Bonds, Italian style

The ECB's new long-term funding scheme is a cunning plan worthy of Baldrick himself.   The so-called LTROs provide cheap financing for the Eurozone's banks, which can then invest the proceeds in sovereign debt at a much higher yield. This allows the central bank to fool Kanzlerin Merkel's voters into thinking that it isn't bailing anyone out; it backstops the sovereign debt market;  and it allows the banks to rake in profits on the spread between what they pay for the LTROs and what they earn on the government bonds, which can be used to rebuild their balance sheets.  Everyone's a winner --  provided of course that the sovereign debtors don't default.  Trebles all round, as Private Eye might say.

Banks enthusiastically hoovered up the first tranche of LTRO money earlier this month, and the past couple of days have provided the first test for the whole scheme, as Italy has come to market with several tranches of debt. Two issues of short-dated paper were well-received, with yields falling sharply from prior levels.  Then came a tougher challenge, in the form of two tranches of longer-dated securities that were issued on December 29 (not, one might think, the most auspicious timing). Here is how the Daily Telegraph website reported the outcome:  

Italy raised €7bn (£5.9bn) in the first big test of the bond markets since the ECB opened its doors with €489bn of cheap loans in an attempt to inject liquidity into Europe's arid banking system. Rome paid 5.62pc to sell €2.5bn three-year debt – a much lower yield compared to the record high of 7.89pc paid a month ago. It paid 6.98pc to shift its 10-year bonds, compared with 7.56pc in November.

The total amount raised in the auction fell short of the €8.5bn target and the cost was still deemed to be unsustainable. The yield on Italian 10-year bonds closed at 7.06pc – stubbornly above the 7pc level seen as signifying the need for a bail-out.

The auction doused the optimism that followed Wednesday's auction of Italian six-month bills when the borrowing costs were halved from a month ago. Analysts said the auctions showed the ECB's action had eased pressure on shorter-term debt, but investors were still wary of longer-dated bonds. 

Let's look at a couple of aspects of that report, starting with the now-obligatory reference to 7% yield "seen as signifying the need for a bailout". Obviously the sub-editor was short of space and cut that sentence down; it must originally have read "seen by lazy journalists as signifying the need for a bailout".  Let's get this straight one more time: even if Italy were issuing all its new debt at 7% yields -- which it isn't -- that wouldn't mean its overall borrowing costs were at that level. The cost of its earlier borrowings is unaffected by today's market yields.

At least one reputable study has been carried out in response to this 7% nonsense, and found that even if Italy had to carry out all its refinancings and new borrowings between now and 2014 at a cost of 8%, the added interest cost would still equate to only half of what Italy expects to save through austerity measures, so the fisc would be better off overall.  That very much gives the lie to the notion that Italy is facing an insolvency problem, rather than just one of illiquidity.  (I have no real hope that repeating these verities will stop journalists from getting it wrong.  Still, I can but try).

Turning now to the somewhat different reception of the short-dated and the longer dated debt this week, an explanation is readily apparent, but unfortunately it's one that suggests that the LTRO scheme may distort the Eurozone's bond markets even as it calms them.  Maturity mismatches -- financing long-term assets like bonds or mortgages with shorter-term liabilities like deposits (or LTROs) -- are the lifeblood of banking, but prudent bankers know not to overdo it.  (Example: Northern Rock blew up because the funding of its long-dated mortgage portfolio relied much too heavily on very short-dated wholesale deposits. When those dried up, the Rock was finished).

The LTROs have a maximum term of 3 years, and every bank that has taken advantage of the scheme can happily count on a positive outcome as long as it buys assets of a shorter term than that.  Hence the enthusiastic response to Italy's short-dated paper.  There is a risk that banks will find themselves rolling this paper over into new issues at a lower yield when it matures in six or twelve months, but that would simply reduce the spread they earn, not drive them into losses.

Ten-year bonds are a different question, however, because the banks can't be sure whether the LTRO scheme will still be in place when the first batch matures in three years time.  If things have stabilised and the ECB is no longer providing such funding, the banks will be faced with raising market funding at much higher rates -- conceivably higher than the yield on the bonds -- or with liquidating some of their holdings.  If a large number of banks choose the latter option, the price of the bonds could plummet, creating substantial losses.

The bottom line here is that the performance of the various Italian auctions this week may well have been driven by the LTRO scheme itself.  The first quarter of 2012 brings a lot of new issuance in the Eurozone, and if we continue to see short auctions doing much better than long ones, the ECB may have some thinking to do.  A very steep yield curve might tempt some issuers into shortening the average maturity of their new issuance in order to save money, but that would of course be risky in itself, if the debt crisis proves very protracted.

Wow,  this is a very long and serious post, considering most people are probably gearing up for their New Year's blowout!  Happy new year to all readers of the blog.