Dear Santa, I Know Christmas Is A Long Way Off, But…

Dear Santa, I know Christmas is a long way off, but I was hoping that you could get me a European Bank License and another round of LTRO.   I promise to be a good boy, and borrow as much money as the ECB will possibly give me, with minimal equity, and buy as much 3 year in and in paper as I can.  I’m afraid I might not be able to bring myself to buy Spanish or Italian debt, but with the broad range of assets available against the money, I’m sure I can find something I like.  I’m not greedy, I don’t need to make 2% of carry, I would be happy with 1%, after all, I my only qualification is having a bank license, and I have no real equity in the deal (though after 3 years if all goes well, I will be a very rich man, or bank).

So LTRO2 is done and dusted.  800 banks and €529 billion.  The ECB is not discriminatory at all.  Everyone gets what they ask for and the rate is the same, talk about “free markets”.  It will be interesting to see who took the money. If Goldman was a European bank, I would bet on them taking down a lot, because they never could resist free money from the Fed (why should they), but I’m not sure if the Europeans see it that way.  Will it be big banks who said “why not” and took down big chunks of money?  They have huge balance sheets to manage, why not simplify it and make it cheaper?  Were there some small banks who had felt left out of the party and decided not to deal with the balance sheet in conventional ways when the ECB was basically begging them to take money, I mean it does seem bad manners not to take a gift.  And finally, there must have been a few banks that were downright giddy in disbelief that they were really going to get this money, they submitted their bids and laughed over cognacs and cigars how no one in their right mind would lend to them.

The world seems safer, but that feels like an illusion.  The world feels more complex, and that is real.

With €1 trillion in LTRO, the ECB has created out of thin air almost €10 billion of profits for themselves per annum (they make 1% on these loans, and it is unclear what their funding/money printing costs are).

For banks you can look at the “profit” as either carry on new assets, but since the bulk is retiring more debt, the profit is more the difference between LTRO and the cost of debt maturing.  Actually that understates it.  The real “profit” to the banking system is the difference between the LTRO rate and what they would have to pay if they rolled debt in open market.  Let’s say that is about 2% across the board (looked at in this way, the benefit goes to the weakest banks, including those in Germany, because it reflects the cost savings on rolling their debt, not what they asset side looks like).  So that is €20 billion of additional money into the banking system.  So all is good, right?

There are several things that should concern you about this arrangement and everything else that is going on in Europe.

This program subordinates all senior unsecured bond holders.  They just got layered by another €500 billion.  If the banking sector runs into trouble, not only is the collateral that was pledged to the ECB not available for the general bondholders, but you can safely bet that the ECB will get paid in full, even if the unwind value of their collateral doesn’t cover their loan fully, before a senior unsecured creditor sees a dime (or whatever the Euro equivalent saying is).  Depositors are already above you, and now the ECB (and National Central Banks) are also legally ahead of you.

Not only are they legally ahead of you in the capital structure, they are morally ahead of you as well (at least in their own mind).  As the banks have come to rely more and more on central banks in Europe, they are being forced to do their bidding.  Does anyone believe a single European bank will not participate in the PSI plan?  Think about it, not a single holdout amongst banks.  Not one willing to think that is best for them?  Maybe I will be wrong, but I do not believe that the banks will risk angering Mother ECB for fear of souring the milk they are suckling (I hope that creates a rather nasty mental image).

But that is only the beginning.  Greece has changed their laws to subordinate bondholders and yet no bank is speaking out about that?  Maybe there are a couple of analysts at European banks who have said anything, but if they aren’t carefully they will be penning their missives without fancy letterhead by the end of the year.  The banks in Europe are now subservient to the ECB.  Compare that with Jamie Dimon who has been willing to question (if not criticize the Fed).

As whatever attempt to create another Greek plan (I refuse to call it a bailout, certainly not a Greek bailout) was dying, who did the ECB and the politicians go to?  The banks.  Banks we need €10 billion more, so on the €206 billion of private sector debt, we are going to cut out another 3.5%, so €7 billion out of your pockets.   Now, now, don’t complain, we will be giving you LTRO, and without us, you might get even less.

What will be asked of the banks next?  Sarkozy’s financial transaction tax has been snickered at, but why won’t it happen?  The politicians, and the people know the banks have been given, handed, gifted, billions of euros through these programs.  Given the willingness to tell banks what to do, and the total lack of opposition by the banks, don’t expect them to be left alone.  Any separation of banks, central banks, and politicians in Europe has been wiped out.  I almost said they were now all in bed together but that brought up images I didn’t even want to think about.

Think about the conversations over the last few days.  How many central banks were talking to their banks, not asking what amount of LTRO they wanted, but telling them how much LTRO they were supposed to take.

Others much smarter than me and/or are far better writers than me have been addressing this issue.  In the midst of the rally, these issues are ignored, as greed takes over, fast money believes they can get out before any sell-off occurs, and the weakest and worst banks just got more money and don’t care about anything since any real accounting would show them as already bankrupt.  This will only come to the forefront and be an additional fear factor when we get another round of weakness.  That is when investors who have ignored all the games being played with sovereign debt, and potentially with bank debt, will become concerned.  Those who have been concerned will be saying “I told you so” rather than buying bonds.  Then the question is will fresh announcement of EFSF, ESM, LTRO, SMP, or whatever else, do much?  Yes, yields are low, but the opportunity cost of sitting in cash is extremely low as well.

In the US, retail flows into HYG, JNK, and LQD, have slowed.  They are still pumping money in, but the fund’s AUM growth is no longer parabolic.  No signs of it changing course, but retail may be getting close to having fully allocated their fixed income money.