Please, click here to read this article in pdf format: March 29 2013

At the end of my last letter, I anticipated I would devote the next one to explain why, in my view, the European Central Bank is hypocritical on the Cyprus situation and why the rest of the periphery has to expect the same fate than Cyprus. Fortunately for me, Mr. Joeren Dijsselbloem who is both Dutch Finance Minister as well as the leader of the Eurogroup of Finance Ministers, confirmed my second point in a press conference 24 hours later, making my work easier…

A quick view of a bank’s capital structure

There are multiple issues on the Cyprus event. Perhaps the most relevant is the fact that unsecured depositors were sacrificed because their banks did not have enough subordinated debt to bail in. For this reason, the official story goes, Cyprus is a special case. Let me explain this point. In the figure below, I show the stylized version of the capital structure of a bank. From top to bottom, every portion of it is subordinated to the one immediately above it. It is clear that the least subordinated should be the deposits that finance a bank.

 

What is clear to us was not clear to leaders of the European Union. At closed doors, they first decided that deposits above EUR100M would arbitrarily lose 9% (in spite of existing subordinated debt to bail in) and put the matter to vote….only to revise this figure a week later up to 40% and without voting. It was hardly an ordinary bankruptcy proceeding; banks did not go through an ordinary liquidation and nobody could see an actual market appraisal of recovery values across the capital structure. The portion of such structure, which was supposed to be the most protected, saw its recovery value fluctuate between 9% and 40% within days because folks who live far away from this drama decided so over a weekend. On the other hand, those who held deposits of amounts below EUR100M are only entitled to them nominally. Effectively, they cannot withdraw their monies, let alone send them outside Cyprus. If they hold demand deposits believing that they can serve as medium of indirect exchange and they cannot use them precisely for that function, their property was affected, regardless of what the official story says.

Let’s return then to the thesis that Cyprus is a special case because the subordinated debt of its banks did not provide with enough cushion in the liquidation. As you can see from the figure above, the thicker the subordinated debt tranche is they lower the likelihood that unsecured senior debt and depositors will be affected. If Cyprus is a special case and it is not a template for the rest of the Euro zone banks, then it must be true that the rest of the Euro zone banks have stronger tranches below that of depositors. The sections below will show that during the last year (since March 2012):

a)   The same Euro zone authorities that imposed the loss on unsecured depositors were the ones who enabled a cash-out of subordinated debt holders, leaving depositors exposed to the firing squad,

b)   The Fed has been the ultimate enabler of this situation, and

c)    The fate of the US dollar is indirectly coupled with the fate of the Euro zone = There is no place to hide.

How the ECB financed the exit of subordinated debt holders

In December of 2011 and February 2012, the European Central Bank (ECB) extended longer-term refinancing operations to provide liquidity to euro zone banks. The liquidity, in euros and at a below market price, was against sovereign debt held by the banks, as collateral. Part of this liquidity was used for what is called “liability management” exercises, where the banks changed the composition of their liabilities: They borrowed from the ECB to repay their subordinated debt holders. This is the reason why Cyprus should actually be a template for the rest of the Euro zone. Because across the Euro zone, subordinated debt was reduced, leaving unsecured depositors exposed….again, across the Euro zone. The figure below, with the aggregate balance sheets of the main players, should help visualize what happened during the last twelve months:

In step 1, we see the focused balance sheet of the Euro zone banks and their subordinated investors (i.e. holders of subordinated debt), with regards to the subordinated debt. The same is a liability to the banks and an asset to the investors.

In step 2, we see the aggregate change caused by the extension of the LTRO Loans (i.e. loans issued under longer-term refinancing operations, by the ECB). These loans are an asset of the ECB and a liability to the banks.

 

Against these loans, the ECB issued Euros, which are an asset of the banks and a liability to the ECB.

In step 3, we see the transaction that I hold responsible for allowing unsecured depositors to be fair game across the Euro zone. With the Euros loaned by the ECB, banks bought out subordinated investors. Unfortunately, I have not had the time to quantify the exact impact of this transfer to date. However, reviewing past research notes released at that time (March 2012), my point will be clarified. (ADDENDUM: I HAVE BEEN GENEROUSLY FORWARDED TO THIS LINK, WHERE ZEROHEDGE.COM DID THE MATH ON THIS POINT, PROVIDING AN UPDATED STATUS ON THE ISSUE) 

On March 28^th, 2012, Barclays’ Credit Research team had published a report titled “European Banks: Liability management shrinks the bank capital market”. In it, it was estimated that at the end of March (only one month after the second LTRO), about 20% of the subordinated debt (equivalent to EUR97BN) had been targeted for exchange. The average exchange ratio of the transactions had been calculated at 82% of par (74% for Tier 1 and 89% for Lower Tier 2).  The reductions were split as follows: Close to 35% of cash out in the Tier 1 market (EUR54BN), 12% reduction of the Lower-Tier 2 (EUR37BN), and 18% reduction in Upper-Tier 2 (EUR6BN).

According to Barclays too, all the transactions had been bondholder-friendly, with an average 7pt (i.e. 7%) premium to secondary market across all issues (9pts for Tier 1, 5pts for Lower Tier 2). The main motivation behind all the transactions was capital optimization. They created capital gains to the banks. Except for two transactions in which the subordinated debt was exchanged for common stock or new Lower Tier 2, the rest were all tenders for cash. Greek banks in particular (i.e. National Bank of Greece, EFG Eurobank and Piraeus Bank) also participated in this liability management exercise; in some cases (i.e. Piraeus’s Prefs at 37 and LT2 floater at 50, announced on Mar 7/12) at premiums ranging 10 to 17pts.

In other words, both banks and subordinated debt holders enjoyed great capital gains, leaving unsecured depositors exposed to higher risk. This played out in the context of a virtuous cycle, where the cheaper funding improved the risk profile of the financial institutions and attracted capital back to the Euro zone. In the process, both the Euro appreciated and the EURUSD basis tightened, which further strengthened the equity of the financial system. The depositors of course, continued to receive mere basis points for their trust. On May 29^th and later on June 25^th, I had warned about the danger of this outcome.

But the story did not end here. In steps 4 and 5 of the figure above, I show the impact the Fed had in all this with its quantitative easing policy. By literally printing money in US Treasuries purchases, it added fuel to the fire, because Euro zone banks took advantage of the situation to borrow cheap US dollars, helping them repay their LTRO loans. Zerohedge.com has explained this with more detail than I can provide in this note, (in chronological order) here, here and here. I recommend that you read these articles in detail, if you want to understand how the game is going to end.

Step 6 seeks to show the status quo after the party. If the Cyprus situation is contained (which I doubt), going forward we should see the reduction in both assets (i.e. LTRO loans) and liabilities (i.e. Euros) at the balance sheet of the ECB and the banks, with banks replacing LTRO repaid loans with unsecured USD funding.

The Fed as the ultimate enabler tied the fate of the USD to the Euro

If you noticed, I circled the US Dollars held at the balance sheet of the Euro banks in step 6 of the figure above, as an asset. I did this because I want to emphasize a point I have been making for a long, long time: The collapse of the Yankee bond market (i.e. the market for bonds denominated in US dollars, where the borrowers are non-US resident corporations), caused by corporate defaults in the Euro zone will unmask the exposure that the Fed has to the fate of the Euro zone.  The dollars that end up with the Euro zone banks get recycled in multiple ways and one of them is via the Yankee market (another one is of course the USD loan market).

It should be clear therefore that this whole transfer of wealth will ultimately (and irresponsibly by the Fed) end up exponentially (through leverage) affecting those holding their savings in US dollars.

 

Final words

I am confident that the story above shows that far from being a unique situation, the fragile exposure of unsecured depositors across the Euro zone is the norm; and that their fragility was further increased in the last twelve months thanks to policies created by the same authorities who now refuse to honor their promise of a banking union, and instead impose capital controls, which have effectively destroyed any credibility on the safety of capital in the Euro zone.

One last word of caution: I think it would be wrong to interpret from the process depicted above that there was a premeditated conspiracy on the part of policy makers to weaken the position of depositors. This outcome, I believe, was simply an unintended consequence in their efforts to sustain the Euro zone. However, even if one accepts my view, the unintended outcome begs the following question: Why was there cheap money available for subordinated debt holders to cash out, but there is none now to protect the savings of depositors? Nobody can answer that question but with speculation, and as such, intellectual honesty demands that I keep mine to myself, because as Mark Antony said in Shakespeare’s “Julius Caesar”: “…You are not wood, you are not stones, but men; and being men, it will inflame you, it will make you mad”.

Martin Sibileau

Today, we think it would be important to leave the analysis of the latest news aside (including the negotiations on Greece’s debt) and instead, to present a theoretical framework that may allow us to understand the ongoing rally and what may develop during 2012 and beyond. There is nothing more practical than a good theory and a good theory is indeed what we are looking for this morning.

Let’s first examine what we are witnessing today, namely the financing by the Fed and the European Central Bank (“ECB”), of the Eurozone financial system. Below, we describe how it works and we carry the analysis to the extreme. We like challenging models to their extreme implications, because this aprioristic deductive exercise forces us to identify what mainstream economists, many months later than us, usually end up calling “tail risks”.

In step 1 above, we see the first pillar of the EU financial system bailout: The Fed extending US dollar swaps to the ECB, at below market rates. As can be seen, these swaps are an asset of the Fed and a liability to the ECB, which receives US dollars in exchange. With these US dollars, as we explained on December 12th, the Fed avoids a liquidation of US denominated assets by EU banks and the resulting increase in the cost of US dollar funding as well as in counterparty risk, for US financial institutions. These swaps can therefore be seen as vendor financing in favor of US banks, at the expense of American taxpayers and anyone who invests their savings in US dollars (i.e. US banks, via the Fed, provide cheap financing to their trading counterparties, all paid for by a devaluation in the purchasing power of the US dollar. On this matter, please refer our comments on September 12^th, 2011).

However, the extension of USD swaps is not enough to save the status quo. The institutional weakness of the Euro zone, having failed (back in March 2011) the move towards a unified bond and fiscal integration, triggered the jurisdictional arbitrage of deposits (Euro funding). Deposits were taken from banks in the periphery (Greece, Portugal, Spain, Ireland, Italy) and shifted to the core (Germany, France, Netherlands). This situation generated a funding squeeze that was and continues to be addressed by long-term refinancing operations (“LTROs”) by the ECB, as shown on step 2. In these operations, the ECB extends collateralized Euros to EU banks. These are loans, assets to the ECB, and liabilities to the EU banks. Since its inception, the ECB has steadily been decreasing the minimum quality of acceptable collateral and increasing the tenor of the financing. Most of these funds have been returning to the ECB as excess reserves, a disturbing fact. But at one point, the repression by the political apparatus and the temptation to use these cheap funds to buy high yielding EU sovereign debt is too strong and we start seeing the use of these funds to monetize (i.e. purchase sovereign bonds in the primary market) EU fiscal deficits. That is shown, as step 3.

On step 3 too, we see that these funds keep open the window for depositors in weak banks to continue the liquidation of their deposits, in exchange of fresh cash. On the other hand, once the governments sell their bonds to the banks, they distribute the Euros issued by the ECB across the Eurozone.

Finally, on step 4, we see the conversion of these Euros by EU depositors and corporations, into US dollars (or Swiss Francs or gold), as a way to protect their savings from the unsustainable status quo: They know that the EU fiscal deficits will remain alive and have uncertainty on the future of the monetary system. Who provides them with the window of opportunity to exchange their Euros for US dollars? Ultimately, the Fed, with the provision of cheap US dollars to the ECB, via swaps.

This circular process, in extremis, brings us to the final line in the graph above, where we show the balance sheets of the Fed, the ECB, the EU banks and the EU depositors & Non-financials. The Fed will own US swaps against which US dollars will have been printed. Yes, printed! This had occurred in the 1920’s and 1930’s, but at least back then, those US dollars were somehow backed by gold reserves. Today, that’s no longer the case. Who will have the US dollars owed to the Fed? Not the EU banks nor the ECB, but the EU depositors & Non-financials! In summary, the people of the Eurozone!

In extremis too, the balance sheet of the ECB will look like that of a middle man. As assets, it will carry long-term refinancings. As liabilities, it will have the US swaps, that it extended to the EU banks. These EU banks however used the euros to buy sovereign debt, which is now their asset, and owe euros (i.e. LTROs) to the ECB. This is a very unstable situation, because if the fiscal situation of the Euro zone does not improve, these sovereign bonds in possession by the EU banks will remain driving capital losses.

This analytical framework leaves us with questions:

If the Fed ends up being the creditor of the EU depositors and corporations…how will it ever get its money back? What will be needed to repatriate these US dollars? We think there are only two ways to solve this problem. The best case and least likely is to see an improvement in the fiscal situation of the Euro zone. If deficits were stabilized or even reduced, the sovereign bonds held by the EU banks would drive capital gains, euros would flow back again to the EU banks in the periphery and US dollars would have to be sold in exchange, to buy these Euros. The EU banks would be then in a position to both return the LTROs and the US dollars to the ECB. The worst case occurs if the Fed implements an exit strategy, raising US dollar interest rates and US dollars flow back to the US. This is also not likely, at least in the short-to-near term, in our view. This would require, a priori, a strong economic recovery.

Another interesting question is related to the Euros in circulation, supplied by the LTROs: What happened to them? In extremis, we see that the EU depositors and Non-financials first took these Euros from the EU banks and later exchanged them for US dollars. Were they taken out of circulation? No, but the velocity of circulation increased, from the ECB to the banks, to the people, and back to the ECB. This is consistent with the monetization of sovereign debt and a context of high inflation. Once again, we note that this analysis is in extremis…For now, we can see it as a natural logical consequence. To mainstream analysts, this is a “tail risk”. The reader is of course free to take a view on this matter.

Please, note that this analysis implies the survival of the Eurozone with the liquidation of sovereign debts via inflation.

Is this status quo sustainable? If not, what will accelerate its demise? How will gold and the rest of the risky asset spectrum behave? Below, we present a flow chart, where we seek to summarize this process.

As we can see, as backdrop to the process described above, the Euro zone today is crowding out private investments, given the high cost of sovereign debt. In addition, it has and continues to implement higher tax rates and further interventionism and financial repression. With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unadressed. All these factors only contribute to prolong the recession and a high unemployment rate.

The flow chart is clear: As long as the people of the EU put up with this situation and the EU Council, chaired by Mr. Herman Van Rompuy effectively kills democracy at the national level AND as long as the Fed continues to extend US dollar swaps, this status quo will remain. If people revolt and the EU breaks up or if the Fed is no longer politically strong enough to force these swaps, the status quo will collapse.

Contrary to popular belief, this status quo is based on the “coupling” and not “decoupling” of the Fed with the ECB. This coupling relaxes correlations, because the US dollars sent by the Fed to the ECB were printed and nobody in the US feels the immediate pain. Hence, we have the rally in stocks and gold, without any correction in the US Treasuries market.

Whenever the political sustainability of the EU is challenged, we will see a run for liquidity. And 2012 will have many of these panic situations, affecting any late longs in gold or stocks.

Finally, when the “decoupling” takes place, the US dollar can only remain strong if the fiscal situation of the US permits. But we fear that the Fed will embark on interest rate targeting. This is a story for another letter…

The trend is for asset inflation, and will last as long as the people of the EU and the US do not challenge the political status quo.

Martin Sibileau