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Friday, September 05, 2008

Trichet Announces New Rules For ECB Funding

In the photo above you can see European Central Bank President Jean-Claude Trichet welcoming Irish Finance Minister Brian Lenihan to the 10th anniversary celebration of the ECB, in Frankfurt on Monday, June 02, 2008.

Time To Stop The Abuse?

The ECB and the Spanish banks are back in the news, following the decision by ECB president Jean-Claude Trichet to take advantage of this week's regular interest rate press conference to announce a number of funding rule changes affecting European bank access to ECB liquidity provision. These changes will affect all those financial entities that have developed an excessive dependence on the cheap "you can see my wallet if I can see your securities" funding which has been available up to now from the bank. The changes were judged by many analysts to have been slightly more radical than expected, and bank stocks in the Eurozone and the UK fell sharply on the news.

Irish and British banks fell the most in European trading after the ECB announcement. Anglo Irish Bank had fallen 12 percent by Friday afternoon. HBOS, a U.K. mortgage lender that has accessed ECB funding via its Irish operation, was down 8.2 percent over the same period, while Barclays, the UK's third-biggest lender, dropped 9 percent. In Spain Banco Sabadell fell 4.4 percent, Banco Santander, the country's largest bank, sank 6.1 percent and Bankinter SA fell 7.7 percent.

Since the UK is not a member of the eurozone, this fall in bank shares may give us some sort of measure of the kind of "abuse" which many have long thought was occurring, but which was not evident due to the lack of transparency surrounding such operations. Other European banks who were "badly affected" by the news were the Swiss bank UBS, and some smaller regional banks such as Erste Group in Austria and Piraeus Bank in Greece.

Ireland in the Forefront

What may well surprise many readers of this blog - although not perhaps after reading this post yesterday - is that it seems to be Ireland and not Spain which has been at the heart of most of the abuse (certainly you wouldn't have known this from the number of articles in the popular press which have been busy pointing the finger at the Spanish banks in recent weks though). Last week the ECB lent a total of 467 billion euros to European banks, or should I say to banks which have some sort of operating facility inside the 15-country euro area - although with banks like HBOS, UBS and even Australia's Macqarie on the list, the term "European" is getting to be a bit stretched - and in return had been accepting a broader range of collateral to back the loans than has been the case at Bank of England. Such collateral may include bonds with credit ratings five levels below AAA as well as asset-backed securities. The existence of this policy differential seems to have prompted a pretty motley crew of non eurozone financial firms to create bonds of variable quality solely and exclusively for use as collateral for ECB borrowing.

But when we look at how this money lent by the ECB has been allocated, then even more eyebrows may be raised on learning that lending to the much castigated Spanish banks has been "only" running at around 49 billion euros (as of July), while lending to Irish banks reached 44.1 billion euros according to data from the Irish central bank in Dublin. I say only, since everyone is aware that Spain's banks have a sizeable problem, so if a facility has been created to help them I would have thought that it is only natural that they use it. Thus I am not sure why this use by the Spanish banks has been being called "abuse", since a sizeable chunk of the lending has been going to Spain's hard pressed savings banks (see below), so I think it is worth asking what exactly it is they are supposed to do? Or put it another way, if people really are so concerned about Spain, then maybe a more appropriate question is why the ECB aren't doing more to help? Certainly US banks don't seem to be labouring under this kind of difficulty with the Federal Reserve, although of course it is precisely this position which has attracted criticism from a chorus of European commentators. Rather than talking about abuse in Spain, perhaps it might be more interesting to ask why we only have a temporary and transitional facility for what is clearly now a longer term and structural problem in the Spanish banking system.

To put what has been happening in perspective, since Ireland is about one tenth the size of Spain, it is as if the Irish banks had been accessing some 440 billion euros in funds. And things only get worse when we come down to the details, since about half of the funding from the ECB has been going of to the Dublin-based units of lenders from outside Ireland, according to analyst Eamonn Hughes at Goodbody Stockbrokers.

HBOS and Barclays are just two of the British banks that have been borrowing from the ECB. Earlier this year it emerged Macquarie Bank had set up a deal backed by Australian car loans specifically for use at the ECB. But the whistle really was blown in mid August when the UK's largest building society, Nationwide, got a lot of media coverage for saying it was planning to expand into Ireland to take advantage of "funding opportunities".

So the first thing to have clear is that the real abuse of the ECB funding has not been coming from Spain, and that access to these funds by Spanish banks has been more or less policed by Bank of Spain Governor Miguel Fernández Ordóñez and his team, who have attempted - as he explained in June in his appearance before the Economy and Taxation Commission of the Spanish Congress - to ensure that participation in eurosystem fundings rise "without going far beyond the "key" subscription of the BoS to the ECB capital" (which is 7.55%). And if Spain's banks have recently gone increasingly beyond this level (10.3% of total loans in July) then this is surely more to do with the pressing needs of Spain's savings banks sector (who really do need liquidity, see below), than it is with any organised system of abuse. But be that as it may, it is Spain's banking sector who will take the lions share of the hit from yesterday's decision, since while in some other countries the ECB funding may well have been considered to be mere "froth on the daydream", for Spain's struggly banking system the lifeline is likely to turn into a life and death issue.

The Measures Themselves

Trichet announced a battery of measures yesterday, all of them having one feature in common: they will increase the cost of using asset-backed securities to obtain ECB funds. Access will also now specifically exclude deals involving underlying mortgages or other loans not denominated in euros.

The changes - which will take effect as of February 1 2009 - include increases in the average “haircuts” applied to asset-backed securities. A haircut is the amount deducted from the market value of a product when judging its value as collateral. In future, a blanket 12 per cent haircut will apply to all securities, instead of the earlier sliding scale of between 2 and 18 per cent. There will be penalties for asset-backed securities valued using computer models and for unsecured bank bonds. Banks will in fact have to take an initial markdown of 5 percent on any ABS that has been valued using a computer model. At the same time restrictions already in place on banks using assets they themselves had created were extended to stop banks using assets from issues to which they had offered currency hedges or liquidity support above a certain level.

Analysts at Barclays Capital are quoted as saying that the extra haircuts would mean banks might have to post an additional €25bn-€45bn of securities for collateral purposes. The general opinion is that the changes will make it less attractive for banks to use asset-backed securities as collateral and will certainly push up the overall cost of borrowing funds from the ECB.

The asset class which will be most affected by the changes are ABS with a residual maturity of up to one year, which currently have a haircut of just 2 percent. In these cases, instead of receiving 98 euros in exchange for a security with a face value of 100 euros, banks will often now receive just 83.60 euros.

Spanish Savings Banks Will Be Affected

Spanish savings banks, such as La Caja de Ahorros del Mediterraneo (CAM), are likely to be hit quite hard by the new rules, and this on the face of it seems to be most unfair, since if there has been abuse of the earlier ECB rules it is hardly towards this quarter that we should be looking given the now evidently parlous state of their balance sheets. The savings banks accounted for almost 70 percent of the total growth in funds borrowed by Spanish financial institutions from the ECB over the last year, according to a research note from Banco Santander. Spain-based financial institutions borrowed 49 billion euros ($71.14 billion) from the ECB as in July, up from 18 billion over the same time last year, according to Bank of Spain data (so the savings banks have had approximately 21 billion euros in the last 12 months). Borrowing by Spain savings banks accounted for 4.4 percent of the 467 billion euro total funding from the ECB last week, up from 0.9 percent last year, according to the Santander research note issued yesterday. Regular Spanish banks increased their participation to 5.6 percent, from 4.6 percent.

Caja de Ahorros del Mediterraneo, which is based in Spain's Valencia region, has now been put on a watch list by ratings agency Standard and Poor's, and S&P's could downgrade the bank by as many as two notches due to the fast deterioration of its asset quality. Spanish RMBS's are currently trading in the secondary market at levels which vary between Libor plus 170 and Libor plus 350 basis points.

And this brings us to the heart of the question. Basically, either what has been happening recently is one of the most brillant recent pieces of "counter information" (or smokescreening) or someone somewhere really quite important just hasn't grasped what is actually going on. Maybe the fact is that the attention recently being focused on Spain's banks wasn't in fact to distract attention away from abuses which have been taking place in Ireland and elsewhere (yes, I am sure there are elsewheres, since total lending is, after all 476 billion euros), but the fuss about abuse could have been a way of diverting attention from the fact that some kind of longer term support system for the Spanish banks is being put in place (this is what I hope is happening, but there really is no visible evidence to support my hope). You see, if Spanish banks really are, as some are urging, going to have to "mark to market" and thus pay up to 350 basis points over 3 month Libor, then as they rollover the stock of existing cedulas over the next 5 years (which are financing existing mortgages, remember), there is just no way they can continue to charge the kind of basis points over 1 year Libor that their mortgage customers are currently paying, which means there will have to be another substantial hike in Spanish mortgages payments, over and above the upward movement we have seen in euro Libor itself. And we have already seen the extent of the damage that is being caused to the Spanish real economy with mortgage rates at their present levels. Do we really want to get to find out what would happen if everybody had to pay 200 to 300 basis points on top of this? I don't know about anyone else, but personally I could happily live out the rest of my life without getting to know the answer to this question. This is certainly the kind of "reality check" I could most definitely live without.


Anonymous said...

Hi again Edward

"This is certainly the kind of "reality check" I could most definitely live without."

It kind a reminded me of an article that mentioned the tale of the little Dutch boy, I read recently

I objected to intervention in a past comment, but after some thought, I need to admit you're right. We'll drown too.

Nonetheless I'd like to add something.
Hussman writes:
"... unless Congress mandates that mortgage originators will be partially on the hook in the event that future mortgages purchased by the government go into foreclosure, we're going to have a “moral hazard” problem of epic proportions."

Without an appropriate framework, all we'll do is move our problems to the future.
The first part of your post, concerning the (ab)use of ECB funding, strenghtens my vision on this issue.


Edward Hugh said...

Hi Geert,

Glad to see that you are well.

"Without an appropriate framework, all we'll do is move our problems to the future."

I definitely agree with this, and with the moral hazard argument. What is involved - eg in the Fanny Mae thing - isn't a "freebie", but a straight swap of public for private debt, in order to maintain mortgage financing during an orderly transition, since we don't want a disorderly one (ie creative destruction is a good thing, but too much destruction and little creation isn't).

But this must not be a green light for any kind of hair raising risky venture. The US and Spain have to come of the "high credit growth" steroids. This means, in my mind, one thing and one thing only.... more industry and more exports.

I would say that the big lesson we SHOULD all have just learnt is that a financial services and construction driven growth model doesn't work. So we need to go back to the drawing board on the industrial society. Industry can't all be outsourced to China, or to China, Germany and Japan. This simply doesn't work.

And it is important we assimilate this acquired knowledge for the new people who are to come in Brazil, Turkey, Peru, India etc. They could also learn something from the problems which are arising with the very low fertility in Southern and Eastern Europe to my mind. Basically, and unfortunately for the Spanish, Spain has simply been a test bed to see what doesn't work.

Also, and off subject, I can't help thinking that Spain and France will now start to try and use the Maghreb as the Germans have been using Eastern Europe, did you see they are thinking of moving part of Airbus to Tunisia?