The T Report: National Acronym Day in Europe. Don’t Underestimate the ECB

Posted by on May 30, 2012 in Uncategorized | No Comments


So the EC wants the ECB to bypass the EFSF and use the ESM to recap EU banks? That was the rumor that shifted global stock markets by 1% in a matter of minutes?

It has been awhile see we looked at the EFSF Flowchart or had a detailed look at the EFSF Guidelines but it looks like it is time to dig a bit deeper into what is possible and what is not.

The ESM is not yet up and running. There was talk that it would be done by June or July of this year, but in typical EU fashion I don’t think much progress has been made towards that promise. So right now the EU is stuck with EFSF and the potential to set up the ESM.

The EFSF actually has a lot of powers. I’m not sure exactly why it is such a big deal if the EFSF (or ESM) invests directly in banks or lends money to countries to invest in banks. In theory the countries could lose on their bank investment but pay back EFSF loans? That is a possibility but it would seem more and more likely that if the bank rescues fail the sovereign is dead anyways, so the market might be reacting too much to that distinction.

The bigger problem is that the EFSF is not well set up to leverage itself. The EFSF is technically the entity that could be buying bonds in the secondary market. It is supposed to have taken over that role from the ECB, yet it hasn’t done that. Why not? It is possible that they haven’t figured out a good way to leverage the EFSF and therefore would get minimal bang for the euro by buying bonds in the secondary market without leverage. The same issues apply to its role in the primary markets. Yes, the EFSF can intervene in the primary markets, but again, had very convoluted leverage schemes, which would never work.

The problem isn’t so much what the EFSF is allowed to do, it is how constrained it is in terms of leverage and access to funding. There is almost nothing that can be done about how EFSF is set up at this stage, nor should there be. That messed up entity should be put out of its misery.

Europe’s big hope is to actually launch ESM and launch it with a banking license. If ESM can be launched, and it can get a banking license, then the EU has a powerful tool. The ESM is allowed to do all the things the EFSF can do – participate in new issues and the secondary market and lend to countries for them to support their banks. Without a banking license its firepower is limited. With a banking license it can leverage itself to a very high degree and can tap all the cheap funding already in place and whatever new programs the ECB decides to launch.

So worry less about any “new” powers the ESM might have and worry about 1) the ESM actually getting funded, and 2) the ESM getting a banking license. Germany was very resistant to the idea of the banking license. I assume they still are, but they have already given the ESM all the powers it needs, and has endorsed leveraging the capital, so a banking license might not be out of the realm of possibility.

With a banking license, the ECB can do a lot to help the ESM. The LTRO deals did a lot for the banks. They really have reduced the pressure on European banks. In spite of the fact that Bankia is a total mess, we are not reading headline after headline about how BBVA or SocGen or even DB are in trouble. The banking system is in much better shape than last year because of LTRO.

The market got carried away with the promise of LTRO as a sovereign debt savior. The market, more than the ECB, created the idea of banks buying lots of sovereign debt. That was never going to work because the banks that would do it, already had too much exposure to their national sovereign debt. It created a potential death spiral. Taking the concept of the “carry” trade and LTRO out of the banking system and into the ESM might have more of an impact.

The market has lots to worry about, whether it is China, Facebook, Banking Regulations, Fiscal Cliff, whether American Idol is rigged, economic data, etc., but we are still very much at the mercy of policy intervention. Strong signals of new QE for the U.S. seem more likely by the day, and in Europe, there is likely to continue to be a lot of contradictory comments, but banking license for the ESM seems more plausible than many of the other rumors (like Eurobonds or Greek Exit) and would be a powerful catalyst for a bounce in European equities.

The credit markets and CDS in particular seem tired. They don’t seem to have the energy to compete with the swings in equities. So far IG18 has traded in about a 1 bp range in spite of the gaps in equity futures. Even MAIN, right in the center of it all, has traded between 173 and 175.5. The high yield market, and HYG and HY18 both had big days yesterday, with cash up as much as 1%. We will likely see some give back there, but there really is no evidence that retail is giving up on high yield and there isn’t as much leverage in the market as there was in 2011 as hedge funds have been cautious and banks have cut their exposures.

Spanish and Italian bonds are definitely getting crushed today, but with Spanish 10 years above 6.5% and Italian 10 year bonds nearing 6%, the potential for intervention rises. The secondary market is affecting the primary market, which is driving up the cost of funds, creating more pressure on the budget deficits. The countries are painfully aware of that, as is the ECB. One ongoing frustration for the ECB is their inability to translate their short term rate setting of 1% into the sovereign debt market. They are looking for ways to ensure that policy can impact all sovereigns because without that occurring it makes their job far harder than the Fed’s where treasuries instantly respond to the Fed rate decisions.