Tuesday, December 20, 2011

ECB's LTRO experience a cautionary tale for the Fed

The markets have been anticipating the onset of QE3 by the Federal Reserve. Indeed, Deutsche Bank believes that the market has already discounted $800 billion in QE3 purchases, which is anticipated to be concentrated in Mortgage Backed Securities (MBS).

Recall how the focus on MBS came about. QE2 involved $600 billion in the purchase of Treasuries, which pushed down the Treasury yield curve, flooded the system with liquidity and prompted investors to take more risk. The net effect of QE2 was to push up stock and commodity prices, but didn't do very much for the real economy. In effect, it found that it was pushing on a string. In response, the Fed wanted to concentrated on risk premiums where it mattered, such as mortgage rates, in order to stimulate the housing market. Thus the impetus for QE3 was born. Target MBS, it was said, and you will push down the cost of home ownership and stimulate housing.

Watch out for unintended consequences
The European Central Bank is currently conducting a Great Experiment with its LTRO (Long Term Repo Operation), where it is offering unlimited amounts of three year liquidity to banks, collateralized by paper with credit ratings as low as Single-A.

There was some hope that LTRO would prompt banks to put on the carry trade. Borrow from the ECB at 1%, buy PIIGS debt at 5% or more and earn the carry (see my discussion of LTRO here). The banks repair their balance sheets. The sovereigns get access to loans. Everybody wins!

The program has resulted in some unintended side-effects. Izabella Kaminska at FT Alphaville wrote that LTRO has created a two-tiered market for collateral and the two markets are diverging:
Simply put, back in the pre-crisis days the two markets worked in tandem. Participants engaging with the ECB did not differentiate on the type of collateral they delivered to the ECB versus the type of collateral they held back for use in private funding markets.

The crisis changed all of that.Suddenly the cheapest collateral to deliver became the collateral of choice for ECB use. The most expensive or ‘quality’ collateral was held back for use in private markets.

A tale of two collateral markets
This is how central bank transmission mechanisms began to be compromised.

The private funding markets, dictated by interbank participants, could from now on only be influenced by large quality collateral holdings — which the central banks increasingly lacked. The public funding market, dictated by central banks, became the domain of trash collateral — which no one really cared about.

The central bank monopoly on the ultimate cost of money thus became based around access to trashy collateral, not quality collateral — which remained the preferred funding option for private markets.

Unfortunately, it’s private liquidity which ultimately determines the scale and depth of the eurozone crisis — and it’s in this market where ECB influence is waning.
Lead a bank to liquidity, but you can't make it lend
In other words, you take your junk lower quality paper to the ECB and you reserve your high quality collateral (e.g. bunds) for the private repo market. The problem is that the private repo market continues to seize up because of a lack of high quality collateral and a rising sense of risk aversion over counterparty risk, i.e. you don't trust that you are going to get paid back so you demand really, really good collateral.

No matter how the ECB steps in to inject liquidity into *ahem* second-tier debt market, Kaminska wrote that the market has lost confidence and there is little the ECB can do [emphasis added]:
Private markets must be convinced to lend unsecured or invest money in more than just the last few remaining AAA bond markets.

But as they say, you can lead a horse to liquidity but you can’t make it drink. Which is a shame, because that’s the main problem the ECB and other central banks are now facing: they are leading banks to liquidity but they can’t make them lend in private markets.
The ECB's experience with LTRO should be a cautionary tale for the Fed as it considers a QE3 program of purchasing MBS. You can lead a market to liquidity, but you can't make lenders lend and borrowers borrow.

Beware of unintended effects, Mr. Bernanke.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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