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!

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

Posted by Lisa Pollack on Dec 19 17:10.
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.

Stocks Rally 337 Points On Hope ECB's LTRO Will Save Europe

Stocks Turn Red

Description of ECB's LTRO

Press Release from website of the ECB:

8 December 2011 - ECB announces measures to support bank lending and money market activity

The Governing Council of the European Central Bank (ECB) has today decided on additional enhanced credit support measures to support bank lending and liquidity in the euro area money market. In particular, the Governing Council has decided:

• To conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months and the option of early repayment after one year.
  
• To discontinue for the time being, as of the maintenance period starting on 14 December 2011, the fine-tuning operations carried out on the last day of each maintenance period.
  
• To reduce the reserve ratio, which is currently 2%, to 1% as of the reserve maintenance period starting on 18 January 2012. As a consequence of the full allotment policy applied in the ECB’s main refinancing operations and the way banks are using this option, the system of reserve requirements is not needed to the same extent as under normal circumstances to steer money market conditions.
  
• To increase collateral availability by (i) reducing the rating threshold for certain asset-backed securities (ABS) and (ii) allowing national central banks (NCBs), as a temporary solution, to accept as collateral additional performing credit claims (i.e. bank loans) that satisfy specific eligibility criteria. These two measures will take effect as soon as the relevant legal acts have been published.
  

Modalities of the two longer-term refinancing operations with a maturity of 36 months and the option of early repayment after one year:

The operations will be conducted as fixed rate tender procedures with full allotment. The rate in these operations will be fixed at the average rate of the main refinancing operations over the life of the respective operation. Interest will be paid when the respective operation matures.
After one year counterparties will have the option to repay any part of the amounts they are allotted in the operations, on any day that coincides with the settlement day of a main refinancing operation. Counterparties must inform their respective NCB, giving one week’s notice, of the amount they wish to repay.
The operations will be conducted according to the schedule shown in the table. The first operation will be allotted on 21 December 2011 and will replace the 12-month LTRO announced on 6 October 2011.

Announcement date	Allotment date	Settlement date	First date for early repayment	Maturity date	Maturity
20 Dec. 2011	21 Dec. 2011	22 Dec. 2011	30 Jan. 2013	29 Jan. 2015	1134 days
28 Feb. 2012	29 Feb. 2012	1 Mar. 2012	27 Feb. 2013	26 Feb. 2015	1092 days

Counterparties are permitted to shift all of the outstanding amounts received in the 12-month LTRO allotted in October 2011 into the first 3-year LTRO allotted on 21 December 2011. Those counterparties that wish to do so are requested to notify their respective NCB by Monday, 19 December 2011.

Details of measures to increase collateral availability:

In addition to the ABS that are already eligible for Eurosystem operations, ABS having a second-best rating of at least “single A” in the Eurosystem’s harmonised credit scale at issuance, and at all times subsequently, ^[1] and the underlying assets of which comprise residential mortgages and loans to small and medium-sized enterprises (SMEs), will be eligible for use as collateral in Eurosystem credit operations. They must also satisfy all of the following requirements:
(a) the cash-flow-generating assets backing the ABS must all belong to the same asset class, i.e. the asset class must consist of either only residential mortgages or only loans to SMEs;
(b) the cash-flow-generating assets backing the ABS cannot include loans which are:

1. at the time of issuance of the ABS, non-performing; or
   
2. at any time, structured, syndicated or leveraged;
   

(c) the counterparty submitting an ABS as collateral (or any third party with which it has close links) cannot act as an interest rate swap provider in relation to the ABS;
(d) the ABS transaction documents must contain servicing continuity provisions;
(e) the ABS must fulfil all other existing eligibility requirements, except for the ratings requirement.
The NCBs are allowed, as a temporary solution, to accept as collateral for Eurosystem credit operations additional performing credit claims that satisfy specific eligibility criteria. The responsibility entailed in the acceptance of such credit claims will be borne by the NCB authorising their use. Details of the criteria for the use of credit claims will be announced in due course.
Furthermore, the Governing Council would welcome wider use of credit claims as collateral in the Eurosystem’s credit operations on the basis of harmonised criteria and announces that the Eurosystem is aiming to:

1. enhance its internal credit assessment capabilities; and
   
2. encourage potential external credit assessment providers (rating agencies and providers of rating tools), and commercial banks that use an internal ratings-based system, to seek Eurosystem endorsement under the Eurosystem Credit Assessment Framework.
   

Massive sell-Off As Market Moves Back to Flat

It was looking like stocks would turn bullish today, but stocks have lost all of a 120-point gain and are now back to flat. That said, stocks usually bounce at the previous day's closing price, so I wouldn't be surprised if stocks form a bottom here and now move higher.

Good Economic News Fails to Buoy Stocks

Good Philly Fed, unemployment claims, and Empire Manufacturing data have failed to buoy stocks. After being higher by about 15 points, S&P futures are now up just 3 points!

I think that the gradual collapse of Europe is weighing upon the bullish news in the U.S.

Commodities Plunge on Euro Worries, Strength of Dollar

Stocks, Euro Tumble

Gold in Freefall!

Down about $90 so far today!

EU News Dampens Stocks

Stocks Tank, Lose Gains, Go Negative After Fed Stands Pat

The market was clearly disappointed that the Fed didn't announce something more aggressive.

Stocks Hit Hard

Leverage Unlimited; Re-Hypothecation

By Christopher Elias (UK)
(Business Law Currents) A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients.
MF Global's bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous $6.2 billion Eurozone repo bet.
If anyone thought that you couldn’t have your cake and eat it too in the world of finance, MF Global shows how you can have your cake, eat it, eat someone else’s cake and then let your clients pick up the bill. Hard cheese for many as their dough goes missing.
FINDING FUNDS
Current estimates for the shortfall in MF Global customer funds have now reached $1.2 billion as revelations break that the use of client money appears widespread. Up until now the assumption has been that the funds missing had been misappropriated by MF Global as it desperately sought to avoid bankruptcy.
Sadly, the truth is likely to be that MF Global took advantage of an asymmetry in brokerage borrowing rules that allow firms to legally use client money to buy assets in their own name - a legal loophole that may mean that MF Global clients never get their money back.
REPO RECAP
First a quick recap. By now the story of MF Global’s demise is strikingly familiar. MF plowed money into an off-balance-sheet maneuver known as a repo, or sale and repurchase agreement. A repo involves a firm borrowing money and putting up assets as collateral, assets it promises to repurchase later. Repos are a common way for firms to generate money but are not normally off-balance sheet and are instead treated as “financing” under accountancy rules.
MF Global used a version of an off-balance-sheet repo called a "repo-to-maturity." The repo-to-maturity involved borrowing billions of dollars backed by huge sums of sovereign debt, all of which was due to expire at the same time as the loan itself. With the collateral and the loans becoming due simultaneously, MF Global was entitled to treat the transaction as a “sale” under U.S. GAAP. This allowed the firm to move $16.5 billion off its balance sheet, most of it debt from Italy, Spain, Belgium, Portugal and Ireland.
Backed by the European Financial Stability Facility (EFSF), it was a clever bet (at least in theory) that certain Eurozone bonds would remain default free whilst yields would continue to grow. Ultimately, however, it proved to be MF Global’s downfall as margin calls and its high level of leverage sucked out capital from the firm. For more information on the repo used by MF Global please see Business Law Currents MF Global – Slayed by the Grim Repo?
Puzzling many, though, were the huge sums involved. How was MF Global able to “lose” $1.2 billion of its clients’ money and acquire a sovereign debt position of $6.3 billion – a position more than five times the firm’s book value, or net worth? The answer it seems lies in its exploitation of a loophole between UK and U.S. brokerage rules on the use of clients funds known as “re-hypothecation”.
RE-HYPOTHECATION
By way of background, hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.
In the U.S., this legal right takes the form of a lien and in the UK generally in the form of a legal charge. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default.
In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital).
Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.
U.S. RULES
Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.
But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500).
This asymmetry of rules makes exploiting the more lax UK regime incredibly attractive to international brokerage firms such as MF Global or Lehman Brothers which can use European subsidiaries to create pools of funding for their U.S. operations, without the bother of complying with U.S. restrictions.
In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation.
BEWARE THE BRITS: CIRCUMVENTING U.S. RULES
Keen to get in on the action, U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules.
Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organisation.
Potentially as simple as having MF Global UK Limited, an English subsidiary, enter into a prime brokerage agreement with a customer, a U.S. based prime broker can immediately take advantage of the UK’s unrestricted re-hypothecation rules.
LEHMAN LESSONS
In fact this is exactly what Lehman Brothers did through Lehman Brothers International (Europe) (LBIE), an English subsidiary to which most U.S. hedge fund assets were transferred. Once transferred to the UK based company, assets were re-hypothecated many times over, meaning that when the debt carousel stopped, and Lehman Brothers collapsed, many U.S. funds found that their assets had simply vanished.
A prime broker need not even require that an investor (eg hedge fund) sign all agreements with a European subsidiary to take advantage of the loophole. In fact, in Lehman’s case many funds signed a prime brokerage agreement with Lehman Brothers Inc (a U.S. company) but margin-lending agreements and securities-lending agreements with LBIE in the UK (normally conducted under a Global Master Securities Lending Agreement).
These agreements permitted Lehman to transfer client assets between various affiliates without the fund’s express consent, despite the fact that the main agreement had been under U.S. law. As a result of these peripheral agreements, all or most of its clients’ assets found their way down to LBIE.
MF RE-HYPOTHECATION PROVISION
A similar re-hypothecation provision can be seen in MF Global’s U.S. client agreements. MF Global’s Customer Agreement for trading in cash commodities, commodity futures, security futures, options, and forward contracts, securities, foreign futures and options and currencies includes the following clause:

 “7. Consent To Loan Or PledgeYou hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate,loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.” 

In its quarterly report, MF Global disclosed that by June 2011 it had repledged (re-hypothecated) $70 million, including securities received under resale agreements. With these transactions taking place off-balance sheet it is difficult to pin down the exact entity which was used to re-hypothecate such large sums of money but regulatory filings and letters from MF Global’s administrators contain some clues.
According to a letter from KPMG to MF Global clients, when MF Global collapsed, its UK subsidiary MF Global UK Limited had over 10,000 accounts. MF Global disclosed in March 2011 that it had significant credit risk from its European subsidiary from “counterparties with whom we place both our own funds or securities and those of our clients”.
CAUSTIC COLLATERAL
Matters get even worse when we consider what has for the last 6 years counted as collateral under re-hypothecation rules.
Despite the fact that there may only be a quarter of the collateral in the world to back these transactions, successive U.S. governments have softened the requirements for what can back a re-hypothecation transaction.
Beginning with Clinton-era liberalisation, rules were eased that had until 2000 limited the use of re-hypothecated funds to U.S. Treasury, state and municipal obligations. These rules were slowly cut away (from 2000-2005) so that customer money could be used to enter into repurchase agreements (repos), buy foreign bonds, money market funds and other assorted securities.
Hence, when MF Global conceived of its Eurozone repo ruse, client funds were waiting to be plundered for investment in AA rated European sovereign debt, despite the fact that many of its hedge fund clients may have been betting against the performance of those very same bonds.
OFF BALANCE SHEET
As well as collateral risk, re-hypothecation creates significant counterparty risk and its off-balance sheet treatment contains many hidden nasties. Even without circumventing U.S. limits on re-hypothecation, the off-balance sheet treatment means that the amount of leverage (gearing) and systemic risk created in the system by re-hypothecation is staggering.
Re-hypothecation transactions are off-balance sheet and are therefore unrestricted by balance sheet controls. Whereas on balance sheet transactions necessitate only appearing as an asset/liability on one bank’s balance sheet and not another, off-balance sheet transactions can, and frequently do, appear on multiple banks’ financial statements. What this creates is chains of counterparty risk, where multiple re-hypothecation borrowers use the same collateral over and over again. Essentially, it is a chain of debt obligations that is only as strong as its weakest link.
With collateral being re-hypothecated to a factor of four (according to IMF estimates), the actual capital backing banks re-hypothecation transactions may be as little as 25%. This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing.
The lack of balance sheet recognition of re-hypothecation was noted in Jefferies’ recent 10Q (emphasis added):

 “Note 7. Collateralized Transactions
We pledge securities in connection with repurchase agreements, securities lending agreements and other secured arrangements, including clearing arrangements. The pledge of our securities is in connection with our mortgage−backed securities, corporate bond, government and agency securities and equities businesses. Counterparties generally have the right to sell or repledge the collateral.Pledged securities that can be sold or repledged by the counterparty are included within Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. We receive securities as collateral in connection with resale agreements, securities borrowings and customer margin loans. In many instances, we are permitted by contract or custom to rehypothecate securities received as collateral. These securities maybe used to secure repurchase agreements, enter into security lending or derivative transactions or cover short positions. At August 31, 2011 and November 30, 2010, the approximate fair value of securities received as collateral by us that may be sold or repledged was approximately $25.9 billion and $22.3 billion, respectively. At August 31, 2011 and November 30, 2010, a substantial portion of the securities received by us had been sold or repledged.
We engage in securities for securities transactions in which we are the borrower of securities and provide other securities as collateral rather than cash. As no cash is provided under these types of transactions, we, as borrower, treat these as noncash transactions and do not recognize assets or liabilities on the Consolidated Statements of Financial Condition. The securities pledged as collateral under these transactions are included within the total amount of Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. 

According to Jefferies’ most recent Annual Report it had re-hypothecated $22.3 billion (in fair value) of assets in 2011 including government debt, asset backed securities, derivatives and corporate equity- that’s just $15 billion shy of Jefferies total on balance sheet assets of $37 billion.
HYPER-HYPOTHECATION
With weak collateral rules and a level of leverage that would make Archimedes tremble, firms have been piling into re-hypothecation activity with startling abandon. A review of filings reveals a staggering level of activity in what may be the world’s largest ever credit bubble.
Engaging in hyper-hypothecation have been Goldman Sachs ($28.17 billion re-hypothecated in 2011), Canadian Imperial Bank of Commerce (re-pledged $72 billion in client assets), Royal Bank of Canada (re-pledged $53.8 billion of $126.7 billion available for re-pledging), Oppenheimer Holdings ($15.3 million), Credit Suisse (CHF 332 billion), Knight Capital Group ($1.17 billion),Interactive Brokers ($14.5 billion), Wells Fargo ($19.6 billion), JP Morgan($546.2 billion) and Morgan Stanley ($410 billion).
Nor is lending confined to between banks. Intra-bank re-hypothecation is also possible as evidenced by filings from Wells Fargo. According to disclosures from Wachovia Preferred Funding Corp, its parent, Wells Fargo, acts as collateral custodian and has the right to re-hypothecate and use around $170 million of assets posted as collateral.
LIQUIDITY CRISIS
The volume and level of re-hypothecation suggests a frightening alternative hypothesis for the current liquidity crisis being experienced by banks and for why regulators around the world decided to step in to prop up the markets recently. To date, reports have been focused on how Eurozone default concerns were provoking fear in the markets and causing liquidity to dry up.
Most have been focused on how a Eurozone default would result in huge losses in Eurozone bonds being felt across the world’s banks. However, re-hypothecation suggests an even greater fear. Considering that re-hypothecation may have increased the financial footprint of Eurozone bonds by at least four fold then a Eurozone sovereign default could be apocalyptic.
U.S. banks direct holding of sovereign debt is hardly negligible. According to the Bank for International Settlements (BIS), U.S. banks hold $181 billion in the sovereign debt of Greece, Ireland, Italy, Portugal and Spain. If we factor in off-balance sheet transactions such as re-hypothecations and repos, then the picture becomes frightening.
As for MF Global’s clients, the recent adoption of an “MF Global rule” by the Commodity Futures Trading Commission to ban using client funds to purchase foreign sovereign debt, would seem to suggest that it was indeed client money behind its leveraged repo-to-maturity deal - a fact that will likely mean that very few MF Global clients few get their money back.
Written with contributions from Jack Bunker and Nanette Byrnes.

Cocoa Collapse

Brief Rally, Then Complete Collapse

Amazing day! After a brief rally that cut about half the day's losses in half with about 45 minutes remaining in the session, the market completely collapsed with just 15 minutes left, making new lows for the day. The Dow finished down more than 200 points!

ECB Pours Cold Water on Stocks

WSJ Headline: Eurozone on Credit Watch

S&P Downgrade Watch Collapses Stocks

Bloomberg reported today that S&P will imminently place all 17 Euro area countries on downgrade watch. The Dow has sold off more than 140 points since then.

Unprecedented Coordinated Central Bank Interventions Stoke Stock Rally

Whisper rumors in the financial markets suggest that a major European bank was on the verge of collapse while we in the US were asleep last night. This was a massive coordinated intervention today by the central banks of China, Japan, Europe, Switzerland, and the United States. 37 major global banks' debt was downgraded yesterday by S&P shortly after the market closed.

Congressman Ron Paul released this statement this morning. I think he is absolutely correct in this. I couldn't have said it better if I was divinely inspired:


"Rather than calming markets, these arrangements should indicate just how frightened governments around the world are about the European financial crisis. Central banks are grasping at straws, hoping that flooding the world with money created out of thin air will somehow resolve a crisis caused by uncontrolled government spending and irresponsible debt issuance. Congress should not permit this type of open-ended commitment on the part of the Fed, a commitment which could easily run into the trillions of dollars. These dollar swaps are purely inflationary and will harm American consumers as much as any form of quantitative easing." -- Congressman Ron Paul
The Dow is up 400 points at this moment. Folks, do NOT misunderstand. This huge stock market rally today is a bet on INFLATION, not prosperity! This is an unprecedented intervention in the global financial markets by the central criminals -- also known as bankers -- as a panic move to stop what could be an imminent global banking meltdown.

This stock market rally is not due to expectations of renewed recovery. It is an oversized bet on massive inflation that will be the natural consequence of the excessive money creation and debt monetization that is being created.

Central banking and other monetary policy authorities are desperately trying to prevent what they see as certain calamity without such broad, coordinated, and extreme measures. What they fail to see in this short-sighted strategy is that with each succeeding threat of catastrophe, the magnitude and impact of it increases. They are just kicking the can down the road, with a bigger and more leaden can reappearing each time they do it. Don't be surprised if we see runs on banks before this crisis is resolved. They are already seeing bank runs (I've seen the photos) in parts of Europe right now just like the ones in the classic Jimmy Stewart movie, It's a Wonderful Life!

Stocks Leap As MSM Reports Strong Black Friday

S&P was up nearly 20 points!

U.S. Labor Market - More European Than Ever

Stagnation in the U.S. job market!

Swiss National Bank Intervenes, Market Not Convinced

The spike higher was the SNB intervention, but the market has subsequently sold off again, and both stocks and the Euro are now lower for the day.

Europe Blows An Ill Wind for Freedom

Stocks Collapse 80 points in Last Ten Minutes

Unbelievable sell-off! Stocks looked like they had put in a low and were scrapping to build some upward momentum, and then Bang!, a collapse and hard sell-off! Dow down 235 points at the close!

Dow Down 200, S&P Loses 22

Eurocrisis Deepens

The contagion is now pandemic!

Stocks Getting Trashed in Evening Trading

S&P down 15 points now! Very unusual for the Asian session!

Lovely Headlines, Bond Market Take Infusion From Spain

S&P 500 now down 13 points!

Up and Down All Night; Then Stocks Tank!

Stocks Take a Drubbing!

Richard Russell: Debt Bubble is Close to a Pin

Writing from rehab (after a hip replacement operation), 86-year-old Richard Russell of Dow Theory Letters fame said: “The world’s inflated debt balloon is moving ever closer to its fate – a pin. Anybody younger than 80 years old is used to viewing the markets like a rubber band; stretch it one way, and it will always bounce back. That’s the widespread thinking and acting. If a correction comes, don’t sweat it, the markets will come back and end up higher. That’s been the story and thinking since the year 1900.

“I’m saying that the economy and the markets have lost elasticity. We’re moving into the period where the markets will go down but they’ll no longer act like a rubber band, they won’t bounce back. This period lies ahead one or two years, or possibly even three. For this reason, timing, or when to buy bargains, is antique thinking. The big picture trumps all timing methods. The strategy now is to get out of debt and accumulate eternal wealth, which is gold and gem-quality diamonds.

“Federal Reserve money pumping has equated with a rise in stock market and numerous bubbles. When the Fed stops pumping the markets stall, as they are doing now.”

It's All About the Debt

S&P 500 is down about 20.