Click to enlarge.
Chart via Nomura’s rates strategists. It’s their version of what the plumbing of the European Central Bank’s rejigged bond purchases should look like:
A word of caution in advance: the optimal structure is deeply complex, which itself should raise concern in the minds of investors…
It’s a thought-provoking note (available in the usual place).
The Nomura strategists are looking at two missing pieces of the puzzle with respect to what comes after the ECB buys up short-dated bonds on secondary markets — how this affects banks’ use of these bonds as collateral for funding; and the effects on the prices of bonds which have longer maturities, or are sold on the primary market.
Not a surprise that Nomura have focused on the €256bn of domestic sovereign paper held by Spanish banks, and their funding tool of choice…
This program will need to be largely focused on buying assets from domestic banks in Spain and Italy. This is because we cannot assume that international banks will increase their purchases of SPGBs and BTPs after selling these assets to the ECB. Hence, the only reliable source of demand for SPGBs and BTPs will be local banks and official institutions. By depleting the existing bond holdings of local banks, the ECB would provide them with room to accumulate fresh debt in the primary market.
The idea is that ECB purchases would also stabilise the value of short-end bonds held by banks as security for borrowing funds, diminishing collateral calls.
But the really interesting thing is Nomura’s concern that Spanish banks won’t be able to sell large amounts of short-dated debt to the ECB. It’s already pledged as collateral in the central bank’s liquidity ops, where some borrowers are already running out of assets to pledge. There’s a key point underlying this. Banks have so far tended to match the maturity of their collateral to the length of the ECB’s three-year LTROs as far as possible, to remove duration risk.
“More effectively, Spanish banks will need to be provided with replacement collateral,” Nomura say. Hence arrows on the chart which involve using EFSF or ESM bonds being injected into Spanish banks (under the planned bailout) for this purpose.
So it’s a possible recycling of risk, but also a question of how much the banks’ exposure to their domestic sovereign will change. The exposure’s maturity may lengthen, if governments sell longer-term debt and banks use the opportunity of selling short-dated paper at a generous bid to buy it. But these ideas would keep overall exposure about where it has been. That’s the impulse towards sovereigns being able to roll over their debt more confidently, we suppose.
It’s certainly complex. But it all comes under “convertibility risk” — a sovereign which can only roll over debt at meteoric yields, or banks which can’t fund using this debt, will eventually reach the same endpoint of funding outside the euro. Therefore it really is all linked in the ECB’s remit. This domestic concentration, though – note Nomura’s assumption that foreign buying won’t be catalysed by the ECB – still feels a little troubling.