Deutsche Bank: “The Spanish Recapitalization Is Not Working” – A Market Shock Is Required
This weekend, everyone’s attention will be on the Greek elections, however it is Spain that has now become the “fulcrum security” of Europe. As such, events in Greece are merely a catalyst that will set off a chain of events that will have an impact not only on Spain, but on all of Europe, and thus, the world.
As we pointed out last week after the Spanish bailout announcement, based on a preliminary analysis which had been compiled by Deutsche Bank’s europhiles hours before the formal announcement, and one which just happened to be a carbon-copy of what was proposed as the ‘final (and failed) Spanish solution’, it appears that the events in Europe are if not orchestrated by the largest German bank, then certainly receiving part-time advice.
Which is why we were somewhat disturbed to read Gilles Moec’s summary this morning, which points out the patently obvious: “Spain recapitalization: it’s not working.” Whether it is that Europe’s brightest minds forgot about the threat of subordination (promptly reminded by Zero Hedge hours after the formal announcement), and that the scars of the Greek cramdown are still fresh in the private sector’s mind, it does not matter: as DB says: “Unfortunately, the market reaction was clearly negative, with Spanish 10 year rate brushing past 7% for the first time since 1996. Two main elements probably explain the market reaction: first, the increase in public debt triggered by the recapitalization whose cost will stay on the sovereign’s balance sheet under the current rules); second the seniority attached to ESM loans, if this scheme is used as the final channel for the EU loan instead of the EFSF.”
Yes, it is “unfortunate” that Spain’s bailout plan was poorly planned, organized and executed. It is not unfortunate that some are still left who can do simple math and call out Europe’s failed plans. Which brings us to the present, where we find that even Deutsche Bank has given up hope for interim solutions, having realized that the market will no longer accept transitory, feeble arrangements. Instead DB is now formally calling for a big bang resolution, one coming from the ECB. Here is the punchline: “ECB has room for manoeuvre, but needs political cover for a ‘big’ policy” or said otherwise, “A shock is required to get a liquidity response.” In other words: Europe’s only real hope for even a stop gap solution… is a wholesale market crash, not surprisingly the very same conclusion that Citi reached on May 19 when they warned that only Crossover (XO) at 1000 bps or wider could push Europe into acting…
Basically stated, anything less than a controlled market crash, one that finally gets the ECB involved with Germany’s permission of course, merely pushes the market higher on nothing but hope of an intervention that said market lift makes even more improbable, as now both Citi and DB admit, which can and will lead to an uncontrolled market collapse, one from which not even the ECB will be able to extricate Europe.
In this light, will Greece simply be the start of the much overdue “controlled demolition”, that will bring the ECB out of hibernation, that is paradoxically instrumental in avoiding an uncontrolled demolition, where not even the ECB will have any powers left to prevent a collapse?
Here is how Deutsche Bank sets the strawman – on the recapitalization, the market is wrong, and our advice was, well, right:
The statement by the German finance minister on Monday that he found find an ESM solution “more efficient” may have rekindled among investors the fear that the “Greek blueprint” would be replicated for Spain, with the private sector left to bear the brunt of any restructuring.
We think that the risk to Spain’s public debt sustainability, even after a EUR100bn recapitalization effort, would remain manageable under what we consider realistic assumptions on growth and interest rates (see FE Europe 8 June). Spanish public debt would remain significantly lower than in Italy and not so far above that of France, for instance.
There is always a but. And in this case, it is yet another event out of left field that will likely send spreads soaring even more than before:
However, even if we think that the long-term issues surrounding Spanish public debt are overstated, meeting the government’s refinancing needs in the next few months is getting increasingly difficult, in our view, since the ‘war chest’ accumulated by Spanish banks in the LTROs of December and February is drying up. At peak, in March 2012, Spanish banks had accumulated EUR 88.7bn on the ECB’s deposit facility. This has fallen to EUR 36.8bn in May. Spanish banks have committed to lend EUR 35bn to the regions this year to help them pay down their arrears. They need to refinance c.EUR 80bn of their own debt before the end of the year. Taking the slack from nonresidents reducing their exposure to the Spanish sovereign is going to stretch their resources further. By March 2012 (latest available data), non residents had reduced their holding of Spanish public debt to EUR 158.7bn (31.6% of the total), down EUR 6.4bn in a month and down EUR 26.1bn in a year. The valve of adjustment under the current circumstances would be to cut lending to the private sector further, thus sending domestic demand into more contraction.
In other words, “the money, it’s a gone.” Needless to say, the bank that will do everything to avoid the market’s attention being focused on its capitalization and leverage ratio, already has a follow up plan, after its first one failed:
To unlock the Spanish situation, we think that three ingredients should be envisaged:
- Another round of long term liquidity injection by the ECB. Even if the political conditions are not met at this stage (see last section of this article), we believe that this would be the only possibility for local banks to continue to support their sovereign. Further tweaks in the collateral rules would probably be needed to ensure that banks could take full advantage of this additional round. In our view, to try to incentivize banks to re-start lending to the private sector, the rules could be changed to allow only recently originated loans to corporations, for instance.
- Announcing recourse to the EFSF rather than the ESM to recapitalize Spanish banks. This could be seen by the market as a sign that seniority is not a major preoccupation of the Europeans when dealing with Spanish bank recapitalization. This would entail a negotiation with Finland on a collateralization of its support which, given the size of the Finnish contribution, is manageable, in our view.
- Ideally, the most powerful signal would be to open the possibility for direct recapitalization of banks by the euro rescue mechanism. This could not be done via the EFSF, but is still doable for the ESM, either via a unanimous change in the list of instruments by the board (article 19 procedure), or via a revision in the treaty – which still has not been ratified by Germany – if the legal basis for an “internal modification” is too weak.
Fair enough, “Door 1” it is, as further confirmed by yesterday’s statements out of Draghi, and various media leaks, that a European ZIRP may be just around the corner. There is, however, a problem with getting another LTRO out of the ECB. As Moec says, “ECB has room for manoeuvre, but needs political cover for a ‘big’ policy.”
Again, from DB:
With the market unconvinced by the Spanish bank recap package and near-term prospects of an ERF unconvincing, the market will be looking to the ECB as a last resort to restore some order.
There were mixed messages from ECB President Draghi’s comments on Friday, 15 June. In his address to the annual ECB Watchers conference, he claimed the objectives of the 3Y LTRO have been “broadly met”, in particular the easing of supply constraints on private credit, but pledged to provide liquid “where needed”. He claimed economic stabilization remains the ECB’s baseline, while at the same time pointing to the weak data since the baseline was agreed and “serious downside risks” to growth. He claimed that the ECB cannot “fill holes” in the EU’s process of mending heterogeneity, but that the ECB “partly responded” to heterogeneity with the enlarged collateral pool, specifically the credit claims collateral.
And here we get to the crux of the issue, the one that has inverted the expectations outcome out of Greece, whereby if Syriza wins, the market’s Pavlovian dogs are now fully expecting a global central bank intervention, aka the Bank. Should Syriza disappoint and Greece end up ungoverned, or paradoxically get a pro-Europe government, the lack of response will likely result in a risk off mood come Monday especially since the entire upward move in the past week was purely short covering on fears of monetary policy response:
A shock is required to get a liquidity response
Draghi discussed the concept of “adequate liquidity” on Friday. He differentiated between normal times, when the volume of liquidity is determined by banks’ obligatory reserve requirements and other autonomous factors, and times of financial instability, when the central bank must counteract bank funding market tensions and “systemic consequences”. Financial stability is an ECB responsibility. Compared to the comments from Draghi at the 6 June press conference, when the hurdles to more liquidity seemed high, there is more of a sense of ‘readiness to act’. That this message came right at the start of Draghi’s address to the ECB Watchers conference implies the importance of the ‘readiness’ message. The full allotment regime remains in place. Banks can get as much liquidity as they require for one week and for three months. The 3Y LTRO Draghi describes as having “broadly met” its objectives, specifically, easing credit constraints. He admitted it would take longer to judge full success (a flow of credit to the private sector), but demand may be weak. We have highlighted the importance of the next ECB Bank Lending Survey on 25 July of the ECB’s judgment regarding the need for additional vLTROs. It is possible in the context of more disorderly market scenarios that the ECB pre-empts the BLS to reengage the vLTRO policy which has, in Draghi’s view, already ‘broadly’ worked in similar market conditions.
And there you have it: if have more “disorderly market scenarios” read market crash, but not terminal crash, then ECB brings out the firepower.
Anything less, and everyone will be disappointed as it merely enforces the continuation of a now failing, and obvious to all, status quo, one which sees Spanish bond yields leaking ever wider, until Italy too finds itself beyond the dreaded 7% barrier.
Will Greece be the catalyst to bring on this much needed response from the Central Banks? Or will Greece “muddle through” for however many weeks before it needs another bailout, and/or finally throws in the towel, while the global central banks do nothing?
Find out on Sunday night.