The Europe an Central Bank held a borrowing party today and everybody came.
A whopping 523 Eurozone banks borrowed a huge €489 billion ($638 billion) at the central bank’s first offering of three-year cash. That’s enough to refinance 63% of the debt, as estimated by Goldman Sachs (GS), of Eurozone banks that will mature and require refinancing next year.
The European Central Bank’s next three-year funding round will be held in February. At this rate, Eurozone banks will be able to pre-fund all their refinancing needs for 2012 and into 2013 that month.
This is either a big step forward in assuring the stability of the European banking system, or the next step in building a horrifyingly risky Ponzi scheme. In my view, it’s some of both—but we won’t know how to weigh the good against the bad until we see what banks do with this money.
The cash offering is certainly a good thing, since many Eurozone banks have been locked out of the financial markets—they literally didn’t have an alternative source of funding for their 2012 refinancing needs. Sales of senior unsecured bank bonds have dropped by 80% since July compared to the same period in 2010, according to Morgan Stanley (MS).
Before today’s offering, bank analysts and economists had feared that banks would shun the money and the potential stigma that might attach to admitting that a bank was shut out of the financial markets despite an estimated €600 billion in bank debt that needed refunding in 2012. That would have left the European banking system staring straight down the barrel of a funding crisis.
Now that crisis seems to have been averted. But what will the banks do with their cash?
There’s intense pressure from some Eurozone political leaders, most vocally Nicolas Sarkozy of France, for the banks to put a big chunk of this cash into the government bonds of their home countries. The argument goes that the banks could make a big profit by borrowing from the European Central Bank at a current 1% rate and then buying bonds of France, Italy, Spain, etc. that are paying much higher yields.
This would also have the effect, these leaders hope, of reducing the market pressure on those government bonds.
It would also create a massive Ponzi scheme where banks borrowed from the European Central Bank, used that cash to buy government bonds, and then used those bonds as collateral for more borrowing from the European Central Bank.
Such a scheme would work only until the amount of sovereign debt in the system caused the whole pyramid to break down when either a bank went bust—because the central bank finally cut off credit or tightened its collateral rules—or a country experienced a debt crisis that caused the value of the bonds held by national banks and the European Central Bank to plunge.
So far, fortunately, most banks seem to be resisting the pressure to bail out sovereign governments by putting their own balance sheets at risk. Banks, especially those that still have some access to the financial markets, know that investors are watching reports of their holdings of sovereign debt extremely closely.
There’s little point in buying government bonds to pick up a profit on the yield spread if it costs a bank access to the financial markets, results in a falling share price, and produces a downgrade from one of the credit rating companies.
As of the last data banks from Spain’s Banco Santander (STD) to Germany’s Deutsche Bank (DB) have been cutting their exposure to sovereign debt from Italy and Spain.
The latest data, however, comes with a considerable lag. And it’s an open question what banks will do with their cash from the European Central Bank’s December and February fundings.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Banco Santander as of the end of September. For a full list of the stocks in the fund as of the end of September, see the fund’s portfolio here.
