Saturday, December 24, 2011

Advantages of a Small Investor

by Barry Ritholz:

Smaller investors do not realize that they possess quite a few strategic advantages – if only they would take advantage of them. Consider these small-investor pluses:

• No benchmark to meet quarterly (or monthly), so you can have longer-term time horizons and different goals
• You can enter or exit a position without impacting markets.
• There is no public scrutiny of your holdings and no disclosures required, so you don’t have to worry about someone taking your ideas.
• You don’t have to limit yourself to just the largest stocks or worry about position size (this is huge).
• Cost structure, fees, and taxes are within your control.
• You can reverse errors without professional consequences – you don’t get fired for admitting a mistake.
• You can have longer-term time horizons and different goals.

Friday, December 23, 2011

Forest Fires and the Logic of Growth

by Mark Spitznagel on the website of the WSJ:

The ubiquitous greenery of the season has me thinking conifers and stock market crashes. There is much to be learned from the coned evergreen trees that form vast forests across the Northern Hemisphere. As the oldest trees on the planet, the mighty conifers have survived threats of catastrophic extinction since the time of the hungry herbivorous dinosaurs.

The conifer's secret to longevity lies in a paradox: Their conquest has been largely the result of episodes of massive forest destruction. When virtually all else is gone, conifers show their strength and prowess as nature's opportunists. How? They have adapted to evade competitors by out-surviving them and then occupying their real estate after catastrophic fires.

First, the conifer takes root where no one else will go (think cold, short growing seasons and rocky, nutrient-poor soil). Here, they find the time, space and much-needed sunlight to thrive early on and build their defenses (such as height, canopy and thick bark). When fire hits, those hardy few conifers that survive can throw their seeds onto newly cleared, sunlit and nutrient-released space. For them, fire is not foe but friend. In fact, the seed-loaded cones of many conifers open only in extreme heat.

This is nature's model: overgrowth, followed by destruction of the overgrowth, and then the subsequent new growth of the healthiest and most robust, which ultimately leaves the forest and the entire ecosystem better off than they were before.

Pondering these trees, it is not too much of a stretch to consider the financial forests of our own making, where excess credit and malinvestment thrive for a time, only to be destroyed—and then the releasing of capital into markets where competition has been wiped out. The Austrian school economists understood this well, basing a whole theory around this investment cycle.

After the purge, great investment opportunities are created, from which prolific periods of growth emanate—provided that sufficient capital remains to reinvest into the fertile and now-open landscape.

Suppressing fire, creating the illusion of fire protection, leads to the wrong kind of growth, which then invites greater destruction. About 100 years ago, the U.S. Forest Service took a zero-tolerance approach to forest fires, stamping them out at the first blaze. Fast forward to 1988 when a massive wildfire at Yellowstone National Park wiped out more than 30 times the acreage of any previously recorded fire.

What obviously occurred was that the most fire-susceptible plants had been given repeated reprieves (bailouts, in a sense), and they naturally accumulated, along with the old, deadwood of the forests. This made for a highly flammable fuel load because when fires are suppressed the density of foliage is raised, particularly the most fire-prone foliage. The way this foliage connects the grid of the forest, as it were, has come to be known as the "Yellowstone Effect."

A far better way to prevent massively destructive fires is by letting the fires burn. Human intervention in nature's cycles by suppressing fires destroys the system's natural homeostatic forces.

Strangely parallel to the Yellowstone catastrophe was the start of the federal government's other fire-suppression policy with the 1984 Continental Illinois "too big to fail" bank bailout. This was followed by Alan Greenspan's pronouncement immediately after the 1987 stock market crash that the Federal Reserve stood by with "readiness to serve as a source of liquidity to support the economy and financial system," which heralded the birth of the "Greenspan put." The Fed would no longer tolerate fires of any size.

From a forestry point of view, the lessons were learned. In 1995, the Federal Wildland Fire Management Policy stated, "Science has changed the way we think about wildland fire and the way we manage it. Wildland fire, as a critical natural process, must be reintroduced into the ecosystem."

Herein are pearls of great wisdom for central bankers today. Central banks are creating a tinderbox by keeping alive many very bad investments, fertilizing them with everything from artificially low interest rates to preferential liquidity to outright securities purchases. As these institutions and instruments overrun the financial landscape, they hamper the economic ecosystem and perpetuate the environment of low growth and high unemployment in which we currently find ourselves.

Seeing periodic, naturally occurring catastrophes as part of the growth cycle requires thinking more than one step ahead, not only longer term but, more specifically, intertemporally. This is perhaps an insurmountable cognitive challenge, both to investors and central bankers in today's news-flash world. When contemplating the forest, we may intuitively understand nature's logic of growth. Yet when we look at the seeds of destruction we have sown through current monetary policy, it is clear we are lost in the trees.

Mr. Spitznagel is the founder and chief investment officer of the hedge fund Universa Investments L.P., based in Santa Monica, Calif.

Thursday, December 22, 2011

The Bull Run Continues

The belated Santa Claus rally continues on paltry volume and questionable news.

Wednesday, December 21, 2011

National Association of Liars

I wonder if they'll revise GDP lower accordingly. I doubt it!

Stocks Crash 160 Points From Their Zenith On More Eurozone Worries

from WSJ:
LONDON—European stock markets fell from session highs to trade only slightly in the black /now in the red/ Wednesday, as the outcome of the European Central Bank's longer-term refinancing operation scheme prompted concerns that the amount funding provided for banks may still not be enough...
The ECB beat market expectations by saying it allotted €489.19 billion ($639.96 billion) in the first of two keenly awaited three-year refinancing operations Wednesday. The central bank said it allotted the three-year loans—the longest maturity the ECB has ever offered—to 523 banks.
Although said to be positive for the banking industry, some warned that it may not be the answer to push banks to lend in order to prop up euro-zone sovereign bond markets.
"As the dust settles, the ambiguous nature of these data is perhaps coming in to focus—does this record LTRO take up imply carry trade support for the 'periphery' or more reflect banks' acute financing difficulties?" said Rabobank.

 I was amazed by this because I was trading live at 3:20 am when the news from the ECB broke and was initially positive and the market rocketed to its zenith. The S&P was up 10 points in just a couple of minutes. Then, reality apparently sunk in and both stocks and the Euro tanked. The Euro tanked first, crashing almost immediately. Needless to say, I am surprised to awaken this morning and see stocks in the red. Europe once again is the central focus of central bank shenanigans!

Tuesday, December 20, 2011

The Challenges for LTRO to Be Effective

From Peter Tchir of TF Market Advisors
Carry, LTRO, Data, and VIX
Once again we seem to have a discrepancy between what “credit” people think and what “equity” and “FX” people think.  The broad market rallied strongly today, at least in part because of the LTRO.
On one thing, everyone agrees, the take up rate will be high.  There will be strong demand for the LTRO.  What differs is the impact that will have on the market.
At one end is a belief that banks will be borrowing this money so they can purchase new assets.  The allure of carry will be too much to pass up, and with government encouragement, they will rush to purchase new sovereign debt and maybe even lend more.  That will turn the tide in the European debt crisis since there will be buyers for every new issue, and the market can move on to “strong” economic data in the US.
The other end of the spectrum is that the banks will use this facility to plug up existing holes in their borrowing.  They won’t have to rely on the wholesale market or repo market as much as they can tap this facility.  It will take some pressure off of the “money market” as banks won’t be scrambling for as much money every day, or over year end, but it won’t lead to new asset purchases by the banks.  Banks need to deleverage and that hasn’t changed.  The bonds can have a 0% risk weighting, but that doesn’t mean anyone, including the banks, believe it.  The road to hell is paved with carry.  That is an old adage and likely applies here. 
High Yield did well today (with HY17 outperforming HYG and JNK).  Investment Grade did okay as well (LQD tightened on a spread basis, though it shows up as a loss for most retail investors).  IG17 also was tighter as no one wanted to be hedged.  Away from that, more exotic trades, like curve trades didn’t show a similar strength.  These are the sorts of trades that would do well if everyone was looking for carry and thought the problems were solved.  Little things like that further underscore how likely it is that banks will participate.
Most banks are overexposed to these risks in the minds of investors anyways.  Will buying more of something that is risky really help?  Will loading up on a single position to the point that it can wipe you out be deemed as prudent?  I think banks that have managed themselves well to this point will be very reluctant to add significantly to their exposure.  You may get some token purchases so they can tell their regulators that they are playing nice, but beyond that, they will wait and see if the situation is really fixed.
The reason banks are not buying more of these bonds has little to do with funding costs being too high.  Risk and leverage are too high.  That hasn’t changed here, and most credit people believe that this new funding will encourage new asset purchases.  Without that, it helps the banks by reducing some uncertainty on their existing debt rollover needs (let’s not forget the hundreds of billions of bank issued debt that needs to be rolled this year), but doesn’t encourage asset purchases or balance sheet expansion.
Earlier today I had a bullish tone and did see 1300 and 1100 as being equally possible.  With a 40 point move from overnight lows it seems like a lot, especially since to the extent I was right, it was for all the wrong reasons.  I continue to believe that there may be an agenda behind the truth that is emanating out of Europe recently, but this LTRO plan doesn’t do it for me.  With our models showing seasonality being strongest from close of business tomorrow until the 27th, it is hard to be short, but without real news, we will be fading this.
On the data front, I am a bit confused why housing starts going up is a good thing.  The only industry that may be worse at predicting future demand than the airline industry, is the homebuilder industry.  They build homes, it’s what they do.  Carefully managing inventory to demand is not their strong suit.  A story about great demand and shortages of homes for sale would be much bigger news and may warrant a rally, I put this in a neutral category, at best.
On the earnings front, it seems like as many companies are missing as beating.  Oracle missed after the bell and is being punished.  It is far from clear to me that the earnings story is that compelling, and the strength in the dollar is the last thing the nascent surge in manufacturing needs.
We have a political system that couldn’t agree that the sun comes up in the morning without holding special sessions.  Their ability to provide any help to the economy is zilch and no matter how many times people say it, there is no strong evidence that “gridlock” and “a government that does nothing” is actually a good thing for stocks over the short term (even though it may be by far the best thing for the economy in the long run).
VIX is back to levels last seen in August.  The fact that those levels preceded a sell-off is largely being ignored on a day the DOW moved up 337 points, but as far as I can tell, VIX is as much a “risk on” / “risk off” asset as anything else and has limited predictive value (as in none).  Somewhere out there, the quants are analyzing the skew of longer dated options as a better tool that may retain predictive value, but that is complex, and requires effort, but is probably the work that is required to make some sense of what the “vol” market is telling us.  It is definitely the sort of work that serious tail risk hedge funds and quant funds are looking at and analyzing. 
Here is the “vol skew” graph function on the SPX on Bloomberg.  As far as I can tell you would need to be either a rocket scientist or a Deadhead to understand it.  I am neither, but am convinced that to the extent the vol market contains useful information, it is far more complex to figure out, than pulling up a VIX closing level. 

Europe's Sovereign Debt Crisis "Is Here to Stay"

by Felix Salmon at Reuters:

“By this time next week,” says Simone Foxman, “the euro crisis could be over”; she obviously doesn’t think much of Fitch’s analysis, which concludes that “a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach”.
I’m with Fitch on this one. But it’s worth looking at the bull case for the eurozone, as spelled out by the likes of Foxman and Tyler Cowen. At heart, it’s pretty simple:
  1. The way to solve the euro crisis, at least for the next couple of years, is for the ECB to act as a lender of last resort.
  2. The ECB is, quietly, doing just that — specifically by lending money for as long as three years against a much wider range of collateral than it accepted in the past.
  3. Even though that money is going to banks rather than sovereigns, the banks will borrow as much as they can, at interest rates of about 1%, and invest the proceeds in Spanish and Italian debt yielding more like 6%, in a massive carry trade.
  4. Which means that the ECB is, effectively, printing hundreds of billions of euros and lending it to distressed European sovereigns after all.
This, at least, is how Nicolas Sarkozy has been spinning things:
“Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6-7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.”
But look at the headline of the article that quote appears in: “EU banks slash sovereign holdings”. Here’s a taster:
Europe’s banks have slashed their holdings of sovereign debt issued by the peripheral nations of the eurozone, selling €65bn of it in just nine months…
BNP Paribas cut its holdings by the most, shedding nearly €7bn of the sovereign debt of Greece, Italy, Ireland, Portugal and Spain and leaving it with €28.7bn as at end-September. Deutsche Bank’s €6bn reduction was by far the biggest in percentage terms (66 per cent) and left the bank with just €3.2bn of GIIPS exposure.
My feeling is that, at the margin, banks are going to continue to reduce their holdings of PIIGS debt, rather than decide to follow in the footsteps of MF Global. But don’t take my word for it:
Senior bankers say they will cut further, despite pressure to use newly available, longer-term ECB loans to buy government debt as part of an officially-sanctioned carry trade.
“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”
That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.
Cowen says that “public choice mechanisms will operate so that desperate governments commandeer their banks to make this move, whether the banks ideally would wish to or not” — and normally I’d be inclined to agree with him. Sovereign borrowing always crowds out other forms of bank lending, when a national government decides it really needs the money.
But in this case, it’s not going to happen. Why? For one thing, the main tool that governments can use has already been deployed: if banks load up on sovereign debt, it carries a lower risk weighting under Basel rules and therefore makes their risk-adjusted capital ratios look more attractive. But that’s been the case for decades now, and it can’t be beefed up at all. Meanwhile, bank regulators and investors are looking at a lot of other ratios too, like total leverage. And as we saw with MF Global, they’re hyper-aware of European sovereign exposures these days. Any bank wanting to be considered healthy will stay well away from Spanish and Italian debt.
On top of that, the financing needs of Spain and Italy are much bigger than their respective national banks can fill — especially in the context of those banks trying to deleverage, and seeing their deposit bases move steadily to safer European countries. While national governments are reasonably good at twisting the arms of their own domestic banks and forcing those banks to lend to their sovereigns, they’re much less good at twisting the arms of foreign banks and getting them to do the same thing. Is there any way at all for the Italian government to persuade French banks to lend to it? No.
And more generally, the national debt of big European sovereigns like Italy and Spain is so enormous that it has to be held broadly, in bonded form, by individuals and institutions. Banks alone won’t suffice. Greece is small enough that most of its debt can be held by banks. Italy, not so much.
There’s an argument that it doesn’t really matter whether the banks buy Italian and Spanish debt or not: the main thing that matters is that the ECB is printing money, which is entering the system via the banking system, and which will ultimately find its way into sovereign coffers one way or another, especially since there’s precious little demand for commercial bank loans these days. But I don’t buy it: there’s a virtually infinite number of potential investment opportunities around the world, and there’s no good reason to believe that the ECB’s cash is going to wind up funding Italy’s deficit rather than, say, getting invested in Facebook stock.
If Europe’s banks use ECB cash to deleverage and buy back their own high-yielding debt securities, the investors getting that money are not going to automatically buy sovereign bonds with the proceeds. Especially since those investors don’t care at all about Basel risk weightings.
So much as I’d love Sarko’s dream to come true, I don’t think it’s going to happen. The eurozone’s sovereign crisis is here to stay.

A Risk Assessment on ECB's LTRO

The FT has already reported on how hesitant banks are about buying ever more sovereign debt. In fact they outright dumped  €65bn of bonds in just nine months. Hopes that banks would hold the hand of the sovereigns that back them continue to dim, as the Sarko carry-trade looks increasingly less likely in advance of this Wednesday’s offer of cheap 3-year ECB financing.
The presumption that banks are going to use the 3-year Long Term Refinancing Operation (LTRO) to buy sovereign bonds comes not just from the dreams of certain politicians, but also from the observation that yields at the short end of peripheral curves have come in dramatically.
Spanish bonds provide an example (chart courtesy of SocGen):

From the above, European financials have deteriorated over the last week while the yields on Spain’s government bonds have been coming in. Is this the result of banks buying up the high yielding bonds that they will soon be able to fund exceptionally cheaply?
Not so much, say the analysts at SocGen in their Rates Strategy daily this Monday. There are many factors at play, and true, one of them may be the anticipation of banks putting on carry trades, but the expectations may not transform into reality.
For one thing, banks are going to have to find a way to fund their existing asset holdings — to the extent that they don’t deleverage themselves into nothingness, that is — and a good portion of the current funding for them will roll off in 2012. SocGen points out that for eurozone banks in 2012, €250bn of senior unsecured bank bonds will mature, along with €83bn of government guaranteed debt, plus €19bn of subordinated debt.
Seeing as the unsecured market is somewhere between frozen and inaccessibly expensive, the most relevant candidate for the replacement of that debt is reckoned to be around €185bn of covered bond issuance, a figure which the analysts acknowledge may well be a bit on the high side (though at least it will be supported by another ECB programme to specifically prop up that market).
The rest of the funding needs to come from somewhere. And, well, the ECB is offering…
True, the ECB ties up collateral as equally as covered bonds do, but there is an extra attraction to the LTRO: the banks that take the 3-year funding will in fact have the option to repay any part of it after just a year, hence freeing up the collateral held against the borrowing at the ECB. Nice option… that isn’t too consistent with the whole “carry trade” concept where the maturity of the asset is matched to the term of the funding for it, the rates team at SocGen points out.
Oh, and the collateral posted to the ECB can be relatively low quality. Not like the stuff required for private markets, or for covered bond pools.
One thing that actually joins the LTRO on the supply-side for liquidity, according to SocGen, is the lower reserve requirements that will kick in for the maintenance period starting on January 18th. Falling from two per cent to one per cent will free up some €100bn that was on deposit with the ECB — something that will happen in advance of the second 3-year LTRO at the end of February. However, the SocGen analysts expect that this move will more likely lead to a decrease in weekly main-refinancing operations (MROs), than a decrease in LTRO demand. One to be aware of, anyhow.
But back to how unlikely carry trades are:

There are several obstacles to carry operations, namely the stricter capital requirements, the pressure on banks to deleverage; and the stigma attached to such trades if ever revealed.
Put even more simply, do you think a bank that shows an increase in sovereign bond holdings in their quarterly reports will find it easier or harder to fund itself in private markets?
And what if there is yet another EBA stress test that whacks sovereign holdings and then demands additional capital for potential losses? How clever will a sovereign carry-trading bank look then?
In addition to that, if the bonds were to reverse course and start tanking again, the banks would have to post additional margin on them.
All of that said, could the banks make a dent if they wanted to? Out of some sense of patriotism perhaps? Emphasis ours:
Euro area banks have some 6% of total assets in government bonds (with ratios slightly higher at 7% to 9% in Spain and Italy as per the most recent EBA data). If half of all Spanish and Italian banks (it is unlikely to be the larger names) were to raise the ratio by 1% next year, that would lead them to buy some €8bn-€10bn in each country. Most likely the impact would be far less, and graduated over time. Buying though on such a scale is modest as a percentage of total issuance (some 9% in Spain, 4% in Italy).
That’s a “no” with words. Here’s the same with a graph, courtesy of Deutsche Bank with a couple of FT Alphaville modifications:

In the end, SocGen predicts a demand for €200bn on Wednesday.
RBC is in a similar ballpark, but warns that there’s a risk that the uptake could be lower than expected. There are currently already €350bn in excess reserves parked at the ECB which is much higher than they were prior to previous LTROs:

Furthermore, banks can fund the €432bn of tenders that mature this week with the weekly MRO and 3-month LTRO, so they don’t necessarily need to go to the 3-year tender just to keep things constant.
In addition to this, the RBC team notes that the exact details on the expanded range of eligible collateral hasn’t actually been decided yet, so it may not be clear to banks whether they have newly-eligible assets lying around that they may otherwise be willing to post.
In conclusion (emphasis ours):
A not too small outcome should suggest that banks use the new facility and get longer dated funding on board. This should sooth some anxiety about their funding risks going into 2012. A not too large outcome should also suggest that no unreasonable risks have been taken.
It’s the goldilocks of refinancing operations.

Market Expect's ECB to be Back-Door QE3, May Disappoint Market

from WSJ:
One of the things driving the market higher today is the idea that tomorrow’s Long Term Refinancing Operation by the ECB will serve as a back-door QE, bailing out the sovereigns and helping banks earn some easy cash with a carry trade.
The idea is fairly simple at first blush: European banks buy high-yielding sovereign debt, which they can pledge as collateral in the LTRO (of which there will be others in the future). The LTRO gives them cheap cash they can use to buy still more high-yielding sovereign debt, pocketing the yawning difference in borrowing costs.
This might help explain why recent auctions of peripheral European sovereign debt have been so well-received — banks were planning to turn right around and offer them to the ECB as collateral in exchange for a cheap loan.
Sounds good so far, but there are complications. Investors, already jittery about European banks, might balk if those banks take their cash and buy too much risky sovereign debt — against which they will also have to hold capital.
Peter Tchir of TF Market Advisors figures this will really end up solving a funding problem for the banks — as advertised, in fact — rather than waving a magic wand to resolve solvency problems of both sovereigns and banks:

Banks are struggling to borrow money right now to finance their existing positions.  How much of LTRO will be used to finance new bond purchases, rather than to replace existing forms of funding?  Any bank that is already running a big sovereign debt position will look to LTRO to replace existing forms of financing.  They can eliminate the repo roll risk on bonds they are financing in the repo market, or they could stop attempting to borrow in the interbank market.  Those are positives for the banks as they can earn more carry (cheaper financing) and reduce roll risk (3 year term).  But that doesn’t create new demand for bonds.
So the LTRO can help the banks with their existing funding problems without a doubt, but it is unclear that encourages new bond purchases.
Banks will have no real reason to buy up more sovereign debt, he suggests — particularly since they already own a lot:
To buy now, you need to believe that the default risk is gone.  Since NOTHING about this program addresses solvency, you cannot change your default assumptions.  You would be betting that the problem is really liquidity driven and that this program can solve that.  But how can you know that?  You need to assume every other bank will add significantly to their exposure.  No one bank can grow their exposure too large, without losing all access to the public debt markets and seeing their share price drop.  So each bank can only add incrementally.  Since the solvency problem hasn’t been addressed, you are buying in the hopes that some other bank buys too.  If everyone buys and takes on even greater exposure to these weak countries, then the liquidity and debt issuance risk can be addressed.  But what if strong banks don’t think it is smart to take on more risk.
Thus he thinks tomorrow’s LTRO will mainly be used for current financing needs, rather than taking big risky bets:
There will be significant interest in tapping the LTRO for existing positions.  Some small amount of incremental purchases may occur at the time, but the banks will use this to finance existing positions.  This should help bank credit spreads.  It should also show up in measurements like OIS as it would reduce pressure in the interbank funding market.  This is positive, but a relatively minor positive, and seems more than priced in.
Lisa Pollack at FT Alphaville had a very good post yesterday putting into perspective just how large the current funding needs of the banks already are — a hole that the LTRO will help plug, but not much more — certainly not embarking on a risky carry trade.
Marc Chandler agrees that this is no Trojan horse bearing QE:
Following the 1-year repo in June 09, there had been market talk of the money going into the short-term Italian and Spanish bonds.  Yet we don’t expect as much of new carry trades some officials might wish.  The lion’s share of the funds LTRO taken we suspect will go to 1) replace current ECB funding, 2) build greater cash buffer and 3) reduce some liabilities.  To the extent banks buy sovereign bonds, we think they are more likely to buy domestic bonds than foreign bonds.   The slope of curves may be an important consideration in whether banks take some duration risk.
But Chandler also thinks huge bank participation — something on the order of 250 billion to 500 billion euros — in tomorrow’s LTRO will be taken as a risk-on sign by the markets anyway.
Nomura currency maven Jens Nordvig, who recently closed his short-euro position when it dipped below $1.30, thinks it best for euro bears to step aside until the LTRO dust settles:
We have squared up our short EURUSD exposure at 1.30 last week, and we are in no major hurry to get back in. In the first instance, we will re-assess after the LTRO results are out tomorrow, but it may be better to wait patiently for fresh opportunities in January.

ECB's "Shell Game"

from Zero Hedge:
It is one thing for irreverent blogs to call a spade a spade an accuse the ECB of engaging in ponzi operations, such as Wednesday's LTRO where the European central bank will give local banks money and hope and pray the use of proceeds is to purchase sovereign debt (something we said previously is very unlikely to happen). It is something totally different when the world's biggest bond fund manager makes the same tacit accusation by saying that all the ECB does is take from one hand and give to the other - a very efficient shell game. Such as what Bill Gross has just done in a tweet from mintues ago. So how are investors, we wonder, supposed to have any faith in bonds (forget equities - they have long given up on those), when even the members of the status quo systematically undermine confidence in the global pyramid scheme (not that we are complaining).

Pushing on a String: ECB's LTRO Doesn't Help Private Markets

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), /correct term is Long Term Refinancing Operations/ 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.
Disclaimer: 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.

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