fix the massive damage the crash caused.

  4. #4 Alexander Ac
    2011/12/23

    William,

    might be that ECB is “not allowed”. I would add that it is good, since more cheap credit (i.e. debt) only worsens insolvency crisis. And yes, there is (huge) capital risk, since italian debt is being trashed again with bond yields crossing 7 % (again), and that is not sustainable. Italy is practically bankrupt,

    Alex

  5. #5 Alexander Ač
    2011/12/23

    And here is the fate of that 489 bn (make it 210 bn) stimulus:

    …as of yesterday, the day after the LTRO, European banks parked almost half of the free €210 billion (recall that while gross LTRO proceeds were €489 billion, only €210 billion was net), or €82 billion, with the ECB’s deposit facility, which incidentally brought the cumulative total to a new 2011 record of €347 billion, from €265 the day before. And that is what monetary policy failure is all about.

    ZeroHedge reports

  6. #6 TheGoodLocust
    2011/12/23

    It sounds like some of the schemes we have in the US. The government lends banks money at 0% and they use that money to buy government bonds that pay them 2-3%.

    And people wonder why the banks aren’t lending to businesses….

    [It doesn't affect bank loans to businesses. Govt debt doesn't count for reserve-calculation purposes, so the debt is free. The banks can still lend to companies -W]

  7. #7 TheGoodLocust
    2011/12/26

    “[It doesn't affect bank loans to businesses. Govt debt doesn't count for reserve-calculation purposes, so the debt is free. The banks can still lend to companies -W]”

    I think there may be a miscommunication or misunderstanding somewhere along the line.

    To clarify what I was saying (i.e. the crowding out effect), instead of taking the money they get from the government and lending it out to businesses, they instead buy government bonds (Recursion banking?).

    They can’t spend the money twice right?

    [Indeed. But if they tried to spend the money on loans to business, they would need to lay up capital against the reserve requirements, which they don't have, so they couldn't spend it there, either. The point about govt debt is that it, uniquely, comes with no reserve requirement -W]

  8. #8 crandles
    2011/12/28

    Italian debt auction:

    http://www.bbc.co.uk/news/business-16343825

    “The interest on the six-month bills was 3.251%, down from 6.504% at the last similar auction in November.”

    A remarkable change unless it is some of that 500bn finding a home.

    [Some might be the new govt. I'd suspect that much is the £500 bn -W]

    >”It may be presented as a good deal, but borrowing at 1% to get a 5% return is not all that attractive when you have a 50% chance of an 80% haircut.”

    If your bank is sufficiently exposed so that it is dead anyway with a 6%+ haircut then there is little extra risk and you may as well take the 5% return. Even with the return dwindling to 2.251%, it also improves liquidity as the italian debt can be used as collateral. So it remains a good deal for banks that know a small haircut will kill them.

    2.251% return with just a 30% risk of 10%+ haircut looks a bad deal.

    So is this a bad sign that lots of banks know they are dead anyway with a small haircut?

    [I'm sure there are many interpretations. Note, BTW, that it can be more than a 2.25% return, by leveraging -W]

  9. #9 crandles
    2011/12/28

    Err, leveraging means taking on debt to do it. But we are already taking about fully doing that as is implict in the 3.251%-1% calculation.

    [No, because you can loop round and do it again -W]

  10. #10 crandles
    2011/12/28

    If you loop round and do it again then there is a larger profit but the 2.251% is a percentage and the denominator gets larger at the same rate as the profit so it doesn’t get you more than 2.251%.

    [You have £1. You buy £1's of govt debt, yielding 5% (say). With that as collateral, you can now borrow £1 from the ECB at 1%, for a net yeild of 4%. You use that £1 to buy govt debt, yielding 5%. With that as collateral, you borrow £1 at 1%. You now have £1, and an income of 8%. Your capital at risk, though, is now £2, not £1. And so on... -W]

  11. #11 Richard Hill
    2011/12/28

    When a govt cannot borrow from banks at comfortable rates it could force its own citizens to cover the debt. For example, the govt could part pay govt salaries, pensions etc in long term bonds instead of currency. The long term bonds would pay interest at a normal rate. If the citizens needed cash they could sell the bonds. (and wear the discount)

    [That is an interesting idea... I could see it being unpopular, but for some countries (Greece springs to mind) it could be a good solution. A large part of their problem is the need for wage deflation in the public sector; this would provide it. Still better, they could pay their vastly inflated over-early pensions in bonds -W]

  12. #12 RH
    2011/12/28

    If a govt cannot get good terms from banks for the govt debt, the govt could force its own citizens to accept the debt. The govt could create long term bonds and part pay pensions and civil servant salaries with the bonds.

  13. #13 J Bowers
    2011/12/29

    Sounds like a potential dream scenario for distressed debt investors, aka vulture funds.

  14. #14 crandles
    2011/12/29

    Not sure it is worth arguing over but:

    Your bank started with £1 of equity. As you said they didn’t have any to lay up in order to lend to businesses, I was starting with a balance sheet containing assets of gov debt £100 and cash £11.11 and liabilities of £111.11 (customer deposits) and no equity. Pledge the £100 gov debt to ECB to borrow £100 to invest in gov debt which is then pledged to ECB to borrow a second £100 which is invested in gov debt.

    The £12-£2=£10 interest on extra £200 of gov debt is then divided by either 0 representing equity for infinite rate of interest or divide by £200 of assets/liabilities/amount at risk created which keeps the rate at 5% however many times round you do it. This is a fully leveraged example as I mentioned I was doing.

    Yours uses £1 of equity so isn’t fully leveraged. That is your only justification for dividing by £1 and contradicts your no equity available to lay up.

    I thought I had made clear that I do realise the profit increases from £5 to £10 and if the equity is positive then it is a fixed amount so there is a greater return on equity. However return on equity is pretty meaningless when there isn’t any, which seemed to be your position.

  15. #15 crandles
    2012/01/13

    >”lord knows what the Greek stuff provides”

    BBC reports greek debt trading at 20% of face value so over 500% return if it is paid in full and still over 150% return if 50% debt writedown holds. Those figure may obviously turn out to be over more than one year.

    Markets obviously think total loss is more likely than the 50% debt writedown holding. Probably not surprising with talks on hold for indefinite period.

  16. #16 crandles
    2012/01/13

    Time to buy Euro.dropped.2012 on intrade at 33?

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