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A significant positive difference to the tail risk on European banks...
Some €15-45bn for Spanish banks and their government’s bonds at least, according to Morgan Stanley’s Huw Van Steenis, who has just produced a very interesting note on the carry trade du jour – or to use its technical name the ECB’s 3-year LTRO.
The two 3-year long-term repo operations (LTROs) are key pieces of a welcome package to ensure that, even if term unsecured debt remains impractically expensive, Europe’s banks will be able to continue to fund their assets. But could it also be a backdoor route to help sovereign funding, as some policy makers hope?
Our analysis suggests that mid-cap Spanish and some smaller Italian banks may indeed use this opportunity to enter new carry trades given very weak outlook for profitability. However, we think large cap banks will be less keen – in part due to concerns about stigma/reputation of becoming overly dependent on central banks for profitability (e.g. with ratings agencies) as well as concerns of being penalised again next year by the EBA. We think it very unlikely that banks will buy government bonds across borders (i.e. French buying Spanish or Italian debt) with ECB funds.
How impactful? Today government bonds+loans are 7% of Spanish banks assets and 9% in Italy vs 18% in Greece. Should domestic Spanish banks increase the ratio by 1-3% in 2012, this could create €15-45bn of buying presumably at the front end of the curve. This said, there are many numerous obstacles to cross.
Now, that’s probably not the numbers President Sarkozy had in mind when he uttered these words last week.
French President Nicolas Sarkozy said the ECB’s increased provision of funds meant governments in countries like Italy and Spain could look to their countries’ banks to buy their bonds. “This means that each state can turn to its banks, which will have liquidity at their disposal,” Sarkozy told reporters at the summit in Brussels.
Banks will have to weigh up the expensive costs of hedging their bond purchases given that sovereign CDS spreads have shot through the roof, reckons Morgan Stanley. Lenders might even have to go unhedged into LTRO funding. What’s more, they’ll face the ECB’s graduated haircuts during the LTRO. While the the haircut might be relatively small at the opening of the trade – over time, any marking of bond prices down to market, or a credit rating downgrade of the sovereign whose debt is being pledged, will mean borrowers have to pony up more capital. And spare capital is not exactly coming out of European banks’ ears at the moment.
Still, the overall take-up for LTRO funding is likely to be large reckons Van Steenis and his team.
We expect the take-up of the 3-year LTRO to be large, depending on three factors: (1) how much funding the banks need to do in the coming year; (2) whether it makes economic sense for banks to enter into new euro carry trades (3) the size of existing term lending facilities that could roll into the new 36-month LTRO.
Adding together the various sources of potential demand for the December tender, we get a number that could be around €160bn-€250bn, with a further potentially large take-up at the February 3-year tender. But the size of the take-up is not the point (although incremental government bond buying would help). What’s important here is that the combined set of initiatives of 3 year LTRO, + wider collateral + $ lines together makes a significant positive difference to the tail risk on European banks.
Additional reporting by Joseph Cotterill
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