The risk free carry, part II : Money for nothing and the bonds for free ?
Earlier this week, we mentioned the rally on high yield European short term government bonds in anticipation of Wednesday's ECB LTRO auctioning (Long Term Refinancing Operation). Markets had expected something in the range of 300-400 bio EUR. The final result was 489 bio EUR spread over 523 bidders, on average almost 1 bio EUR per financial organization. A term of 1123 days or 36 months @ a 1% funding cost for banks, with greetings from Mario.
Under JC Trichet, similar LTROs occurred but that was mainly to help the money market in an effort to unlock the interbank market freeze (6-9-12 months). 36 months is however something entirely different. And though it was a success - and to be repeated in February 2012 as well - financial markets yesterday realized that it means we are still in big time trouble (Trichet's first silver bullet in Aug 2007 was 95 bio eur, already back then a huge operation). Now what will happen with this money, now and next February ?
We have suggested that this early Christmas present for European banks might be used for buying up distressed European government bonds (PIIGS and to some extend OLOs). So it won't immediately filter through the real economy and is in no sense useful for the business cycle. It helps however governments (yields coming down making their upcoming refinancing more cheap) and bank balance sheets as well before 31/12/11 : with the rally, it will crick up prices of existing bond assets on their balance sheet. We leave it in the middle for now whether this was the ECB's intention, it surely comes in handy for both banks and governments. On the other hand, the ECB might be acting here as a true last lender of the last resort for other reasons.
Next year, European banks face more than 600 bio eur of debt maturing of which 75% is unsecured. In the first quarter alone, we talk about an amount of 230 bio eur. Banks' 2012 refinancing is about 35% more than the current year. So the good news of this successful auctioning is that banks are home free for 3 years. On 8/12/11, the European Bankers' association advised European banks to urgently increase their safety buffers to cope with future crises. It ordered financial firms to raise 114,7 bio eur of additional capital to bolster their core Tier 1 ratios to over 9% of risk weighted assets by mid 2012. The EBA statement's final paragraph clearly mentions that "faced with a potential credit crunch, banks have to raise money from investors, retain earnings and lower bonuses. Failing that, companies may sell assets, provided the disposals don't limit overall lending to the real economy".
So this ECB policy move might stabilize the sector for now, buying precious time for banks and hoping to soften the upcoming credit crunch. It's one building block and an important one. But the bases of a future well functioning financial markets will require more than just this 1 building block.