Random Shots - The Bad Bank is Dead, Long Live the Bad Bank

Most of the sell side macro research that I have been sifting through this week is pretty constructive on the future which always makes me worry. Still, it is difficult to not agree a little bit with the point that if, indeed, the world is not ending there is still a lot of cash on the sidelines that can get sucked in on this rally. 

In principle I agree with Steen Jakobsen's latest views that the upside is strongly driven by the global QE put and low holiday volumes. Hope of policy intervention as the market grinds up and beyond new highs usually is bad sign. Still, as a macro guy I should also point out following for example the latest from Simon Ward that the macro data has indeed improved. For one, investors should note that emerging economies have been slowing down to a grinding halt for 12 months and are likely already turning up from a bottom. In the US, the continuing revival in residential and commercial construction  is real and starting from a low point which suggests that more upside surprises are possible here. 

The problem though is that the amount of conflicting information right now is dizzying and against a backdrop of a continuing fear of the end of the workd, this creates and even more binary and frustrating world for investors. Hussman for example believes we are on the verge on a major inflection point. 

We are presently in an environment that has historically been associated with the overvalued segment of late-stage bull markets. This segment of the market cycle has been frustrating for us before, and that frustration may not be over. Yet in each instance, our defensiveness was overwhelmingly vindicated. The drum-beat of investors is that “this time is different.” Simply put, I doubt that this time is different.

With that in mind, my base case remains that the scope for a choppy upward movement of the equity market is not yet exhausted and, consquently, that complacency and euphoria can get much more extreme. 

The Bad Bank is Dead, Long Live the Bad Bank

Investors have only slowly been given information on the Spanish bailout which was (in)formally announced back in the beginning of July with €100 billion for the banks. By the letter of the law, Spain has not yet requested for aid and despite the ECB's verbal intervention outright ECB financing of Spanish deficit spending will require full Troika programmes. 

So far then, it is difficult to know whether to laugh or cry at the news that Economy Minister Luis de Guindos and the government has apparently decided to create a new bank just months after the other bad bank (Bankia) went belly up. 

Quote Bloomberg

Spain will put its bank rescue fund in charge of the bad assets separated out from the nation’s struggling lenders that are receiving a European bailout. The FROB fund will be the main shareholder in a so-called bad bank, according to a proposal that will be approved by the Cabinet on Aug. 24, Economy Minister Luis de Guindos told the Efe news agency in an interview today.All the banks receiving loans from European rescue funds will have to transfer their non-performing assets to the bad bank, he said. The comments were confirmed by a Spanish official, who asked not be identified, citing government policy.

You seriously cannot make this up, but the only difference now is that it will be easier to add the liabilities to the Spanish sovereign since, sooner or later, the FROB itself will have to be bailed out. Of course, Spain may ask for an official bailout long before that and then the transformation will be complete. Losses in the Spanish construction and RMBS industry will have migrated from one consolidated bad bank balance sheet to another, on to the sovereign and finally into the heart of the Eurosystem. 

This process has been clear for a long time what hasn't has been the speed and twists and turns for us to get there. Speaking of twists and turns, the news coming out of Germany (apart from a rapidly slowing economy) is also mixed with Merkel apparently fighting other members of the government on whether to cut Greece some slack all the while that Der Spiegel apparently is reporting that the ECB is going to cap yields in the periphery. 

Until action proves otherwise, the base case remains that the ECB will refrain from strong intervention until memorandums of understandings have been signed, but Spain and Italy are big fish compared to Greece. Their respective governments know that they could bring the euro down and inflict mortal damage to Germany. It is difficult to see exactly what the position of Germany is here, but one is certain , Germany (and all other so-called safe havens) have benefitted from the ongoing euro crisis charade in that it has been significantly cheaper for them to borrow. Italy and Spain could merely be seen as asking Germany to pay for this privilege.

Ultimately though the market will call Italy and Spain on their bluff and the onus will be on the ECB to do just enough to keep the boat afloat, but not so much as to be seen caving in to guerilla tactics. This is already an incredibly difficult minefield for the ECB to maneouevre and it won't get easier as the recession intensifies.  The end result is that losses will increasingly be mutualised and this may, in the end, make it more palpatable for the ECB to engage in outright monitisation. 

Emergency Liquidity Assistance in the Eurozone - Draghi's Irreversible Euro Put Explained

Last week was not short of volatility with a three party central bank bingo and the nonfarm casino to cap it off. Markets went into the week with extreme expectations and as it became clear that central banks would do nothing concrete, the disappointment loomed. 

Still, Draghi seemed to pull yet another rabbit out of its hat by explicit reiterating the irreversibility of the euro and also explicitly mentioning that there would be no going back to the Lira or the Drachma. Empty words to buy time you might say. Not quite and while the ECB may certainly now buy as many peripheral bonds as it wishes if it deems convertibility risk to be a real issue money is already trickling into cash strapped peripheral economies through the arcane tool of emergency liquidity assistance (ELA) by which the national central banks can support specific banks deemed to be illiquid. The most important news coming out last consequently came late Friday night when Reuters reported that, 

The ECB's Governing Council agreed at its meeting on Thursday to increase the upper limit for the amount of Greek short-term loans the Bank of Greece can accept in exchange for emergency loans, the newspaper said in an advance copy of the article due to appear in its Saturday edition.

Until now the Bank of Greece could only accept T-Bills up to a limit of 3 billion euros ($3.70 billion) as collateral for emergency liquidity assistance (ELA) but it has applied to have this limit increased to 7 billion euros, the daily said, citing central bank sources.

The ECB Governing Council gave this wish the green light, the paper said.

The move should enable the Greek government to access up to an extra 4 billion euros of funds, the paper said, adding that this should ensure the country keeps its head above water until the "troika" of the European Union, the European Central Bank and the International Monetary Fund decide on the disbursement of the next tranche of money from its aid program in September.

I would recommend anyone to read this note by Morgan Stanley from 2010 as well as this more recent research note by Citi's Chief Economist Buiter. Both provide a good re-cap of what the ELA is, why it is where and how it is used. The main definition from the Eurosystem's own documents is useful however;

One of the specific tools available to central banks in a crisis situation is the provision of emergency liquidity assistance (ELA) toindividual banks. Generally, this tool consists of the support given by central banks in exceptional circumstances and on a case-bycase basis to temporarily illiquid institutions and markets. This support may be warranted to ease an institution’s liquidity strains, aswell as to prevent any potential systemic effects, or specific implications such as disruption of the smooth functioning of payment andsettlement systems. A credit institution cannot, however, assume automatic access to central bank liquidity.

The provision and magnitude of the quantity of ELA in operation at any given point in time is not aggregated by the ECB or the Eurosystem, but will instead be reported by the national central banks. This is logical as it is explicitly stated that national central banks take on the market risk. Yet, the question market participants are now obviously asking themselves is what this means in the case of an irreversible euro. The following quote from the 1999 ECB annual report is crucial. 

The main guiding principle [for the ELA] is that the competent NCB takes the decision concerning the provision of ELA to an institution operating inits jurisdiction. This would take place under the responsibility and at the potential cost of the NCB in question.

The ELA as it is described here is then an operational tool the national central bank can use in a situation where a specific financial institution is in trouble. Examples of such usage of the ELA was the €42 billion guarantee granted by the German government to Hypo Real Estate in 2008 through a special purpose vehicle (SPV) who itself tapped the Bundesbank for liquidity through the ELA and which then got collateral from Hypo. In 2009, the Belgian bank Fortis was also given access to the ELA on the eve of its collapse with loans, according to Barclays, amounting to about €54 billion. 

These two cases are examples of the intended use of the ELA facility in so far as goes the fact that both Germany's and Belgium's current ELA balances are 0 (as far as we know from current data). 

Using the ELA as a bailout fund

The ELA has been active at several occasions during the crisis, but the usage of the facility in Ireland and Greece represents a completely different use of the facility than the one originally intended. According to figures compiled by Citigroup Ireland has had a constant use of the facility since 2008 with the central bank in Ireland providing anything between €40 and €60 billion since 2010. Most recently, Greece has also taken to the ELA to the tune of about €55 billion [1].

Such constant use of the facility was never envisioned and suggests that the ELA is being used as additional bailout funding in countries where negotiations with the IMF/EU bailout party has hit a snag. This is evident in Greece where the ECB effectively pushed the country into ELA funding earlier last month as Greek government bonds were deemed unacceptable as collateral until the Troika had completed its review. 

Thus, The wording of the Reuters article above thus suggests a wholly different use of the ELA, namely as a very last resort used simply to keep the lights on in a country in tight negotiations with its bailout counterparties. Of course the price of such funding is higher, but this is a technical point here which is irrelevant for a country on the edge. It is not difficult to see how precarious this could be for the ECB which could effectively be forced into kicking a country out of a the euro by shutting off ELA funding. More specifically, this would happen by the ECB effectively instructing its counterparties that whatever reserves created by the national central bank in question. But even more precarious could be the process by which the ECB first deems an individual country's bonds ineligible as collateral only to have to accept that the national central bank takes such bonds in collateral for ELA funding. 

With this backdrop in Greece, and with a Spanish request for ELA funding coming sooner rather than later Draghi's comments on the irreversibility of the euro are critical. Market participants can consequently now countenance that the ECB will not shut a country out of the ELA and national central banks in Greece and Spain will take note of this. More than a promise to intervene in the secondary bond market through the SMP, the implicit commitment to keep the ELA open could be the real bazooka. 

However, it is also clear that the ECB and the EU could end up in a royal mess. Usage of the ELA is essentially, from the point of the ECB, a pull mechanism by which national central banks request funding. This is in line with the operational use of the LTROs in which euro area banks applied for as much funding as they needed and put up collateral to back it. This was not, strictu sensu, a breach of the famous article 101 in the EU treaty prohibiting but it came close in the context of French president Nicolas Sarkozy recommending banks to buy sovereign bonds. The consistent lowering of collateral requirements as well as stories about reverse repos with banks' own securities also added weight to the idea that the LTRO was merely an alternative way to bring sovereign bond yields down. 

The ELA then opens up to a much more problematic avenue in which the ECB could end up shouldering the counterparty risk of the invididual national central banks. Going back to the point emphasized by the Buiter and Citigroup it is suggested that the steady use of the ELA at the behest of the national central banks over time may undermine the monetary union itself akin to the developments which ultimately tore apart the Rouble zone (my emphasis).

We think the existence of ELA on a country-by-country basis undermines the monetary union by allowing different monetary, credit and liquidity policies in different member states of the Eurozone. The damage is not (yet) fatal because the GC of the ECB sets the upper limit on the size of the credit an ELA facility can extend and because the GC also has a veto over the terms on which this credit is extended. As noted, the ‘protection’ offered to the Eurosystem by the denial of loss sharing for ELA exposure is only effective if the central bank and sovereign backing the ELA exposure have sufficient loss-absorption capacity.

Clearly, neither the sovereign in Ireland, Greece nor Spain are in any position to shoulder losses in their respective banking system and indeed, the usage of the ELA in countries have opened up avenues liability and loss migration to the very heart of the Eurosystem. With Draghi now putting his weight behind the euro the ECB may find it even more difficult to effectively shut a country out of the usage of the ELA and with Spain about to wind up its own ELA, the ECB may have cornered itself. 

While the ELA may always be effectively in-operational due to the lack of collateral we have already seen the ECB backpedaling on several occasions and quite simply, in an emergency a national central bank will accept whatever collateral the domestic banking system can come up with. The ECB is effectively already doing so and it is unreasonable to expect anything less in Greece, Ireland, Spain or any other individual country. 

Summary

• The use of ELA by countries already in or close to getting an EU/IMF led bailout is hugely contentious because the explicit guarantee from the sovereign towards the national central bank is meaningless. ELA usage in the context of a country negotiating a bailout should be seen as a de-facto expansion of the ECB/Eurosystem's balance sheet. Greece is currently a good example. Draghi could then be seen as taking a stance here by suggesting that a country resorting to ELA financing of its banking system (potentially in connection with sovereign bond issuance used as collateral) would not be shut out if this meant that the country would effectively go bankrupt and exit the Euro. 

• The distinction between when a country requests ELA usage either to avoid asking for a bailout (Spain?) or effectively to keep the lights on will be extremely difficult for the ECB to navigate. This plays into the narrative formulated by Buiter and Citigroup that national central bank financing will steadily grow as a function of individual countries objectives. The ECB may of course accept and deny funding on a discretionary basis, but it won't be easy.

• In the context of sovereigns who are obviously unable to properly guarantee the potential losses at the central bank level arising from losses on underlying collateral, the ECB and the Eurosystem could be forced to foot the bill of national central bank losses. 

• If Draghi is serious in his message that the euro is irreversible, it will be difficult for the ECB to shut a country out of the ELA if this would mean that the country would effectively be bankrupt and thus potentially exit the euro. 

• All this is happening and will happen largely beyond the knowledge of investors as ELA usage is very difficult to track and the institutions, collateral arrangements, haircuts etc are not publicly disclosed. 

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[1] - These figures are from Buiter's piece and are best estimates. It is very difficult to get a handle of the real magnitude since the national central banks are, understandably weary about giving out too much information, and since the ECB does not record these transactions on its balance sheet. 

The Curious Case Of Liquidity Traps And Missing Collateral - Part 2

In this second part of my take on liquidity traps and missing collateral in global financial markets I would like to respond to some of the talking points set out by FT Alphaville's Cardiff Garcia (again in response to the much talked about piece by Credit Suisse). Even though blog posts tend to age quickly, recent central bank action suggests that this topic is relevant as ever. Specifically, negative readings across a wide range of short term interest rates in Europe has raised the question not only what the effect of such abnormal interest rates are, but also whether such market prices are sending a signal to central banks that they ought to act much more aggressively. 

Following up on FT Alphaville's coverage, one question that is intereting to consider is the following. 

2) The movement of M1 and M2 in recent years seems not to have told us anything helpful about inflationary prospects. Should the Fed finally ditch them and start concentrating on another measure, perhaps one that incorporates some of the items above? Or bring back M3 (which at least included such shadow banking elements as institutional money market funds and repo)?

Initially, I should point out that I disagree with the premise of this statement. I think that there are still important effects from fluctuations in M1 and M2. Specifically, I believe that while being in structural process of deleveraging may certainly mitigate the inflationary pressures from central banks generating excess reserves (and liquidity) in the system, it is dangerous to assume that expanding base money does not have a real economic effect. 

Still, this raises a very important point. The traditional monetary policy transmission mechanism is broken and as a result the size and expansion of base money aggregates have little bearing on credit creation in the real economy. The key question is the whether central banks should extend their control of the money supply further down the credit foodchain (i.e. closer to the end user/beneficiary of the credit)? And if you answer to this is yes, how do central banks do this most effectively. 

Firstly, it is important to emphasize that, in many ways, they already have. Initial responses to the crisis in the US (and QE conducted by the BOJ) have been engaged in strategic and direct purchases of several kinds of marketable debt and equity securities, but central banks generally do not like to do that. Historically, the Bank of Japan has been most direct trying to influence market prices through the purchase of corporate bonds and exchange traded funds. 

Now however, they are at it again of course. The BOE recently suggested open market operations with strings attached in the form of banks only getting access if they added to their balance sheet and in Europe, the ECB has cut its deposit rate to 0% and may even push it into negative this week. 

The problem however is that it is very complicated for the central bank to do this effectively and a central bank will always be adverse to taking direct market risk (even if e.g. the allegedly most conservative central banks of them all, the ECB, has taken substantial market risks through the collateralised LTROs). In addition, targeting M3, M4 etc would mean an even more direct involvement in the credit process by which the central bank potentially acted as direct underwriter for pools of securitised loans of all shapes and sizes. This adds illiquidity to the balance sheet and exposes the central bank to significant mark to market risks which eventually may have to be covered by printing money. Such an implicit backstop to securities that the central bank may agree to buy creates significant moral hazard. 

But it is certainly a fair question to ask whether central banks have been using the wrong tools as e.g. Izabella suggests in her coverage of the concept of the negative money multiplier. 

Traditionally, a central bank will respond to a liquidity trap by supplying (potentially) unlimited levels of excess reserves to the banking system and thereby expanding the potential credit supply in the economy. The counterbalancing asset side entry here will usually be short term government bonds but also, if need be, longer term government securities. In this sense, expanding the balance sheet at the zero bound is essentially a fiscal expansion. However, as Izabella suggests, this may actually be counterproductive in an economy suffering from a structural lack of liquid and investment grade collateral. 

The central bank will then actually exacerbate the lack of such assets by doing textbook QE which involves creating bank reserves in exchange for short term government securities. Demand for government securities (collateral), the story goes, would be more than enough to keep yields down and allow the government to conduct fiscal expansion at the zero bound. Still though, one would have to assume a complete lack of any market response from bond vigilantes ad infinity for this to work. I am not sure that I accept this. 

So where does a broader monetary aggregate target come in? Well, from the account above the central bank could do two things. 

1. Act on the liability side by aggressively cutting excess reserve requirement and enforcing a penalising rate on excess reserves. This would be a direct way (through the liability side) to attempt to jump start the money multiplier and force up velocity, but it will require the central bank to be indifferent between currency and reserves on its liability side (see below). 

2. Avoid crowding out demand for safe collateral by booking anything but government securities on the asset side. 

On the second point, I would note that this assumes a complete lack of bond vigilantes of any kind and thus no disciplinary market action in the context of financial repression. In the context of structurally overlevered governments across the developed world, I am not sure that this is a reasonable assumption over time. What would Gilts be trading at if the BOE was not holding 30% of the total stock outstanding and how would this have affected the government's ability to borrow. In addition, taking direct market risk by e.g. purchasing pre-assigned tranches of securitised loans (to beef up broader monetary aggregates) would certainly not work if the underlying problem was one of a structural lack of solvent credit demand. I have argued for example that this is a major part of the problem both in the context of private and public borrowers. 

On the first point, events have caught up with theorizing here with the ECB the first major central bank now imposing zero interest rates on its deposit rate (the Riksbank did this in 2008/09 too) and there is a serious probability that the rate may be moved into negative. 

I have been lucky to have the opportunity to discuss this with the financial columnist and investor Sean Corrigan who makes the following crucial point. 

People are treating this [negative deposit rates] in a completely erroneous fashion.  Even negative rates cannot force the banks to lend out the deposits they hold at the central bank; this is to assume they - as a whole - have choice in the matter: they do not. If the central bank creates what is called 'outside' money, by buying securities, etc, the corresponding reserves cannot be voluntarily removed: they have to be held as CB liabs/commercial bank assets on the central bank balance sheet.

(...)

What such a move could possibly do is to make it more imperative for banks to leverage up by creating new, extra loans (To whom? On what terms?) and to accept new customer depo's (given that they hold a huge surfeit of reserves on their balance sheets with which to backstop these) and so compensate for the negative rate drain by the volume effect. I take this as dubious, however, given normal credit concerns and, in some cases, binding capital constraints.

Sean then goes on to make the final point that if the central imposes negative interest rate on reserves while at the same time wanting to maintain the size of its balance sheet, it would have to generate currency as reserves were withdrawn. 

I think a couple of points are important to note at the offset.

The situation at the ECB and the Fed/BOE is different. More specifically, reserves created in the Fed/BOE is, as Sean points out, "outside money" and is thus what we could call "push QE". The central bank has a policy objective to affect government bond yields and the only way it can do this is to generate reserves in the system. At the ECB and while the central bank may certainly have intended to affect government bond yields in the periphery this was "pull QE"; i.e. reserves were pulled from the ECB based on banks' demand for such liquidity and, presumably, their need to shed themselves for collateral.

One of the main objectives as stated by the ECB was to provide liquidity to banks who could not otherwise refinance themselves in the short term money market. I think it is critical here to note that while the Fed and the BOE have always put forward specific targets for their QE operations, the ECB has not! If the banks had put up 2 trillion worth of collateral in the LTRO and asked for 2 trillion in liquidity they would have gotten it! 

Anyway, to the point that banks are forced to hold these reserves (as a counterpart to the size of the balance sheet), in the perfect world it is not certain that this is the case. Let us assume a central bank conducts QE through the expansion of reserves with two objectives in mind.

1) To affect government bond yields (perhaps to allow the sovereign to run higher cyclical deficits for a period to boost aggregate demand).

2) To improve risk sentiment and risk taking in the economy through higher credit creation by commercial banks. 

One immediate effect of such a policy in an environment where the monetary policy transmission is broken is that while government bond yields may go to zero it has no effect on lending to the real economy.

What can the central bank do? Not a whole lot as it were. 

The central bank created the reserves in the first place and cannot easily induce banks to lend these out without compromising its asset side. In other words, it is difficult to pursue both objectives directly at the same time.

Specifically, if banks started to draw on its excess reserves to lend out to the real economy the central bank would need to one of two things. Maintain the size of its balance sheet constant by creating currency or reducing its holdings of securities on the asset side (government bonds). The latter is difficult to do especially if the central bank has been very aggressive in its sovereing bond purchases. Still, theoretically the central bank will be informed by the notion that the economic multiplier of commercial banks lending out to the real economy is higher than central bank financed government spending. It is not inconceivable that this is what central banks may start trying to do. We are seeing this by the BOE now giving preferential treatment to banks lending out and the ECB with its latest move.

Finally, negative rates could, as noted above, force banks to lever up to make money and it is not inconceivable that this could work in some countries where the banking system sounder or where some banks may have the buffer to do so. The main risk for the central bank is that this reduction in its balance sheet simply forces reserves into government bonds anyway as commercial banks see no other choice. The structural features of financial repression also will point towards this.

Here of course, the practicality becomes an issue. The BOE now holds 30% of all Gilts outstanding and if it started to sell these off as banks started to lend to the real economy interest rates across all maturities and lending products could rise very fast and in complete disconnection with underlying fundamentals. Currently, the position for central banks in this matter is complicated because as we have seen liabilities tend to migrate to the government balance sheet and as such the central bank needs to work very hard to keep borrowing costs in check for the sovereign.

Now, as for creating physical currency it is not clear to me that central banks would want to do this but the notes that I have read so far simply assume that it is given that commercial banks would be able to shift reserves into currency. This then brings up a whole hosts of other issues regarding the existence of cash at the zero lower bound. Citi's chief economist Wilhelm Buiter for example has suggested that physical currency be retired altogether and that electronic money be used instead. Such electronic money could of course be subject to exactly the level of negative interest rates the central bank deemed fit or perhaps even be subject to a fixed maturity.

Negative deposit rates have another effect in so far as they induce carry trades in with the negative currency yielder as funder and thus pushes the currency (euro) down. Such real effective depreciation could be a powerful tool for the ECB and for once it is a first mover here. 

Ultimately, negative deposit rates are no panacea and certainly in the context of central bank creating the excess reserves in the first place, but the effect of FX markets as well as the potential for its effect on the quantity of currency in the system should be keenly watched.