ECB Monetary Tools and the Bazooka Option

One of the most cited possible solutions to the current European Debt crisis is the so-called Bazooka Option. Proponents of this exit strategy want the ECB to use its unlimited monetary firepower to place a ceiling on the yields of Italy, Spain etc. by becoming the buyer of last resort (at 5% yield is the suggestion). Various estimates of the size of the bazooka have been given and the general consensus is that a minimum of 2 trillion Euro should be enough to calm the markets. In fact, the ECB through the Securities Market Program (SMP, Item 7.1 in Balance sheet) engaged in this outright buying of periphery bonds when the Greek crisis entered a critical phase last year. The ECB re-opened the SMP the last couple of months to support Italy and Spain. Currently the size of the SMP is around €160.5 bn. So why not go all the way as the Bazooka fans advocate and use the unlimited firepower? Opponents of this option usually cite:

•  Although the letter of the law says the ECB is not allowed to buy government debt directly (see box) from the issuers, it so far has avoided the problem by buying secondary market bonds. This is a violation of the spirit rather than the letter of the law. 
•   Moral Hazard. Politicians no longer need to worry about balancing budgets since any financing need will simply be absorbed by the ECB. 
•    Once the ECB starts buying Bonds at 5% yield, it becomes incredibly difficult to stop since yields would most likely widen on all peripheral debt to achieve this ECB price. It would cause losses even in markets that have no problems as yet. 
•    ECB would become susceptible to political pressure as the threat of haircuts on the debt by governments becomes a significant risk to their balance sheet (ECB has infinite buying power by printing new euros but limited capital of some €10bn to absorb any losses from their balance sheet purchases, ECB officially could then be considered a bad bank)
  However, another reason, which is rarely mentioned, is the issue of monetary policy and the transmission mechanism i.e. 
  
   
  Article 21
  Operations with public entities
  21.1. In accordance with Article 123 of the Treaty on the Functioning of the European Union, overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments. 
  LOSS OF MONETARY CONTROL OF INTEREST RATES AND TRANSMISSION POLICY 
  
  Like many central bank in the world, the ECB controls market rates by determining the price at which liquidity is provided to the financial institutions. In Europe this is achieved via the use of Open Market Operations (OMOs, items A5.1, A5.2 in ECB Balance sheet) whereby the central bank lends euros to financial institutions against them posting suitable collateral. These operations are known as Repurchase Operations (Repos) and have tenure of 1 Week, 1 Month, 3 Month or even longer if deemed necessary by the Central Bank.  To control interest rates, the ECB maintains three separate facilities. The Deposit Rate as the lower bound (0.75%), the Marginal Lending rate (Upper bound, 2.25%), and the Repurchase agreement (middle of the range, 1.50%.
  In simple terms, the ECB’s aim in the Eurosystem is to manage the price of money (Interest Rate) by controlling the amount of liquidity supplied. i.e. the amount that helps banks to fulfil their reserve requirements. The standing facilities set a corridor of interest rates and if the supply is balanced relative to t he banking community’s requirements, then short-term interest rates should be close to the middle of this corridor. Reserve requirements also help to reduce volatility in short-term interest rates by giving commercial banks a buffer for unexpected liquidity flows on their accounts.
  The fact that the Eurosystem is short liquidity is thus used by the ECB to manage the short-term interest rates through their OMO’s. Before the crisis, the ECB would calculate on a weekly basis how much liquidity the Eurosystem needs and it would provide it using the Repo operations. With the introduction of full allotments, financial institutions could, if desired, borrow more than needed as a precautionary measure against market disruptions.

The calculation involves, the Autonomous factor on both the Asset and Liability side of the ECB’s balance sheet. In the graph above, the green line is the total liquidity shortage in the system, including the regulatory requirement (Item L2.1. Balance Sheet Data from ECB Website). It excludes the SMP program and its sterilization plus the Covered Bonds Program (unsterilized). Currently the total shortage in the system would correspond to approximately € 450 bn. If we now introduce the Covered Bond purchase program and the SMP (including sterilization), we find the funds needed to balance the system have dropped to around €400 bn. Finally, the Red line corresponds to the amount of liquidity needed by the system if the weekly sterilization of the SMP program was unsuccessful. In this instance, we clearly see that the drop in liquidity to balance the system has now reached around €250 bn.  (The blue spike in 2008 is due to the ECB reporting a Fine Tuning Operation line 2.3 of the liability side of the balance sheet instead of the normal 2.4 entry.)

Regulatory Reserve.

The Regulatory Reserve Requirement is calculated per financial institution as 2% of the short term liabilities. Banks need to have an average deposit with the ECB equal or greater to this amount every maintenance period (4-5weeks). It is item A2.1 in the ECB’s balance sheet

Firing the Bazooka may negate the OMO tools 

SMP and Covered bonds purchases help banking stability but destabilises Open Market Operations. 
Here lies the essence of the problem. The recent announcement of the reopening of the covered Bond purchase program by some €40bn coupled with a possible significant increase in purchases by the ECB in the SMP program (another € 200bn) may result in the ECB now transferring liquidity controls to the banking sector. Open Market Operations are no longer needed by the banks to satisfy their reserve requirements since instead of participating in the SMP sterilization program, they can use their extra cash to satisfy their reserve requirements. In this scenario the ECB is no longer a creditor bank and loses the firepower of the REPO and its main policy transmission mechanism. In other words, it cannot enforce its monetary policy decisions through its OMO (Open Market Operations).  The banks now determine how the excess cash in the system will be used either to park it in the deposit facility on a daily basis or lend the money for 1 week via the SMP sterilization program (if they find the ECB rate attractive enough for their needs) 

IMPORTANT NOTE: Currently the ECB is sterilising the SMP program by withdrawing the cash liquidity injected through the SMP via a weekly deposit (Item L2.3 in ECB balance sheet). However, Eurosystem banks are NOT obliged to give this money to the ECB. Although the ECB sets an upper limit ( 1.5% and same as repo rate) the amount offered by the banks and the rate at which they offer is beyond the control of the central bank.  Although in the present market conditions where excess liquidity is around €200bn, sterilization is easily achieved, if excess liquidity decreases to €20  or €30bn then sterilization may not be a smooth operation. A significant increase in the SMP purchase program may therefore permanently damage the ECB’s ability to remove excess liquidity from the system even if full allotments were no longer applicable in the OMOs. EONIA fixings would therefore no longer return to fixing 6 to 8bp above the repo rate  (normal conditions) but instead would drift between the deposit rate and the repo rate depending on the banks desire to participate in the sterilization operations.

The total size of the SMP matters, as it is a permanent injection of liquidity and not a REPO, as such it would stay in the system until bonds naturally mature. During this time, the ECB would no longer have full control of rates via the OMO’s but be forced to steer rates by changing the spread between the deposit rate and the repo rate (apart from begging for banks to participate in the sterilization program). In the future, in order to avoid inflationary pressures then the ECB may attempt to sterilise the excess liquidity by increasing the rate at which they sterilize the SMP program without changing the repo rate but this simply can be seen as begging with a sweetener attached. The ECB would simply become like the FED which no longer has any control in market rates as long as all the excess liquidity created by QE is still in the system. In reality, the ECB’s SMP program above €450bn is the same as QE although they may not be willing to admit it at that time

Since the need for liquidity by the banking sector is dependant on the regulatory reserves they need to post at the central bank, some may say, one possible solution would be to increase the Regulatory reserves from 2% to 10% (say) thus requiring banks to deposit close to 1.1 trillion with the ECB. This would of course force Eurosystem banks to deposit the excess liquidity back with the central bank. The problem would this change is that it represents a significant change of paradigm since Regulatory Reserves have stopped being used as a monetary tool for many years now. More importantly the reserve requirement limit is an important determinant of the money multiplier effect in the economy, a significant increase in it’s value would therefore likely result in banks being forced to significantly reduce the size of their balance sheet and therefore have a huge knock on effect on the real economy.

In conclusion, increasing the size of the SMP plus covered Bond purchase program above the threshold of € 450bn poses serious problems in the implementation of the monetary policy of the ECB, which after all is one of its primary objectives. Maybe, this is the real reason why the ECB is reluctant in pursuing this bazooka option. Incidentally, many exit strategies that have been proposed, directly on indirectly suffer from this defect (Increasing permanently the ECB’s balance sheet).

Central banks can steer short-term interest rates because they are the monopolistic suppliers of liquidity and are therefore able to lay down the terms for supplying it’

José Manuel González-Páramo, Member of the Executive 

Restructuring the Restructuring

On the 21^st of July European leaders agreed on a second bailout for Greece totalling 109bln. This was on top of the original 110bln agreed between Greece and the famous Troika (EU+IMF+ECB) to be given in instalments assuming Greece complied with the Troika’s demands. Right from the start we expressed reservations as to the ability of the 2^nd bailout to deal effectively with the sustainability of the Greek debt. It became increasingly obvious that the 2^nd bailout was produced with the health of the banking sector as a driving force and not the reduction of the Greek debt. So it was a matter of time before reality took over.

The news are full of reports, analysts, economists and politicians advocating a much higher haircut of 50% or a “technical revision” of the 2^nd bailout. In fact most of the market is concentrating on one aspect of the bailout and that is the PSI (Private Sector Involvement) haircut.

Here we argue that a revision of 2^nd bailout need not only involve changing the PSI haircut to 50% but some of the other elements of the bailout.

Main points of the 2^nd bailout:

·            34bln of new money.

·            20bln to buy back Greek bonds in the secondary market.

·            20bln to recapitalise the Greek banks.

·            Marshall plan for Greece through NSRF (National Strategic Reference Framework, Cohesion Plan).

·            PSI. Rollover of bonds maturing up to 2020. Implied yield of 9% means effective haircut is 21%.

PSI. A 50% haircut? Is it doable without a full proper Default?

EFSF ideas

When in 2008 the world almost came to an end, most politicians were very quick in apportioning blame on the bad practices of banks, the lack of regulation and the greediness of the investment bankers. They pointed out that the practice of moving assets to SIVs and SPV’s off balance-sheet in order to hide the leverage was detrimental to the world’s financial health. These SIV’s had the following characteristics:

1)    Had little capital compared to the assets they were holding

2)    They financed the assets by issuing paper (mainly short term)

3)    Because of the collateral, they were given AAA status by the rating agencies

4)    Had liquidity provision lines back to the mother company (which was eventually called, causing the credit crunch)

So when the price and quality of the assets (mainly mortgages) went down, investors stopped buying the SIV’s bonds. The result was a huge shortfall of funding. As they were not banks but offshore entities (so called “Grey or Shadow banking”) they did not have access to the unlimited provision of ECB or FED money. Feeling desperate they went back and activated the liquidity provisions they had with the mother company. This in turn caused the credit crunch and the global crisis.

Now move fast forward to 2011 and look at the proposal for saving Europe.

1)    Establish a European SPV (or transform EFSF) with 50billion (say) of capital

2)    Give it the status of a banking institution

3)    Leverage it 20 times or more to 1 trillion by issuing bonds into the market

4)    Use the proceeds to buy Peripheral debt and/or bad bank assets.

We do not know whether the plan involves short term or long-term bonds. The difference between this new SPV and the previous one is that it would no longer be a “Shadow banking”, as it would have access to the unlimited funding of the ECB. This is the mother of all leveraged SIV’s. It actually transfers the financial technology that was responsible for the credit crunch to the sovereigns and to the real banking system. If the quality of the bonds this SPV owns, goes down, there would be no problem in funding them forever, assuming the accommodative ECB stance is forever. The whole scheme is a stealth way of printing money without the ECB violating article 21 (grey area). I don’t understand why we have to complicate these things. We do not need SPV’s, just ask the local banks (Italian, Greek, Irish etc) to buy more new Government debt and then repo it with the ECB. Even better, ask the local NCB to increase the ELA (Emergency Liquidity) to 1trillion. In fact this is the real onshore “Shadow Banking”. The ELA has the ability to finance any kind of toxic asset by “Ponzi-ing” it with the state. The Irish are doing it for a year now. Why not extend the practice across all Europe?

Alternative ELA Proposal

Let the Greek banks give tax-loans to the Greek retail customers. In other words, loans for the Greeks to pay their government’s Taliban tax raids. The lender bank can turn around and give these loans to the Bank of Greece’s ELA and get the funding. Doing so the Greece collects all the taxes and appears perfect in Troika’s eyes. The fact that the ELA is a liability of the Greek state is a minor detail that can conveniently be overlooked for some time. 

These new proposals are just a covert way of introducing more leverage to the already overleveraged banks and governments by placing smokescreens and printers. It is just another sleight of hand to distort reality and buy some time.

Greek Bond Prices and Default Probabilities

In the past few weeks a flurry of articles have hit the popular press regarding the probability of default of Greece. Headlines like, “Markets predict Greek Default probability 99.99%” or “CDS markets predict 100% probability of default for Greece” inspired fear to the hearts of investors and to Greek depositors who rushed to take their money out of Greece. Most of these stories have originated from the financial press[1] and from traders who used a well known mathematical formula that computes the probability of default given the bond Price.

One cannot argue the correctness of this number or the mathematical involved which have been checked by many practitioners and academics alike (including me). There is however, great ambiguity and controversy at applying this mathematical formula and interpreting this number as the market’s prediction for the probability of default for the Hellenic Republic. The reason is simple. Many of the underlying assumptions, which unfortunately are almost never mentioned, are violated in this case.

Market Liquidity and Efficiency

 

Figure 1. Monthly traded volume of GGB's

The credit spread of any bond whether corporate or sovereign is comprised of the following components:

a)    Risk of Default.

b)   Optionality if any.

c)   Liquidity Premium

d)   Other, like Convexity, Repo specialness, etc.

In the case of almost all Greek bonds the credit spread is simply (a) and (c). I.e. Risk of Default plus Liquidity Premium.

So how much is the Liquidity risk or premium embedded in the spread. Do we know? Can we somehow estimate its value? Most academic studies have shown that it is significant but unfortunately no satisfactory model exist (to the best of my knowledge) that can separately price it.

So, how liquid are the Greek bonds and the Greek Bond market. Greece has about 350 billion of debt. In the form of tradable bonds around 280billion as the bailout package have so far transformed 60billion into bilateral loans and there are also around 10billion in short term Tbills. How many of these bonds are traded on a monthly basis now and how many a year ago. The graph below (Figure 1) is revealing. From a high of around 45billion in March 2010 (when the debt crisis erupted) we are down to 1.7billion in March 2011 (Data are from the major providers, HDAT, MTS, Brokertec, BGC, ICAP). This is an absolute staggering reduction in liquidity to the once vibrant Greek bond market. Why did it happen? Why are these bonds not traded? Why do investors shy from them even at extremely low prices and why are scared holders don’t sell them?

New risk Emerge. Leviathan. Turkey Israel Cyprus

·            Papandreou cancels trip to NY

·            Conference today at 17:00 (London time). New measures to be announced

·            Coupon Payment delay unlikely.

·            Elections?

·            Leviathan

Papandreou cancels UN trip

The Greek saga continuous and it is better than watching Joan Collins in Dynasty. In a theatrical and dramatic gesture the Greek PM swapped, UN cocktail parties, Bloomingdale sales and a meeting with Turkish PM Mr Erdogan for Mr Venizelos. The official reason given is that Mr Venizelos encountered a hostile reception (putting it in polite terms) by his European colleagues who did not believe that his latest Taliban Tax raid on housing was going to work. The European leaders were also possibly annoyed by the support of the Americans and especially by Mr Geithner who urged the Europeans to stop bickering about the debt and get on with the job of dealing with it. Judging from the recent, last hour debt ceiling deal in the US, which brought the US within days of defaulting most Europeans would be sceptical of his wisdom.

New Measures

Greek government target is to:

·            Comply with the 2011 budget as dictated by Troika

·            Achieve primary surplus in the 1H of 2012

Both targets are ambitious. In order to be within the 2011 budget, as time is running out, further tax raids may be on the cards.

Merkezy, PSI, Taliban Taxes, Conditions for Default. 15 Sep 2011

·         Merkezy statement on Greece

·         PSI

·         New taxes in Greece

·         Default cui bono

·         Conditions for expecting default

Anyone expecting some big announcements after yesterday’s Sarkozy, Merkel and Papandreou videoconferencing, does not comprehend how the EU works and functions. The principles of opaqueness and secrecy are adhered religiously. Why, was it only Merkel and Sarkozy versus all European leaders? After all, this is a European problem. Is this a new EU body that I missed? In any case, what was really said and decided we will find out in the next few months. Afterwards, they stated the obvious i.e. that Greece would remain in the Eurozone and that Greece would stick by the medium term plan. Most importantly of all, they reiterated the resolve to proceed with the PSI.

It is obvious that some kind of political deal was struck but we would not risk speculating. One however, could infer that the threat of disrupting the instalments the past few days was directed at Mr Papandreou and not at the markets. There are no significant bonds maturing till December 2011, so any delay in the instalments would have meant bringing down the Papandreou administration by October end, without risking default. So, by saving his job for now, it is natural that the Germans got something in return.

One should expect some major announcements from Greece in the next few days possibly even today that aim to convey the message.

Europe implicitely asks Greek PM to go.

·            Greece announces one more tax raid to plug the hole in the budget as the estimated deficit jumps to 9.5% from the 7.6% forecasted for 2011.

·            Greek PM credibility at its lowest

·            European leaders barking at Greece

·            Scenarios going forward

It should by now be very clear that every time we are approaching an installment, Greece would start kicking and the European leaders/lenders would start shouting verbal abuse. In addition, there would be the customary rumors regarding Greece exiting the Euro, declaring default over the weekend and the seven plagues visiting Greece together with the Troika inspectors.

I am surprised, by the inability of the market to comprehend that the European Union is just a babel of views and that it should not pay attention to what they say but what they can or cannot do. With that in mind, can we seriously estimate the cost of Greece proceeding with a disorderly default and possibly exit from the common currency? I think not, at least not in the near future. It is not a question of morality or whether it is right or wrong to punish the non-compliant Greeks. Morality exists only in humans and not in states and right or wrong never enters a political calculation. It is rather the monetary consequences to the European Financial institutions, the ECB and the Global economy.  Then we have the social consequences in Greece and across Europe. The philosophical ideal of a united Europe would suffer a blow and the notion that we have a German led coalition of northern countries against the south would gain credibility. In short, other countries not having similar problems might think of leaving the Union or not entering at all. After all, this is supposed to be a Union of willing partners and not vassalage. 

I therefore find the market’s reaction slightly over the top and that the most likely outcome to the current mess is a compromise and more time-buying.

Greek PM has become part of the Problem.

Watching the PM’s speech in Thessalonica was a painful ordeal. The market was expecting some mood changing announcements and instead they got the usual Greek rhetoric. The PM seems to have forgotten that the speech’s audience was the European politicians and the markets and not the Greek public. He reiterated the usual “we shall fight on the beaches” and “we will do whatever it takes” slogans coupled with the customary attack on the conservative opposition.

Greece May Default as Finns Demand Aid Collateral: Euro Credit 2011-08-25

By John Glover
Aug. 25 (Bloomberg) -- Finland’s demands for collateral on loans to Greece may trigger a default on 18 billion euros ($26
billion) of bonds sold by Europe’s most-indebted country.
The securities, which represent less than 7 percent of Greece’s 286 billion euros of bonds, are governed by English, not Greek, law, and include conditions that insist on equal treatment for all investors. Giving collateral to Finland as a condition for aid may breach the requirement that fresh debt doesn’t win repayment priority over existing notes.
“I am pretty sure the Greek government didn’t even know this, their incompetence is legendary,” said Andreas Koutras, an analyst at InTouch Capital Markets Ltd., a London-based fixed-income adviser. “One should be very careful when giving securities or other collateral, like the Greek government is with the Finns.”

Greece decides to wake up. Is it too late?

In a cabinet meeting full of the usual Greek drama, the finance minister and deputy Prime Minister Mr Venizelos announced the capitulation of the Greek government to the Troika’s demands (salary review, privatisations, closing of state enterprises, opening of closed professions etc) . For the past 2 year the government of Mr Papandreou is playing the game of chicken with the EU creditor-partners. i.e. committing to changes outside and implementing nothing (or at least watering down reforms) inside.

This policy was successful initially in scaring/tricking the EU politicians and the markets but it now seems to have reached the sell by date and the EU now clearly demands action and deeds and not just the usually empty promises. In fact, the EU politicians are more scared that Italy may follow on the path taught by the Greeks rather than Greece itself. It is no secret that Greece is being used as a laboratory monkey, to test economic policies, European public opinion and political careers (Merkel, DSK, Lagarde, Regling and many more).