Please, click here to read this article in pdf format: may-20-2010

In our view, nothing really new has taken place, except for the German reaction on Tuesday to deteriorating market conditions. We have already addressed the issue of the systemic risk embedded in sovereign credit default swaps (refer: www.sibileau.com/martin/2010/03/01 ). However, banning their trading is wrong, it leads nowhere and makes matters worse.

Briefly, sovereign credit default swaps are instruments where counterparty risk is totally underestimated today. If Spain defaulted, what would be the value of a credit default swap on its debt, sold by Banco Santander? None, we think, for Banco Santander would suffer the same fate. As these contracts on EU sovereigns are in USDs, the shortage of USDs in case of a default would rise exponentially, pushing the ECB to request additional USDs swap lines from the Fed. It is precisely this scenario that Congressman Ron Paul sought to avoid last week, unsuccessfully. As we wrote back on March 1st, if the Fed satisfied that USD demand by extending USD swaps to the ECB, the contagion would spread 100% across the Atlantic, which is the scenario where we think paper money collapses. We give this scenario a high probability.

Given that this issue must be addressed, what would we have done differently, had we been in Germany’s shoes? We think it would have been enough to pass a resolution, EU wide, explicitly making crystal clear that the portfolios of those selling sovereign protection will not be bailed out with public funds in case of stress and that those responsible for not separating (capitalizing accordingly) those trading portfolios from other (i.e. banking) portfolios would be liable to criminal charges. On such announcement, the market alone would re-price the underlying counterparty risk on the outstanding trades and those who cannot meet the increased margins would have had to quit, leaving a healthier market.

Finally, the fact that the German ban on short-selling was unilateral and comprised a limited amount of financial institutions invites one to speculate that somebody is anticipating something. Why 10 banks? Why not 5 or 12? Why those 10 banks?  As the easier explanation is usually the one closer to the truth, we are left thinking that it was mere idiocy on the part of German authorities, rather than conspiracy.

On another note, in our letter of May 13th we wrote about the alternative the ECB had, to sterilize by issuing debt (for the comments below, refer the chart we made for this scenario: Sterilization with short term debt: www.sibileau.com/martin/2010/05/13, reproduced at the end of this letter). On Monday, the ECB announced it would do so yesterday (Wednesday) with a 7-day tender at a variable rate with a maximum bid of 1%. (this rate is very good, compared to the EONIA, the effective overnight reference rate for the Euro). The total purchases of sovereign debt in the previous week had been EUR16.5BN:

-May 10-14:
a) ECB credits EUR16.5BN of sovereign bonds and debits EUR16.5BN
b) Euro Banks credit EUR16.5BN of cash and debit EUR16.5BN of sovereign bonds

-May 19th:
c) ECB credits EUR16.5BN in cash and debits a EUR16.5BN 1-week term deposit (short-term debt, for the ECB)
d) Euro Banks debit EUR16.5BN in cash and credit a EUR16.5BN 1-week term deposit

Yesterday, the term-deposit was over-offered (given the 1% rate), at EUR163BN, suggesting that thanks to the ECB initiative, there is no shortage of liquidity in the system. The weighted average rate paid (by the ECB) was EONIA-6bps.

An interesting feature of these transactions is that the deposits are eligible as collateral in refinancing. Given the liquidity in the system, we don’t expect any such usage but we ask ourselves how it is that the market cannot short banks or make naked derivatives bets, while banks can use the cash they debit as collateral! Who is playing with fire? What risk manager at any bank would not be fired if he/she allowed a customer to use as collateral funds already used to buy securities?

We continue to read abundant analysis that is positive on the impact of ECB policy, and we continue to disagree with it. Essentially, the optimistic here believe that the ECB policy will lower rates as well as drive the Euro to an optimal value. They also believe that if given time, Euro members can produce significant deficit reductions. They also bring up the fact that Greece is not a meaningful EU member, in GDP terms.

On our side, we fail to see how the ECB will lower rates by buying non-benchmark debt (benchmark debt = Bunds, non-benchmark = Greece, Portugal, Spain, etc.). We understand that this policy will deteriorate the quality of the assets backing the Euro in a spiraling process (=no optimal value or devaluation speed). We can’t see where is the motivation for countries like Greece to effectively cut their spending (or pay their taxes) when they are bailed out, and we laugh at the naïve notion that GDP weight has anything to do with currency risk, in an over-leveraged world.

Finally, on the bullish side, there is (we think) the misunderstanding that the ECB policy is passive (“passive quantitative easing”), because it is financial institutions that decide how much funding is needed. We think this is utterly wrong. The ECB is not bailing out banks. The ECB is bailing out sovereigns’ fiscal deficits, dumped on Euro banks. Euro banks here are only the middle men. How much funding is “needed” is driven by consolidated Euro fiscal deficits. This is key, folks! If the ECB was bailing out banks, the Euro would not have been sold off so dramatically!!! The market sells the Euro because it knows the Euro eventually represents the liabilities of the sovereigns, BECAUSE THE INDEPENDENCE OF THE ECB IS DEAD AND FISCAL DEFICITS ARE BEING MONETIZED. How can someone be bullish of this? How, we ask?

Scenario 2: ECB sterilizes PIGS debt purchases issuing short-term debt
Figure 2, reproduced from the May 13th letter. Notice that the ECB debt supply/demand graph on Step 3, right, is not yet significant, given that there’s only been one transaction so far (discussed above) and the resulting price was EONIA-6bps. Also notice that on step 2, PIGS debt increases on the asset side of the ECB. Last week, this increase was of EUR16.5BN, representing approx. 0.8% of ECB assets, as of May 14th (Source: ECB), which means that the credit quality of the assets backing the Euro has deteriorated. At this speed (=EUR16.5BN/week), it would take 14 months to have a Euro 50% backed by PIGS debt.

Martin Sibileau