Picture of Fear

Cash in Europe has nowhere else to go.

[chart from ZeroHedge--click to enlarge]

When the economy is running smoothly, banks lend to each other readily and willingly. Conversely, a curtailment in inter-bank lending is a sign that the economy is stalling. Or, in the current instance, seizing. The chart above shows that European banks with money to spare are parking it with the European Central Bank, not lending it out. Deposits at the ECB have reached a record €464 billion, higher than the peaks seen following the Lehman failure of 2008 and the flash crash of 2010.

These deposits have soared by €200 billion since December 21, when the ECB released a flood of fresh three-year loans through its Long-Term Refinancing Operation (LTRO). The operation is a desperate attempt to sop up impaired collateral held by stressed Eurozone banks, such collateral consisting of either discounted sovereign bonds or their own junk-rated debt. Collateral is the grease that makes the whole Rube Goldberg machinery run. When it goes bad, the machinery grinds to a halt. As the Wall Street Journal explains, "banks favor using the ECB as a safe haven for excess cash rather than lend it out to other banks...due to concerns about their counterparties' exposure to risky euro-zone sovereign debt."

Bond expert Marc Chandler, at his niftily named blog (www. marctomarket.com), points out that Eurozone banks need to re-fund, or roll over, €230 billion of their own maturing debt and expects that "the bulk of the ECB's liquidity provision will not be used to buy sovereign bonds, but to address the banks' own needs." Charles Smith, Chief Investment Officer at Fort Pitt Capital Group, uses more colorful language to describe this shell game:

These “refinancings” are nothing more than the (panicked) banks dumping their very worst collateral on the ECB to cover immediate withdrawals/maturities. And these withdrawals/maturities will keep on coming! And if they run out of pledgeable collateral, no worries. They simply issue new bonds, get a government guarantee on those bonds, and then post them as collateral for cash at the ECB. Italian banks issued 40 billion euros worth of such bonds yesterday! There’s a very vulgar term for this sort of behavior…”circle jerk”.

ZeroHedge insists that much of the LTRO liquidity is coming right back to the ECB as overnight deposits. The depositing banks no longer have a sufficient collateral cushion to recycle the 1% LTRO debt into higher-interest loans (e.g. short-term sovereign notes), thereby earning a positive "carry." Instead, they park the cash for 0.25%, effectively earning a negative return. Such is the price of impaired collateral, which itself is the end-product of risky lending.

Negative interest rates are a harbinger of impending deflation. Bloomberg Businessweek reports that earlier today Germany sold a six-month bill yielding -0.01%, "the first time a national money market instrument offered a negative yield" at issuance. Secondary markets have been marking yields on Germany's one-year debt below zero since November 30 [FT]. Before this is all over, we shall hear of many more "first evers."

[update, 11:30 a.m.--]

Reuters has an article just posted on how private-sector non-banks, and not just the ECB, are becoming sources of cash for struggling banks. These non-banks are familiar names--Johnson & Johnson, Pfizer, Peugot, etc. They are cash-rich multinationals looking to put their money to work (but not, it should be pointed out, by investing in their own businesses). They are the "shadow" bankers. They lend to the banks through so-called "repo" transactions, in which they buy collateral from the banks, then sell it back later at a discount, pocketing the "haircut." Lehman Brothers, you'll recall, used repos to hide the firm's leverage from investors and regulators. Remember how that turned out?