Good article from Reuters today on how Draghi brought PIGS bond yields down in 2013.
(Nothing to do with Enda’s State of the Nation speech on ‘Market Confidence’ etc.)
Draghi is a controversial character - ex. Governor of Bank of Italy - whose actions in the Bank of Sienna scandal are worth googling.
Bernanke can do direct QE where the FED now buys over 70% of all US Sovereign Issuance.
This has flattened the US yield curve with benefits for reflating assets + injecting carry into US banks.
In Europe however the Germans were not so keen for the ECB to nakedly buy PIIGS debt (as they could default as Greece did in 2010).
Instead, the ECB have given local PIIGS banks large amounts of liquidity at cheap rates to buy their own sovereign debt.
LTRO I & II (ended Q2 2012) where temporary successes, however once the new capital was spent, PIIGS yields exploded again.
Post Draghi’s ‘whatever it takes speech’, PIIGS banks have been getting 0% repos with the ECB to buy PIIGS sovereign debt.
As PIIGS debt requires no backing bank capital (unlike loans), or any mark-to-market, PIIGS banks loaded up for free carry again.
This saw PIIGS sovereign yields collapse again in H2 2012 / 2013 (but exposure of PIGS banks to domestic sovereign debt exploded).
[Note - people sometimes assume that the end of LTRO II in Q2 2012 was the end of the PIGS banks sovereign bond buying.
The OMT repo facility has been even more powerful and seen an even greater build of sovereign bond exposure in PIIGS banks.]
[Note - people assume PIIGS bond auctions are successes due to large international take-ups, however PIIGS banks cannot use the ECBs repo facility to buy ‘primary issuance’ (they can use their own cash) - they therefore get international banks / I-banks to front-run the ‘primary auction’ and buy off them in the ‘secondary market’ later.
From Draghi’s perspective it puts the PIIGS sovereign’s banks ‘ass in the pan’ as a sovereign default is now a domestic banking collapse.
This is very like what the Greek & Cypriot banks did (under their government direction) in 2009/10 which led to their collapse.
From the German’s perspective, doing a repo facility instead of LTRO III, meant that the ECB’s balance ‘technically’ stabilised.
(I say ‘technically’ as the ECB’s exposure to PIIGS debt is effectively growing - although its Target2 imbalances are offset).
From the PIIGS banks’ perspective it is a no brainer.
Irish banks converted insolvent tracker mortgage books - earning <1% at +200% LTV - and repo’ed them for Irish debt @ 5% carry.
It injected large carry into the Irish banking system (but created a perverse situation where Ireland has had zero mortgage foreclosure).
More importantly falling sovereign yields gave US investors (who think ECB is same as FED) courage to buy Irish assets off Irish banks.
(the effective knowledge of the typical US REIT active in Irish real estate market about things like Draghi’s Doom Loop is weak).
The problem now is who is really guaranteeing this PIIGS debt AND what happens when the PIIGS banks run out of collateral to pledge.
As any bond trader knows, when new money dries up, prices fall (i.e. needs a constant ‘flow’ of buying - the FED has learnt with QE3).
We will therefore definitely need another LTRO III for this (and many more IF the PIIGS don’t use the lower bond yields to reduce debt).
A huge moral hazard is that PIIGS governments use the carry of Draghi’s trades for political projects, and not pat down debt.
This would be a disaster for Draghi as to maintain sub 5% PIIGS sovereign yields, constant LTROs would be needed.
Parts of the ECB are therefore getting cold feet about the quantum of PIIGS bank domestic sovereign debt buying.
There are also calls from the ‘Bundesbank’ (remember that institution), to apply risk weightings to sovereign holdings in PIIGS banks.
The PIIGS banks however are no so overloaded with their own sovereign debt, such a step would make them insolvent.
The cessation of sovereign PIIGS debt build up by PIIGS banks (nobody else wants it at these yields), would see yields explode again.
If the ‘Draghi Doom Loop’ is ever stopped / reversed, the consequences will serious on multiple fronts - sovereigns, banks, everything!