Tuesday, 13 March 2012

Draghi’s Den

It’s been a busy four months for Mario Draghi, the European Central Bank’s (ECB) third President.  On his second day in charge the bank cut interest rates for the first time in two and a half years.  At the end of that month he coordinated with the Federal Reserve and four other central banks to provide European financial institutions with cut-price dollar swap lines.  In between was the wrangling over the departure of Italian premier Silvio Berlusconi, a move apparently hastened by Draghi’s ECB briefly withholding bond purchases under its Securities Markets Program (SMP).

December came and with it another interest rate cut, back to their all-time low.  Then, later that month, came the first Long Term Refinancing Operation (LTRO), in which banks were permitted to pledge assets in return for loans of cheap cash.  Nearly half a trillion euros of new liquidity were created.

January saw less action but more talk as Greece’s creditors discussed what level of losses they might be prepared to tolerate in exchange for switching from normal Greek debt into a combination of new Greek bonds, European Financial Stability Fund (EFSF) bonds and growth-linked securities.  The eventual outcome was a decision that the ECB should not be drawn into the swap lest it suffer losses on its Greek bond purchases.  Come February a further half a trillion euros of new liquidity was created through the second and (presumably) final LTRO, capping a busy first few months for Signor Draghi.

All this despite having been dealt a difficult hand:
  • The requirement of European regulators, that banks increase capital ratios, has discouraged bank lending (although investors have been similarly keen to see banks improve the quality rather than the quantity of their balance sheets).
  • But the real hospital pass Draghi received was the SMP.  Of all the sticking plasters used to maintain the European financial system this was the thinnest: to prevent bond yields rising, buy bonds - with no apparent exit strategy!
And how has he done? 

Let’s not take anything away from a man who has apparently single-handedly averted a major financial crisis.  But when Greece’s inevitable restructuring came it was assumed that the ECB would suffer losses like other investors - and they didn’t.  By virtue of this decision they made profits which it was decided would be distributed to governments.

The rationale is that the central bank should not suffer losses on monetary operations.  Suffering losses would deplete capital, capital would have to be replaced and that would cost tax payers money - so Signor Draghi’s reasoning goes.  That ignores the merits of a fiat currency which allow central banks to manipulate their supply of currency for monetary purposes.  That would allow the ECB to be capitalised by the central bank’s ability to expand and contract the money supply.  

Such a policy would provoke shrieks of terror at the prospect of the central bank monetising government deficits.  But if the ECB makes profits from monetary operations in Italy and Ireland and losses from monetary operations in Greece and Portugal, and is agnostic between the two, then there need be no moral hazard.  The hazard arises when the central bank subordinates private sector lenders in order to avoid a loss, as it has done in the case of Greece.

Italian and Spanish bonds have strengthened since the LTRO.  Maybe this strength will be sustained by economic reforms, but certainly the hurdle rate to encourage the private sector to fund these behemoths must be higher now that the ECB’s €220 billion euros stand senior in the capital structure.


1 comment:

  1. If I never hear the acronyms "EFSF", "LTRO", "PSI" and "SMP" for another hundred years, it will have been too soon.

    How does one legislate for this kind of risk in long term portfolio construction and management? The market has taken it's leads almost exclusively from anything-but-Europe since late last year.

    Summits and conferences that had investors quaking in November now are coming and going, almost as if... Greece's economic woes were never a significant headwind to begin with, and "contagion risk" so far has only proven to be an opportunity for investors to take advantage of beaten-down yields in countries with very different economies to Greece/Portugal.

    So, is Mario Draghi a monetary genius who makes Trichet look like a fool for solving the world's problems? Is the market going to suddenly start caring about Europe again if the word "Portugal" is substituted in for Greece? Or have we all been the victims of a self-imposed investment tailspin since early August, when the monthly economic indicators began to falter, and the automated trading robots urged us lower?

    A hallmark of the second part of 2011 was volatility and panic on a scale comparable to 2008 and early 2009. Am I the only investor who feels that - if we continue the 2012 trends of astonishingly low volatility (VIX now under 15), just weeks after the panic and scrutiny of suddenly-relevant European debt - we all should be wiping the egg from our faces?

    Not to say that any sensible investor shouldn't have been worried ij 2011 - or that the correct risk management hasn't successfully steered us clear of too much pain. But after 20% corrections from highs in major equity markets in such a small space of time, when leading indicators were still pointing towards economic expansion in the States, do we need to learn lessons from August-November now that we see volatility is flat and the Dow is breaking multi-year highs?

    Did we get carried away with pessimism, looking for leads in the wrong places, when growth was staring us in the face? Or is the market still drunk from it's New Year optimism, on low volume, waiting to deliver another hammer blow?