Monday, 19 December 2011

Crisis solved. Didn't you get the memo?

On 8 December ECB announced a new 3-year financing facility. It is UNLIMITED, and with a suitable weakening of the quality of the collateral for the loans, it could end up being a major game changer.

The LTRO will make possible a simple idea to recapitalise European banks: take 3-year loans from the ECB at 1% and place the money in southern European government bonds. EU has promised that banks no longer have to take losses if a European government goes bankrupt. Banks have again been given a "free lunch".

Apparently I am not alone in being able to see this simple idea. Spanish and Italian 2-year yields fell like a stone yesterday. The attached chart could be interpreted as indicating that:

• The market believes that Italy, Spain and Ireland no longer represent a bankruptcy risk.
• Portugal is on the verge but may hold on to dear life
• The conditions of the Greek debt restructuring is still not in place (personally I think that the haircut will end at 80% and not 50%)

ECB begins the new LTRO 3-year loan facility on 21 December. It will be very interesting to see how much this credit facility will be used. Rumours in the market say that banks in each country are buying domestic debt in the two-year segment in some volume, a  sign that demand could exceed expectations. If that happens, the new facility is as close to a Euro-QE as we can come without changing the charter of the ECB.

If we now try to put a positive spin on this development so it could read as follows: the ECB has with its new facilities taken big step towards disarming the liquidity crisis. The EU has with his "paradigm shift" given a guarantee for bonds issued by 16/17th of the euro zone. ESM and EFSF will operate at full volume in about two to three months.

The lower yields at the short end of the curve mean that it becomes easier for the troubled countries to achieve the goals of a budget surplus now that their refunding costs are falling.

Hey presto - euro crisis is solved! Well, maybe we still have a small growth problem here and there ...

This is of course the ultimate positive interpretation of things. However, amid all the end-of-the world headlines, we must also remember to keep an eye on the positive developments. ECB’s initiative is one of them.

Before we let ourselves be engulfed by a warm and fuzzy Christmas feeling over the Euro-zone’s step in the right direction, let us remember that the crisis is not completely gone. It will just move to where it was always going to end. At the banks.

We have heard more than enough lack of ethics and accountability in certain countries. The next theme will be that the private sector has contributed dramatically to the increase in debt / GDP in the OECD area and the banks have been the willing / necessary instrument in this wave of financial leverage. With Europe’s abysmal growth prospects, the ongoing deleveraging everywhere will continue to mean losses for banks.

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