Notes From Underground

If my radar is right, the coming European Central Bank QE program will be a concoction of asset-backed securities in an effort to remove non-performing loans from bank balance sheets. There have been a multitude of  “conjectures” about how the ECB is going to pump liquidity into a very low growth economy. Previously it seemed that some at the ECB wished to install negative yields on bank reserves. This would be an experiment fraught with danger as it could cause great problems for the money funds that have recently returned to Europe. The problem for money market funds was epitomized in a statement from Bank of New York Mellon’s CFO Todd Gibbons after today’s earnings release and reported in tomorrow’s Financial Times:”If the eurozone were to go to negative rates that would actually present the opportunity for us to charge for deposits and we are giving that very serious consideration.” The idea of  “negative interest rates on reserves” has been bandied about as some members of the ECB board have tried to stem the euro currency’s recent strength. It has been surmised that charging banks for parking excess reserves at the ECB would force European banks to reverse course and put the funds out to lending rather than having to pay a fee for the safety of the ECB.

The question arises how far rates would have to go negative before the European banks would seek other alternatives for their funds. If the money funds abandon Europe then the ECB‘s plan would be neutralized. The alternative to negative rates has been following the BOJ and the FED and just doing massive amounts of BOND BUYING. However, that notion has been met by the fear of the German Constitutional Court calling a halt to Germany’s participation in financing that sort of QE program. During the last four months Mario Draghi,has raised the possibility of the ECB buying European domestic bank loans that are tranched into what are known as asset-backed securities (ABS). President Draghi has raised the issue about bundling problem loans that are clogging the balance sheets of European banks and preventing the needed loans to small and medium enterprises. By removing the “troubled assets” to a safe harbor (the ECB), the banks will receive cash to put on their balance sheets and unclog the financial system. This makes sense because Europe’s economy is much more reliant on bank lending than the U.S. capitalist system. Free the flow and many issue of a lack of credit will dissipate.

Yesterday, two articles appeared that revealed why the ABS plan will be the most likely policy for the ECB and Mario Draghi. One article appeared on Reuters and the other was an op-ed piece in the Financial Times though both were from the hand of Jacques de Larosiere (consult your copy of the Rotten Heart of Europe). Mr. de Larosiere is the epitome of the aristocracy of European monetary policy. (He is the former head of the IMF and was also the President of the Bank of France.) Through his think tank EUROFI, the 84-year-old is an important voice in the business of European finance. Reuters said, “Now he is proposing a scheme to securitize (repackage) and sell to insurers, pension funds and possibly even the ECB–loans made in the go-go years that have turned into a dead weight on banks’ finances.” In the FT article, de Larosiere articulated the rationale for the ABS program with the ECB as the backstop. He wrote, “With fresh investment capital no longer forthcoming, the stringent liquidity and capital adequacy ratios can be met only through a reduction in assets, including loans. American banks, too, face harsher rules. But for now at least they can offload a large portion of their mortgage loans to government-backed entities such as Fannie Mae and Freddie Mac.” The bottom line for de Larosiere is that the U.S. is already doing it and moving along while leaving the financially stressed Europeans behind. If the Europeans fail to accept this, economic growth will remain fragile regardless how low sovereign borrowing rates drop.

Mario Draghi has spent the last two years buying time for the ECB and European policy makers to find a way to circumvent Germany austerity and its Bundesbank. The German High Court has opined on the issue of bailing out sovereigns but the use of ABS collateral from private domestic banks appears to be a method of creating a single resolution mechanism for the European financial system by avoiding the issue of direct sovereign bailouts. Will the Germans sign on to this new move by Mario Draghi and his muse, Jacques de Larosiere? More of a problem will be how the ECB will ultimately haircut the ABS to get enough liquidity flowing through the financial pipes. If the ECB haircuts the debt too much, the European banks will be short liquidity and have to do new capital raises. Another serious issue is that the ECB has taken on the role of bank supervisor so it is a tremendous conflict of interest for the assessor of credit quality to be the arbiter of price. But let there be little doubt about the way QE in Europe will go. No wonder 2+2=5 in Notes From Underground.

If the scenario I have laid out comes to fruition then I will be putting forth possible trade ideas. But I caution that there are many possible outcomes to a European liquidity program. U.S.-based private equity groups and hedge funds have been actively raising money in an attempt to buy European-stressed debt, but if the haircuts on problem loans are too deep the ECB will not be in favor of foreign participation and will be forced to rely its balance sheet, placing pressure of domestic banks and pension funds. As the old saying goes, “We know what you are, now its just a matter of price.”

***Quick hitter: Tomorrow afternoon at 4:00 p.m. CST the Reserve Bank of New Zealand (RBNZ) announces its interest rate decision. The market consensus is for the RBNZ to raise rates to 3 percent from 2.75 percent. This is important because the KIWI DOLLAR is near 33-year highs and I am doubtful that Graeme Wheeler will raise rates, especially as China may indeed be an issue for New Zealand. A slowdown in China could negatively impact New Zealand agriculture exports. If the RBNZ surprises the markets by not raising it will point to the currency levels as the culprit and that should affect all the KIWI crosses. More importantly, it will reflect the importance on currency values for bank policy, which is a much greater issue for global currency trading.

Tags: ABS, asset-backed securities, BONY, ECB, Euro, Europe, Jacques de Larosiere, Kiwi, Mario Draghi, money market funds, negative rates, New Zealand dollar, QE, RBNZ

This entry was posted on April 22, 2014 at 7:10 pm and is filed under Debt Market, ECB, Europe, RBNZ. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.