There is no doubt that the LTRO has been spectacularly successful in averting a liquidity-driven collapse of a European bank and has also managed to ease pressure in the sovereign market. Italian and Spanish two-year yields have come in 230 and 185 basis points, respectively, since it was launched.
But this is no way to run a banking system. Nothing has changed in the market apart from the LTRO, which is underpinning sentiment in European debt and equity. Cheap ECB money might have averted short-term disaster but it could cause long-term damage to these markets.
If rumours among bankers are true, and the next LTRO on February 29 comes in around twice December’s €489 billion auction, it would deliver a stunning blow to the senior funding markets and be a damaging indictment of the health of the European banking system.
ECB president Mario Draghi has tried to dampen speculation, commenting that take-up might not be as large as it was in December. For the long-term health of the industry, let’s hope that he is right.
While everyone else looks at the undoubted benefits that the LTRO brings, let’s look at the problems.
First, the initiative will cannibalize FIG issuance this year. This may come as a shock to DCM bankers that have spent the first four weeks of the year saying that 'bond markets are on fire!'
And so they are compared with the second half of last year: according to Barclays Capital there was €21 billion of senior, euro-denominated, unsecured bank debt in the first 26 days of January (Lloyds and Swedbank have added a further €2.5 billion to that total) compared with €14.4 billion for the entire second half of 2011.
But the figures are cast in a rather different light when compared with this time last year. According to Dealogic, euro-denominated FIG senior unsecured issuance this time last year was €43.7 billion and for 2010 it was €65.6 billion.
In fact, the last time that issuance volumes were this low was in 2003.
Analysts at Credit Suisse recently confirmed that total debt issuance by European banks is down 60% year on year, with senior issuance down 70%. "Such a drop in issuance levels indicates that the December LTRO is being used as a substitute source of funding," they say.
Indeed, certain German Pfandbrief issuers have announced that they will cease issuance below four years’ tenor altogether. That can’t be good for markets that were largely shut for half of last year.
The issuance that has taken place has been spurred by the banks’ desire to accrue collateral that it can pledge to the ECB at the next three-year LTRO. As a bank treasurer if you buy a covered bond, say, SEB and take it to the ECB as collateral for the LTRO you can make 2% on the trade. It is little surprise that banks have made up such a large chunk of the order books of recent covered bond deals.
According to Euromoney’s sister publication, EuroWeek, bank treasuries bought 25% more sub-three-year senior debt in the first three weeks of 2012 than in the same period last year.
The collateralized nature of ECB funding means that the more banks tap the LTRO, the more their existing senior creditors are subordinated and the fewer assets there are on the balance sheet to act as security for senior lenders. This makes concerns over covered bond encumbrance on the balance sheet look like small beer. Another worry is that many banks, particularly in peripheral eurozone countries, have used LTRO money to load up on sovereign exposure – a recent Spanish auction was 90% taken up by domestic banks.
Although this achieves the short-term aim of easing sovereign spreads, what happens if the sovereign is downgraded? Guy Mandy at Nomura calculates that if Moody’s and Fitch were to cut their ratings on Italy to triple-B plus or lower this would call for an additional 5% margin across the BTP curve. This might lead to a repricing of other peripheral curves, which could trigger a chain of margin calls.
In this context it is sobering to reflect that Italian banks took a full third of the €489 billion December LTRO auction, with Spanish lenders not far behind.
