“A case of White Lightning please, and three bottles of Mothers’ Ruin”. The European banking system is like a drunk on payday.
With a bit of cash burning a hole in his pockets, he wants the strongest stuff available, regardless of the long term consequences. Senior debt at 300bp looks tempting.
But the very same cash flooding the system with liquidity is undermining the credit quality of senior debt. Every asset pledged to the ECB leaves fewer unencumbered assets to pay senior creditors.
And the more troubled the bank, the more it has pledged to the ECB. Royal Bank of Scotland analysts estimate the first three year LTRO pushed senior debt 1% down the capital structure. The next, due at the end of February could easily be twice the size, and there is even talk of a third in September
However keen the central bank may be to ensure that LTRO access doesn’t come with a stigma, it should do. Deutsche’s Joe Ackermann is right here.
Senior debtholders that are getting pushed down the capital structure should see this in higher spreads – as they did when regulators first talked up bail-in.
A bank with a big chunk of balance sheet pledged to any repo counterparty is a worse credit than one with an unencumbered balance sheet.
Of course, some banks are using LTRO cash to build up capital through tenders, or, more subtly, through slowing asset disposals.
Long term cash at generous rates means less pressure to ditch non-core assets, or more lenient mark-to-market on the risk assets that have rallied since the start of the year.
This helps, a little. Senior debtholders get pushed back up by fatter capital cushions while pushed down by asset encumbrance. The drinker drowns his sorrows, until the morning.
But repo means repurchase. European banks need cash on hand to get their collateral back from the ECB, preferably in one year, potentially in three.
It’s hard to see where this will come from. A better market tone, three years of good macro numbers from the peripheral countries and a clear route out of crisis will help. But senior debt for the biggest LTRO users will still be a tough sell.
A bank where the business model relies on term funding at 1% won’t be a good credit. There’s no guarantee Europe’s banks will any more profitable in three years, particularly if weak players are held in stasis and the creative destruction of capitalism suspended.
And then there’s bail-in on top.
Of course, all this only matters if banks go bankrupt. Senior unsecured creditors only need an unencumbered balance sheet to get hold of when a bank doesn’t have the cash on hand.
Here, the LTRO is positive, at least for bank credit. It’s a strong signal that the ECB is prepared to keep European banks afloat, even at the cost of lavish subsidies. So maybe the senior market is right to take it as good news. Special Brew for the road?