Monday, September 21, 2009

Economics 21/09/2009: ECB's penalties?

Updated version (00:42am September 22)

On June 23, 2009, ECB opened bidding for its first 12-month refinancing operation.

Back in May 2009, the ECB announced that it would double the maximum length of time it lends money from six months to a year and in June it set the rate for 12-months financing at 1%.

Last time it applied a longer term horizon, ECB placed 348.6 billion euros in December 2007.

So in the nutshell, 1.5% coupon on our bonds bound for ECB and bearing 6 months maturity is a rotten deal.

How rotten? If we were to issue bonds at the ECB own long term financing facility rate with 12 months maturity. The expected cost of total borrowing over 15 years inclusive of the expected costs of roll-overs and reflective of the expected yield curve for ECB rates will be around €15.4bn. In contrast, current structure of 1.5% pa coupon plus 6-months maturity is expected to yield total interest cost of ca €17.5-18.9bn. Then again, what’s €2.1-3.5bn for the Government that burns through €400mln in borrowing on a weekly basis?

What is interesting is why didn't ECB make a similar deal with the Irish Government, allowing it to issue lower coupon bonds or extend maturity of these bonds or both? One can only speculate, for ECB will never tell one way or the other, but I suspect the answer to this lies within the ECB statement that Nama should not overpay for assets it purchases.

Hmmm... Leni took his plan to the ECB men, saying we will buy €77bn worth of stuff, that includes €9bn of rolled up interest, and we will pay €54bn for it. The ECB men pulled out a calculator and extracted: [€54bn/(€77bn-€9bn)-1]*100%=20.6%. The ECB men stared at Leni in disbelief... "Herr Brian, yor ekonomi iz in truble? Djast less fan 21% dropp in yor properti praicez?" 'Oh," replied Brian Lenihan, "but Frank Fahey School of Economics says you'll give us free money!" And here the ECB men smelled a rat...

Otherwise why would the ECB, amidst quantitative easing exercise, impose sanction-level conditions on our bonds? 6-months paper and 1.5% is worse than what ECB gives money to commercial banks at. Much worse, folks.

Now, ECB is no stranger to being taken for a ride. What is telling is that ECB's reaction to 'abuses' in the past is very similar to its reaction to Nama to date.

Most recently, back in July 2008, both the Australian bank, Macquarie Group and the British building society Nationwide have used their Irish subsidiaries to upload hundreds of millions of dodgy ABS packages (in the case of Macquarie, €455mln was borrowed against the most ridiculous collateral –Australian car loans) at the ECB discount window.

On September 4, 2008, ECB’s President, Jean- Claude Trichet stated that he will make it more expensive for banks to borrow from the ECB against most asset-based securities, starting from February 1, 2009. Amidst the crisis gripping European markets at the time, ECB raised `haircut' on the securities it allows to be used as a collateral for 12-months borrowing from 2% to 12%. Additional 4.4% were to apply to paper with no immediate market price.

Note, Irish haircut on bad debts is in effect just below 21% - not that far off the haircuts applied by the ECB (16.4%) on lending backed by much more robust collateral (average European mortgage-securing assets - i.e prperty markets - are down single digits across the entire crisis) than dodgy Irish development projects (down 60-80% and some down 90% in value and falling). When ECB haircut on unsecured banks bonds is added, the total asset discount that ECB could have applied was in excess of 21%. But what is even more significant, the value of the underlying assets accepted by the ECB is supposed to be calculated as the market price less the haircut.

Again, this stands in contrast to Nama which is taking not senior bonds, but ordinary loans, and which is using farcical long-term-economic-value 'pricing', not current market prices. Despite this, Nama haircuts are just 20.6% (once rolled up interest is accounted for) on lower grade assets than the ECB would consider at its window…

No wonder they won’t let Ireland issue bonds with a coupon of 1% or less with 12-months maturity - as would be consistent with a rating on par or better than that for commercial banks. In effect, contrary to the assertions of Brian Lenihan, it is now clear that the 1.5% for 6-months paper deal is far from being endorsed by the ECB. Instead it is a reflection of ECB’s unease with the details of Nama plans. All in, the ECB is now applying nearly as strict terms to the Irish Government Nama bonds as it does to private sector bonds issued by less than thriving European banks.

In July 2008, before changes were announced, the ECB run two-tier pricing system, whereby haircuts of 0.5-5.5% applied to Government paper against the key ECB rate of 4.25%. Mortgage-backed securities – especially Spanish and Irish ones – incurred 18% haircut. Now, do the maths – the spread of 0.5-5.5% haircut on 4.25% lending rate implies the cost of capital of 5-10% for government bonds collateral and up to 24% for MBS. Since July 2008, Irish property markets have fallen by over 12%, so the same collateral rules, that were described by analysts as being loose back in 2008 would require a haircut of ca 27% at the very least, for 1-year long holding period. Again, Nama is implying a haircut of 20.6% on a 15-year holding period.

27% cut held over 1 year was a ‘loose’ condition that had to be drastically revised by the ECB, but 20.6% shave on 15-year holding is deemed by the Irish Government to be reasonable? Who do they think they are foolin?

Another interesting note: following the expression of it dissatisfaction with ‘loose’ borrowing by Spanish and Irish banks, the ECB started quietly talking to the banks urging them to fall in-line. Exactly the same has happened when the ECB issued its thinly veiled directive to Leni – ‘do not overpay for Nama assets’…
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