For Mega Bank (the big four mortgage banks) to not enter a deleveraging phase, it must continue to raise funds in offshore markets. Domestic sources of funds will not meet the demand even as the commonwealth government raises funds offshore and pumps those funds into the economy and Mega Bank. Having caused pain last year, Europe is coming to our rescue now.
To be clear, nothing in the LTRO (long term re-financing operation) program is supposed to directly benefit any party outside of Europe, but the law of unintended consequences is very powerful. The LTRO program is in effect a 3 year repo arrangement with the ECB, where banks post collateral and borrow against that for 3 years at 1%, under the same terms and conditions as normal short term repurchase agreements. Is collateral from Mega Bank in the form of covered bonds or unsecured debt eligible for repo? No, but that does not mean they’ll not benefit.
Banks drawing under the LTRO will post eligible collateral in the form of say European bank covered bonds, European sovereign debt, or other forms of eligible debt securities, and receive euros at an interest rate of 1%. With that pocket full of cash those banks will look for some easy assets to arbitrage with little effort. The purpose of LTRO is supposedly threefold, to help the EU members raise sovereign debt, help mend the balance sheets of European banks, and lastly, maybe those banks will also increase business lending to help the battered economies. I don’t believe that propping up the inflated Aussie mortgage market was on the agenda, but that’s what is happening.
Practice is somewhat different to theory. The banks now with cheap unencumbered funds will be bidding up assets all around the globe, creating demand and significantly decreasing funding margins, as evidenced by the spread compression in the European covered bond and unsecured debt markets.
European banks and funds had lent about $250bn to Mega Bank, mostly through the UK, but the lending base is large and diverse across Europe. This has been a very stable lending base, especially reliable since 2008, allowing Mega Bank to significantly grow its mortgage book. Mega Bank has been attractive for European investors due to both a perceived flight to quality and the carry trade, but this was changing. As Europe was imploding and creating zombie banks, deleveraging meant that Mega Bank was going to feel the heat rising, and even rolling the necessary funding in 2012 was becoming very difficult and very expensive, as evidenced by the covered bond issuance in early January. Then along came LTRO I and II. To be fair LTRO I was late December but I think everyone was slow on the uptake on what it meant at the time.
So Mega Bank’s loyal lenders, and a few new one’s, suddenly are endowed with a new cheap source of liquid funds, ensuring that immediate funding requirements of the bank will be met. Whilst no Mega Bank paper is eligible directly for LTRO or any other repo arrangement with the ECB, the higher margin and a perceived low risk means that Mega Bank is an attractive investment, for now. Either directly or otherwise, the ECB’s LTRO has unwittingly stabilised the Australian financial system.
Nevertheless, this is only a temporary reprieve. A structural issue which may play out badly is that LTRO is only for 3 years, and to make the most of its benefits Mega Bank must issue into maturities of around this term. This concentration of maturity is clearly something to avoid due to the larger refinance risk, but at least its manageable on its own.
The larger risk is: What does Mega Bank do when the LTRO benefits disappear and any sort of landing from China kicks in? The stability of the Australian financial system depends on at worst maintaining the level of its offshore borrowings. Certainly, at the moment domestic deposits are rising marginally due the governments borrowings, which the RBA estimates is about 80% sourced offshore, but with the push towards a surplus this will not last or be significant enough. The responsibility for Australia’s foreign liabilities rests squarely on the shoulders of Mega Bank.
There will be a point where Mega Bank will fail in its responsibilities. This is certain, regardless of individual or government capabilities, because it’s not in our control, and events which have significant effects are occurring all the time. In the same way that we had no control over LTRO and as the lucky country we benefit greatly, some other action made in some other uncontrollable part of the world will occur and have the opposite effect. The key is recoginisng the tipping point and selfishly benefitting from the fallout.