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Europe’s banks beached as ECB stimulus runs dry
The European Central Bank’s E1 trillion (L824 billion) lending spree over the winter has stored up a host of fresh problems, leaving parts of the banking system more vulnerable than before as the short-term “sugar rush” nears exhaustion.
Credit experts say the Spanish and Italian banks are trapped with large losses on sovereign bonds bought with ECB funds under the three-year lending programme, or Long-Term Refinancing Operation (LTRO).
Andrew Roberts, credit chief at RBS, said Spanish banks used ECB funds to purchase five-year Spanish bonds at yields near 3.5 percent in February and 4.5 percent in December. The same bonds were trading at 4.77 percent on Wednesday, implying a large loss on the capital value of the bonds.
It is much the same story for Italian banks pressured into buying Italian debt by their own government. Any further dent to confidence in Italy and Spain over coming weeks — either over fiscal slippage or the depth of economic contraction — could push losses to levels that trigger margin calls on collateral.
“The banks are deeply under water. This is turning into a disaster for the eurozone periphery now that the liquidity tap has been turned off,” said Mr Roberts. “But given the opposition in Germany, the ECB can’t easily do another LTRO until there is a major crisis.”
Spanish banks bought E67 billion of sovereign debt between December and February, while Italian banks bought E54 billion. The purchases almost certainly continued in March. These lenders have soaked up most of debt issues in their countries over the past three months, picking up at a juicy return under the “carry trade” while at the same acting as a conduit for the ECB to shore up crippled countries by the back door.
The snag is becoming evident. Weaker lenders are merely parking the ECB’s ultra-cheap funds in these bonds until they need the money to roll over their own debts. That is coming due since European banks have E600 billion in redemptions over the rest of the year. Many are now stuck with losses that they cannot afford to crystalise.
“It is going to be a problem if the funding market does not open soon and they have to liquidate their holdings,” said Guy Mandy from Nomura. “What the LTRO has done is concentrate systemic risk even further. If everything now goes wrong, it could go wrong in a hurry.”
Mr Mandy said the EU’s fiscal austerity is itself “self-defeating,” asphyxiating growth and further entwining the perilous nexus of fragile banking systems and indebted states. “Europe still lacks a commensurate policy response. The dogged pursuit of pro-cyclical fiscal austerity could force countries into a downward spiral. To minimise risk, monetary policy needs to be exceptionally loose,” he said, calling for a blitz of quantitative easing (QE) to remove assets from bank balance sheets.
Mr Mandy said the LTRO is entirely different from the stimulus of the Anglo-Saxon central banks. “There has been no transfer of risk to the ECB’s own balance sheet, which is what we think is needed to take away the tail risk of another EMU blowup.”
Benoit Coeure, France’s board member at the ECB, on Wednesday hinted that Frankfurt may be willing to restart direct purchases of Spanish bonds to cap rising yields, saying the debt rout over recent weeks is unjustified.
The comments triggered a recovery of Club Med debt but such action is fraught with its own risks even if the German Bundesbank is willing to help a country that is seen — in German eyes at least — to be dragging its feet on fiscal austerity.
David Owen from Jefferies Fixed Income said that the ECB pushes other investors “down the food chain” instantly when it buys Spanish and Italian debt, raising the loss ratio if either country slides into a Greek-style restructuring.
This has become a sore subject for investors following the Greek debacle where all EU bodies — including the European Investment Bank, which is not a lender of last resort — were exempted from having to take haircuts. Others such as the Norwegian state pension fund suffered 75 percent losses.
Japanese investors have sold E48 billion of eurozone debt over the past year, according to Bloomberg, and are steering clear of any EMU states that could be given the Greek treatment.
“I’m not planning to add Spanish or Italian bonds any time soon,” said Masataka Horii from Kokusai Global Sovereign Open Fund.
Mr Owen said the eurozone’s slide into recession will intensify debt jitters and force the ECB to respond. “It will have to cut rates to near zero, and ultimately launch full-scale QE, perhaps as soon as the third quarter.”
Mr Owen said contortions caused by ECB intervention would not be an issue if the bank acted with force majeure and conviction, as the central banks of the US, UK, and Switzerland have.
“The ECB says its action is ‘temporary and limited,’ and that is precisely the problem,” he said. “They are making things worse with piecemeal measures. Economic historians are going to be very damning of the policy mistakes made during this whole episode.”