Basel - Frankfurt : 0 - 5

Before turning to our little soccer game - which the Swiss supervisors apparently seem to be losing - we like to turn one more time to what is happening over in Frankfurt. After the successful LTRO of last December (489 bio EUR cash injection into banks), a new round of auctioning is heating up for 29/02. And it seems we are gonna lift the game higher in various ways.

Last week, a Goldman survey revealed that lenders could take 680 bio euros of loans in this second round of free money coming from Frankfurt. It would also raise the total LTRO to about 1,5 trillion (1,500 bio) which is higher than what the FED did in autumn 2008 to keep the system afloat. Some numbers.

Note : 219 bio EUR government bond purchases under SMP (securities market programs, ECB secondary buying) include 55 bio eur of Greek debt with possible haircuts of 70%. The remainder is mainly covered by Spanish and Italian bonds.

1) The Goldman survey also covered the question "what are you gonna do with the money ?". 56% replied refinancing maturing debt, 26% replied investing in sovereign bonds while a mere 4% replied to use the money in increased lending towards customers.

2) This boost in liquidity has a considerable effect on bank profit margins going forward. In the case of an Italian bank picking up 1 bio eur and buying 3 year Italian BTPS we have a difference of 2,6% (1% cost 3,6% yield). That implies 26 mio eur yearly profit. The case of UK RBS - the nationalized hedge fund from former knight sir Goodwin - is even more pronounced. It borrowed 5 bio £ in December on which it will pay 50 mio £ yearly interest. If RBS would have had to raise the money in the market of unsecured bank debt, it would have been obliged to pay 215 mio £. 3 times 165 mio £ is almost half a bio £ of opportunity gains over a 3 year lifespan, subsidized by Frankfurt. My suggestion to David Cameron : don't complain.

3) With the ECB balance sheet currently ballooning at 2,733 bio EUR, this would lift the balance sheet towards 3,400 bio EUR, higher than the FED balance sheet. Although this match between the world's largest 2 central banks is not over yet and we certainly gonna have prolongations after 90 minutes of play : markets are already pricing in a new round of QE in the US with expectations of almost 700 bio USD in Mortgage backed securities monetization. And to prove this : Bill Gross Pimco's total return funds - 250 bio USD AUM - is now 135% invested (borrowed 35% or almost 90 bio USD) in order to bet on this, lifting his exposure in mortgage assets to 50% of his total fixed income exposure. Quite an epic moral hazard bet !

These are quite extraordinary efforts to keep current systems afloat. On the issue of windfall profits for banks and LTRO, some concluding considerations

1) Some argue that with this present coming from Frankfurt, the public should be served as well. One way of achieving this, is to force banks to retain profits coming from LTRO carry trades and enhance capital reserves. An average estimate of profits to be made over the 3 year lifespan is about 120 bio EUR. This would be in line with what Basel is urging for but the mechanics are questionable (cfr infra).

2) In order to avoid stigma effects and to be politically neutral, the ECB is urging all financial players to participate in the scheme. So the scheme will probably over-shoot its targets by being beneficiary to those who don't need the money (but welcome it). Wouldn't it be more cost effective and less risky if the scheme would be restricted to problem systemic banks in real need of the money ?

3) On ECB balance sheet risk : with some 80 bio of capital cushion and a balance sheet ready to move towards 3400 bio, it implies the leverage effect within the ECB will reach 42,5. It basically means that whenever its asset position goes down by some 2,5% and you have to realize the loss, you are wiped out. To that extend it resembles the LTCM hedge fund back in 1998 which had a similar leverage (50) and which is also similar to the one of the FED today (55). And there is indeed a possibility that it can turn out bad for the ECB in view of the (softer) collateral acceptance against the LTRO loans the ECB provides. So the question should be raised : if wiped out, who will recapitalize the central bank(s) ? Germany ?

Gutt feeling : I think the Basel exercise of reforming the financial sector (stronger capital base, less leverage) is a questionable and superfluous exercise indeed. While some private banks will enjoy a better environment, it seems that for the largest public financial players annex system supervisors other rules apply. So mass private leverage brought us into trouble but don't worry, mass public leverage will get us out. I really don't see an improvement here on the issue of systemic risk. A well known public saying goes as follows : Today's best rangers were poachers/marauders in a previous life. And with the rangers again switching camps today, I am not quite sure whether the world will be a safer place tomorrow.