Eurepo curve inverts further

The Eurepo rates have risen in the past week (ht Kostas Kalevras) with the curve becoming even more inverted. This is likely an indication of further flight of deposit capital out of periphery nations (possibly out of the Eurozone altogether) ahead of the Greek elections, as banks look to replace lost deposits in the secured funding markets. The preference continues to be in the overnight funding because banks do not want to lock up collateral for longer periods. This is an indication that liquidity conditions in the Eurozone are becoming tight once again and another round of LTRO funding from the ECB this summer may be in the cards.

Eurepo curve

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The inverted Eurepo curve spells trouble

Only one yield curve represents the pan-Eurozone interest rates implied by actual lending transactions. It's the Eurepo curve - rates at which short-term EUR lending is done on a secured basis (collateralized lending). Sovereign curves are specific to each nation, while Euribor does not represent any real transactions and is basically a figment of bankers' imaginations.

A month ago the Eurepo curve was upward sloping, as hopes of some sort of stabilization in the Eurozone later this year still existed. These hopes have now been dashed, with the curve becoming inverted in the short-end and flat at around 11bp out to one year. There is no active repo market beyond one year.

Eurepo curve: now and a month ago

This demonstrates lack of borrowers willing to tie up precious repo-eligible collateral beyond a month, while money market funds and other cash accounts are desperately trying to get any non-zero secured term yield. Inverted yield curves rarely spell good news - and the only news here is the onset of the Eurozone recession.

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Money funds' use of repo continues to grow

Here is a quick update on US money markets' exposure to EU banks. The percentage of funding provided to European banks via secured lending (repo) vs. unsecured funding (commercial paper) continues to grow. US money funds are desperately looking for any yield and EU banks may offer a couple of extra basis points. But the funds will increasingly demand collateral and execute this lending via tri-party repo for additional security.

Source: Fitch

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Finding alternatives to LIBOR

Bloomberg recently published a story that provides an overview of the problems with the LIBOR index. We discussed this issue some time back as the investigation against UBS and others was beginning to take shape. There were multiple reasons for banks to manipulate this artificial index depending on how these firms were positioned. And they did, since there were no rules against it - it is purely a survey.

Bloomberg: The BBA, the lobby group that has overseen Libor for 26 years, is under pressure to find an alternative way to calculate the benchmark, or cede control of it. Regulators from Canada to Japan are probing whether banks lied to hide their true cost of borrowing and traders colluded to rig the benchmark, the basis for interest rates on securities from mortgages to derivatives.

But the solution to this issue is not obvious. A common but a naive proposal is to use only the actual transactions in calculating LIBOR.

Bloomberg: “It can’t be beyond the wit of man to come up with a rate that is based on actual trades rather than guesswork,” said Tim Price, who helps oversee more than $1.5 billion at PFP Group LLP, an asset-management firm in London. “The idea that you can trust the banks and the BBA with this is laughable.”

But the reality is that for many banks, particularly in Europe, there are no "LIBOR transactions". LIBOR represents a rate on an unsecured loan from one bank to another. But except for overnight or very short-term maturities many banks are not able to borrow on an unsecured basis. Some can not borrow at all except from the ECB. Finding actual 3 or 6-month transactions would be extremely challenging and may even be impossible for certain currencies.

Another proposal is to use just the overnight rate that is targeted by the central banks (such as the Fed Funds effective rate for dollars or EONIA for euro). Certainly it is much easier to obtain quotes for all major currencies using the overnight rate, although in times of stress it would be biased to only the stronger banks. The key issue of this approach is that it limits one to only one tenor - the overnight. The industry clearly needs more of a term structure, ideally out to one year.

An extension of the overnight rate proposal is to use the Overnight Index Swaps (OIS). That gives one the term structure and the market is fairly active. Some in the industry and even central banks are beginning to use OIS rates quite actively for various purposes.

EUR (EONIA) OIS curve (Bloomberg)

Another good option is to shift to secured funding rates. That is now the primary way that banks lend to each other in Europe. The other positive aspect of secured lending is the fact that it is not limited to banks. From money market funds to hedge funds and corporations, secured funding is used quite actively globally. As long as the collateral type can be specified, the index is easy to obtain. Eurepo is a good example of secured lending index that is comparable to LIBOR/Euribor (although there may be issues with the way it is computed as well).

Eurepo curve (Bloomberg)

But even that index would need to be monitored carefully for longer tenors because the transaction liquidity for secured lending drops off greatly for longer maturities. Even in the US, where repo markets are massive, the tenor rarely goes beyond 3 months.

Dollar repo curve (Bloomberg)

It is therefore unlikely that the industry will find a LIBOR substitute that is both verifiable via actual transactions and has the tenor out to one year. But in spite of the tenor limitations, it is imperative that the industry begins to transition toward "observable" indices such as OIS or Repo. It will take years because so many existing long term contracts reference LIBOR (supposedly $360 trillion in total), but it is necessary given the lack of confidence this hypothetical and manipulated index has created.

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The issue with LTRO-II is not the spike in Deposit Facility

The American Enterprise Institute blog has posted an article entitled "The chart that should terrify the ECB" by Daniel Hanson. It shows a massive spike in the ECB Deposit Facility.

The deposits, which pay interest at 0.25 percent, have largely been made with funds obtained through two rounds of long-term refinancing operations, which charge an interest rate of 1 percent. Basically, banks are hoarding cash and losing money on the deal—something that will surely be a problem for the European economy.

Well, here is some news for Mr. Hanson and the American Enterprise Institute. The spike in the Deposit Facility was entirely expected. Even if every last euro from the 3-year LTRO facility was lent to Erozone citizens and corporations or used to buy securities, the Deposit Facility would still grow by the same amount. The rise in excess reserves, the bulk of which are balances in the Deposit Facility, simply represents net new lending by the ECB.

EUR MM, source: ECB

As discussed before, when the ECB lends money to a bank (via the National Central Banks), it simply credits the bank's reserve account. In the latest LTRO facility, about 2/5th went to repay short term loans from the ECB (rolling them into the 3-year loans). The other 3/5th became excess reserves. And banks just moved much of the excess reserves to the Deposit Facility because it pays a better rate than what they get in the reserve account. Some, possibly a big part of this liquidity will be used to repay bonds issued by banks during "good times" that are maturing in 2012 (many of these banks can not roll their maturing bonds - there are simply no private buyers).

The reason the spike in excess reserves is higher now than it was after the previous LTRO loan (chart above) is due to the fact that a smaller portion of the recent facility (LTRO-II) was used to repay existing short term loans. This generated larger net new borrowings from the ECB, thus higher excess reserves. At this stage the bulk of the borrowing from the central banks in the Eurozone is in the form of 3-year loans.

The mistake people often make is assuming that if banks were to lend these new euros out, the euros would leave the Deposit Facility. But any euro "created" by the ECB (via net new lending) has to end up in some bank's excess reserves (like the game of musical chairs). It may not be the same bank that took out the loan from the ECB, but it is still a bank within the Euro-system. So one way or another (whether banks, lend to each other, to clients, or buy securities) some bank in the Euro-system will end up with the excess reserves (net new euros never leave the system).

The issue with LTRO-II is therefore not the spike in the Deposit Facility. It is with the fact that Eurozone periphery (plus French and Belgian) banks end up using far more of the facility than banks from the "core" (particularly Germany). That has three effects:

1. It increases TARGET2 imbalances, with periphery central banks owing Bundesbank more money (as discussed here).

2. It creates a further imbalance in M3 money stock. Periphery banks use up the collateral previously employed for secured interbank borrowing (repo) to now post with the ECB against the LTRO loans. The collateral effectively leaves the system (and gets "trapped" at the periphery central banks for 3 years). A decline in repo borrowing among the banks in the periphery reduces broad money supply in these nations.

3. As more of the collateral, including retail and business loans (including ABS), that now qualifies for LTRO, is pledged to the ECB, any unsecured bonds that periphery banks still have outstanding will have zero recovery in case of default - since all the "good" assets have now been pledged (encumbered).

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The increase in triparty repo usage and other developments in the repo markets

There is still a misperception in the media that only the CDS market can afford significant amounts of leverage to risk takers. Tremendous leverage is in fact available via repo, a market far larger than CDS. The media often misses the fact that MF Global failed because of repo based leverage. And by the way so did Lehman and Bear Stearns and Merrill Lynch - all failed because they could not roll their repo loans. That's why repo markets are of critical importance to the financial system and need to be well understood by policy makers. It's amazing that a typical US politician knows more about the Kandahar Province in Afghanistan than what a repo transaction is.

Data on repo markets is difficult to come by. Recent report from Fitch sheds some light on the latest developments in that market. Repo haircut (initial margin) - a key measure to track in these markets - obviously depends on the type of collateral. According to the report, treasuries tend to have a 2% haircut these days, while corporate bonds are 5%. That's 20 to 1 leverage. Haircuts for high yield bonds are higher (15-25%) and equities haircuts are around 50%, but vary with the volatility in the market. (There are other ways to leverage equities such as total return swaps.) Just for illustration, the diagram below shows how repo leverage can force asset sales if haircuts are increased from say 5% to 10%. Increasing haircuts is all it took to put MF Global out of business.

One recent development in the repo market has been the return of structured credit such as RMBS securities as collateral in repo transactions. Three years ago leveraging structured credit bonds in the repo market was impossible.

Source: Fitch Ratings

The biggest development has been the recent growth in triparty repo market. To begin with, here is a diagram of a triparty repo transaction (a number of readers have asked to see how this process works.)

Source: Fitch Ratings

Triparty repo eliminates counterparty risk that exists in a bilateral repo transaction. As concerns about counterparty risk increased in 2011 with fears of US banks' exposure to the Eurozone, the usage of triparty repo rose.

Source: Fitch Ratings

The repo market continues to dominate short term funding in the banking sector in Europe, with unsecured interbank funding basically dead across the Eurozone. Also with new derivatives regulation pushing CDS into central counterparties (clearinghouse), repo based leverage becomes an even more attractive way to put on risk. Following such developments in the repo markets will be increasingly important to understanding the health of the financial system.

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Contraction in Eurozone's repo markets is driving M3 decline

Yesterday the ECB released its monetary aggregates measures for the Eurozone through Dec-2011. The following chart shows the absolute level of Eurozone's M3 aggregate, a broad measure of money stock. (Note that at times it is helpful to look at monetary indicators on an absolute basis rather than as percent changes as economists tend to do.)  The upward trend in the money supply growth has reversed, mostly during the last quarter of 2011.

Eurozone M3 in EUR billion (seasonally adjusted)

An obvious question here is whether this broad money supply decline is similar to the US during 2008-2010. One key component of M3 driving this contraction in money stock is the amount of repo (secured) lending. The Eurozone repo loan balances have declined materially in Q4 - an issue that is quite different from what had occurred in the US.

Repurchase agreements (repo) component of  Eurozone's M3 in EUR billion (seasonally adjusted)   

Since repo has become the only form of interbank lending in the Eurozone, this is clearly an indication of deteriorating credit conditions. With the ECB providing longer term financing not available in the interbank repo markets, it is often quite attractive or even necessary for many financial institutions to shift their collateral into an ECB facility (ECB secured loans are not included in the monetary aggregates). LTRO term lending for example provides far more funding stability than rolling short-term interbank repo loans. The ECB has also been considerably more lenient with collateral than the current repo markets. The rapid rise in the ECB's balance sheet (EUR 2.7 trillion) "soaked up" a great deal of the collateral out of the repo markets, dampening growth in interbank credit.

ECB consolidated balance sheet (EUR million)

The pie chart below shows the contribution by country to the drop in the Eurozone repo levels over Q4-2011. Nearly half is coming from Italy as Italian institutions shifted financing to the ECB. It is not surprising therefore that Italy continues to deal with tightening credit conditions that are more extreme than the Eurozone as a whole.

Contribution by country to the Q4 drop in repo component of M3

The unprecedented accommodation provided by the ECB is not yet helping to expand the broad money supply. The banking system has shifted a substantial portion of its eligible collateral from the repo markets to the ECB who is providing longer term stable funding. Only once the dependence on the ECB is reduced and the interbank funding markets begin to heal, will we see a stabilization in M3 growth.

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EU corporates move cash from bank deposits to repo

A number of large European corporations have sizable cash positions, a similar trend to what's been happening in the US. In the past these corporations would simply deposit that cash in their local eurozone banks. But these days the companies are much more cautious with their cash. Some corporations have bank subsidiaries (for example Nestle owns Nestle Bank), a practice generally illegal in the US, but common in Europe. They use their "internal" banks to deposit funds with the central bank to avoid credit risk, contributing to this rapid rise in the ECB Deposit Facility balances.

EUR Billion (source: ECB)

Corporations that do not have a bank subsidiary do not want to leave unsecured deposits at the banks, so they revert to lending to banks on a secured basis via repo.

Reuters: ... a group of well-known, cash-rich companies with solid cash flows has stepped in the repo market, which provides a form of lending so far almost exclusively in use between banks, and between banks and central banks.

To obtain additional protections on these loans, the collateral is often held by third parties in a so-called triparty repo.

Reuters: Based on his daily practice, Euroclear's Reiss estimated that up to 25 percent of the triparty market was on behalf of companies, a massive and sudden rise from the 2 to 5 percent where it had traditionally been.

To accommodate their corporate clients, banks need collateral to post on these repo transactions. And that is putting additional strain on collateral availability and helping to drive down repo rates in the eurozone.

3- month Eurepo rate (Bloomberg)

Hat tip Blankfiend

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Recent trends in US money market funds

Today we got the highly anticipated Fitch report on US money market funds. There are two key items in the report worth discussing:

1. European bank exposure continues to decrease (which is not surprising) but there is also quite a bit of rotation going on.

Fitch: MMF exposure to French banks, which declined by 63% over the past month, was partially offset by increases in exposure to Dutch, Swiss, U.K., and Nordic banks. European bank exposure currently represents 33.4% of total holdings of $645 billion within Fitch’s sample of the 10 largest MMFs, a decrease from 34.9% of fund assets at the end of October. The current exposure level is the lowest in percentage terms for European banks, which was as high as 51.5% as of month-end May 2011

Funds rotated significantly out of France into Canada and somewhat into Japan. Exposure to French banks is now only 3%.

2. The biggest development in US money markets continues to be a shift from unsecured commercial paper and into collateralized instruments, namely repo (as is the case with eurozone banks lending to each other.) The next chart shows the increase in usage of secured lending.

This trend will certainly keep US money market funds from major redemptions as we saw in 2008 (particularly with the Reserve fund), but as the earlier post shows, Eurepo rates have collapsed.  Lack of product that meets the strict new criteria and near zero rates makes the money markets business  unprofitable - it's difficult to charge fees on something that earns close to zero. Money markets funds will continue to be an "asset gathering" mechanism used to lure investors into more profitable asset classes.

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From EUR-LIBOR and Euribor to Eurepo - the only viable market index

Emails on an old Sober Look post discussing EUR LIBOR vs. Euribor indices continue to come in, with readers offering their explanations for the divergence between the two. As the chart below shows, the 3m Euribor to LIBOR spread is still elevated, now at about 7bp (7.7bp was an all-time high).

Euribor-EUR LIBOR (Bloomberg)

Besides a slight difference in the calculation, the best explanation continues to be the differences between the two “panel banks” that provide their quotes for the calculation. The Euribor panel includes a large number of eurozone banks.  The panel has for example 6 French banks, 4 banks from Spain, and 3 from Italy. It is generally believed that the eurozone banks would quote higher levels, since their increased funding needs will prompt them to pay higher rates. There is some evidence for that difference in the daily rate contributions.

Sample panel bank contributions: The US banks show lower levels than for example the French banks

The EUR LIBOR panel on the other hand is much smaller and has a higher percentage of US, UK, Swiss, and Japanese banks that may not have the same funding concerns and would therefore quote lower rates. At least that’s the theory behind this persistent spread.

Sadly, the reality has little to do with what many eurozone banks are actually quoting. Almost no material transactions have been done in term unsecured loans (which is what Euribor represents) for some time. The bulk of term interbank lending in the Eurozone is done on a secured basis, using repo. The European Banking Federation (EBF) has coined a name for the index that represents secured funding in euros. It is called the "Eurepo" and is calculated in a fashion similar to what's done for Euribor, using a panel of banks. Unlike Euribor however, which unfortunately is used to settle trillions of swaps and calculate interest on corporate loans, Eurepo actually represents a relatively active market in secured (collateralized) lending.

But in this crisis even the Eurepo transactions now function in less traditional ways. Rather than collateral being placed directly with a counterparty as is typically done in a repo transaction, many banks now prefer a triparty repo where the collateral is held with a third party. As Izabella Kaminska pointed out a while back, tri-party repo has become as common as the bilateral repo transaction in the Eurozone:

… the recent European crisis has now nearly completely vaporised what little unsecured interbank lending was left in the market. What’s more, the demand for tri-party transactions — where collateral is managed by a custodian rather than bilaterally — has almost doubled from less than 25 per cent before the Lehman crisis to almost 50 per cent since.

As the chart below shows, the Eurepo rates have been collapsing as the eurozone economies slow. This is what one would expect to happen to rates in this part of the economic cycle in the eurozone.

Eurepo rates (EBF)

The following chart shows the Eurepo yield curve. The spike at the 2-week point represents some premium for lending over the year-end as institutions do some "window dressing".  Again, this shows an actual supply/demand component of the market.

Eurepo yield curve (Bloomberg)

Going forward for any economists or risk managers who wish to look at true nominal short-term interest rates in the eurozone, Eurepo is the most representative index. On the other hand both Euribor or EUR LIBOR do not represent any actual market and therefore have little economic value or meaning.  Hopefully in the long term any instruments that currently use Euribor for settlement or rate calculations will shift to Eurepo.

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