One unintended consequence of the ECB's solution is that, as happened after unprecedented government stimulus in 2009, the rules of the investment world appear to have been turned upside down, with the the worst shares performing best and the best worst. It's the kind of bizarre logic that would be more at home in a story from the master of the absurd, Lewis Carroll, the man who introduced us to the character of the White Knight in the first place in his tale "Through the Looking-Glass".
And like the White Knight, Mr Draghi may not turn out to be much of a saviour after all. Lewis Carroll's White Knight invents an upside down storage box, which keeps out the rain but allows all the contents to fall out – similarly the ECB's solution appears fundamentally flawed – in short, while it may have saved the banks again, it has also drained much of the liquidity out of the repurchasing market and increased risks to banks rather than taking us closer to a long-term solution. I wonder if anyone has had the courage to ask Mario Draghi the same simple question as Alice did about the White Knight's malfunctioning solution to his storage problem: "Do you know the lid’s open?"
Heading for another fall?
Given, at first glance, how spectacularly successful the LTRO has been, it's possibly more a question of self interest than courage. Since the ECB launched the LTRO on 21 December the FTSE 100 has risen 8 per cent and the German DAX has rocketed 14 per cent. The banking sector is leading the market as RBS has soared 40 per cent with Eurozone banks have followed in kind.
New inventions and unintended consequences
Simply accepting this LTRO as a saviour of the markets and jumping on the rally could be a dangerous strategy for investors; momentum is all well and good, until it goes off the edge of a cliff. It was repurchasing operations just like this that were used extensively in Lehman Brothers before the bank went bust in 2008, and it was alleged that repurchasing operations allowed both Lehman and more recently MF Global to hide millions in losses.
So what are these repurchasing operations? Simply put a repurchasing deal, or repo transaction, is the sale of something and an agreement for the seller to buy it back at a later date. It allows banks to fund their operations by turning assets on their balance sheet into cash. Moving to the real world, say we have a bank A, they would exchange an amount of Greek government bonds in return for an equal amount of cash, and agree that in the future they would buy back those Greek bonds at the same rate. When the normal functioning of this repurchasing market breaks down it is serious because as Bank A's debts come due they end up in a situation where they are holding lots of Greek bonds and have no cash to make repayments. Turning away from bank A for a moment, Credit Suisse research estimates the European banking sector has to pay back €1.7 trillion between 2012-2014. This is a problem when the credit markets have seized up as they have recently. Levels of interbank lending reached critical levels before Christmas and without the ECB providing funds in the new year some European banks were rapidly going to go bust, unable to repay vast debts built up in the boom years.
The ECB repurchasing deal now allows bank A to use the Greek bonds and other periphery debt as collateral and exchange these for cash which it can then use to pay off debts. The hope is that at some point in the next three years the credit markets recover and somebody wants to buy Greek bonds again, allowing the deal to unwind without either party taking losses. These transactions are usually short term but the LTRO is going even further by providing banks with cash for three years in exchange for a range of different government bonds and other securities.
Credit markets replaced by a lender of last resort
This is having a huge impact on the normal function of the repurchasing markets through which banks usually carry out this transaction. Icap, which is one of the largest repurchasing brokers in Europe, has reported a collapse in the volume of deals done. As the ECB plays a bigger role and accepts more funds in exchange for three year loans, the health of the Eurozone repurchasing market is suffering. And it is not just the European markets that are becoming stressed. The US funding markets are also reporting similar effects, with banks hoarding cash and high quality German bunds and using lower quality assets in repurchasing transactions. It was recently reported that the use of lower-rated debt in a key US funding market has returned to pre-crisis levels. This isn’t the healthy functioning of a credit market but a market on life support that is having to use more and more extreme medication to keep it alive. The LTRO scheme came just in time, but for how long has it averted the inevitable credit crunch and has its operation just increased the risk of a catastrophic failure in the future?
The answer is: quite possibly. Although LTRO has been described as “Quantitative Easing by the back door”, it is very different. Unlike the QE preferred by central bankers in the US and UK, the ECB hasn’t just purchased European government bonds in a one way transaction, but instead exchanged Euros for other assets. In the process, it has inadvertently created a banking sector more reliant on ECB funds, and at the same time, starving the healthy function of the market which will have to take its place eventually or in the event that the ECB stops buying.
Perversely this increases the level of risk which banks are ultimately exposed to through the ECB mechanism. The ECB are holding the assets from the European banks, but if their value falls below set levels, or if they receive further ratings downgrades they will issue a margin call and demand more money to cover the risk. Sound familiar? It should do, because this is Lehman v1.0 all over again. And as the UK and Eurozone head into what many expect will be a grinding recession, would you bet against Italian, Spanish or Portuguese government bonds having another lurch south in terms of ratings at some point during this year?
Invention fails to solve the fundamental problem
Based on the current available data, I wouldn't. Economists from Citi have just lowered their Euro zone growth forecasts for 2012 from -1.2 per cent to -1.5 per cent, and Spain’s Budget Minister Montoro has just warned the country may miss its 4.4 per cent budget deficit target for 2012. In the UK the Office of National Statistics revealed that real income fell 3.5 per cent in 2011, ask anyone on the street and they will tell you through gritted teeth how train fares, petrol and food prices have left wages in the dust. Meanwhile, the Baltic Dry index which tracks the cost of shipping bulk freight and a key indicator for the health of the international economy, is in freefall. The index has fallen 67 per cent since early December to a price of 651, a level not seen since the last collapse in 2008.
It is also doubtful whether any of these funds will reach the real economy. Mario Draghi said he wanted the LTRO funding to help promote business lending and growth. But banks are hoarding the cash to repay debts later in the year, rather than dishing it out to the companies that need it. That's borne out in the European Central Bank’s latest lending survey, which showed that the cost of loans to business are increasing; banks want more security on the loan; and are increasing the strictness of the terms. In the ECB’s December release on monetary developments, Societe General analyst’s highlighted the biggest ever decline in loans to the non-financial sector. In effect, the banks are stifling the very investment they need to ensure that their involvement in the LTRO does not scupper them later.
Investor risk is heightened
Investors, meanwhile, will have to manage their portfolios in an environment where banks are increasingly reliant on emergency funds, and the real economy continues to struggle. Any additional shocks such as Greek default, rising borrowing costs in Italy, or further ratings downgrades will stress a system that is on life support. In this surreal market where investment valuation appears to be turned on its head, it is probably best to take some advice from the unusual world of Lewis Carroll. Once Alice realised that her White Knight, having fallen from his horse a fifth time, was not quite the saviour he appeared to be, she decided to stand well back and watch from afar. In investment terms, that means avoiding piling into a rally that appears to be built on some very shaky foundations indeed.
