Wednesday, October 24, 2012

European Officials as the Source of Convertibility Risk

ECB President Mario Draghi identified convertibility risk as the source of increasing yields in Spain and noted the ECB's mandate and determination to address it since there should be no convertibility risk in the euro.  Under the relevant treaties, membership in the EMU ranges from "irrevocable" to "irreversible".    Nevertheless, the risk of a euro exit by Spain concerned depositors and investors in Spain.  What explains this?

In early May, there was a spate of remarks by European officials that could have affected perceptions of the irrevocability of the euro:
  • On May 8, in the wake of the first round of Greek elections, ECB Governing Council member Jorg Asmussen threatened: "Greece needs to be aware that there are no alternatives to the agreed bailout program, if it wants to stay in the euro zone."
  • On May 10, similar comments followed from European Council President Van Rompuy and European Commission President Barroso (EU Turns the Screw on Athens...).  
  • On May 11, in response to a question of whether Greece could be forced from the EMU, Barroso amplified: "Look, if a member of a club, I don't want to talk about a particular country, but if a member of a club does not respect the rules, it's better that it leaves the club...."
  • At the May 14 Eurogroup meeting, Eurogroup head Jean-Claude Juncker warned his colleague Greek Finance Minister Filippos Sachinidis: "If we now held a secret vote about Greece staying in the euro zone…there would be an overwhelming majority against it."
That these comments came from European officials was surprising, as they are creatures of the collection of treaties that make the euro irrevocable.

A measure of the interest of Spaniards in this topic is the frequency of searches from Spain in Google for "exit from the euro" without mentioning Greece and "open an account in Switzerland".  (We recognize that the share of population that does these searches is small.)  This graph overlays these measures on a chart of the 2-year yield spread between Spain and Germany:

People had discussed Greece's departure before Asmussen’s speech, but the idea that the ECB and EU officials could cause it was new.  Depositors and investors in Spain, already concerned by bank solvency, may have thought that this casual treatment of euro membership could apply to Spain as well.

Draghi attempted to repair the damage  on May 16:
"While the ECB will continue to comply with the mandate of keeping price stability over the medium term in line with treaty provisions and preserving the integrity of our balance sheet, I want to state that our strong preference is that Greece will continue to stay in the euro area."
This failed to stop the rise in Spanish yields.   ECB changed "strong preference" to "immutable preferencetwo days later, with little effect.  It's difficult to counter effectively what appeared to be the broad-based view of EU officials.

A further round of stress in Spain began during the week of July 16, when news that the Troika would be inflexible in its upcoming visit to Greece reignited concern over Greece's ejection.  This began with a leak of a draft Troika report describing the "awful" situation in Greece. Reports of the Troika's inflexibility grew during the week.  This culminated over the weekend of July 21 when three senior German government ministers said there would be no flexibility and suggested that Greece should leave the euro.

On July 26, Mario Draghi indicated that the ECB would "do what it takes", which became the OMT program to buy bonds of countries with convertibility risk premia.  Draghi's dramatic move was intended to respond to a crisis perhaps triggered by his own contemporaries.


Preview of Forthcoming Post: 

Convertibility risk isn't the only cost of a Greek departure.  Presumably unconsidered by the officials who spoke of Greece's departure was the effect on the ECB's balance sheet.  Given the ECB's exposure to Greece through Target2 of about €120bn, a loss of that would have left the ECB with negative equity of about €-100bn, not counting any SMP losses.  (The ECB's exposure to Greece is not collateralized.)  Since the provisions of the treaty ( PSESCBECB Articles 10.3, 28.1, 32.4, 33.2, and Council Regulation 1009/2000) require a  weighted 2/3 vote to go beyond modest recapitalization or loss sharing in the event of a large ECB loss, the ECB could be stuck with negative capital.  This would be awkward at best. 

Tuesday, October 23, 2012

Convertibility Risk - Cherry Picking* Interest Rate Spreads

ECB President Mario Draghi explained that the OMT program to buy sovereign bonds was within the ECB's mandate because unfounded fears of a euro exit had caused excessively high yields in Spain and Italy. Speech to the Bundesverband der Deutschen Industrie, September 25, Berlin:

"In recent months, we have seen highly divergent borrowing costs for the real economy in different parts of the euro area. In our analysis, these differences were larger than justified by individual credit risk. They reflected, to a considerable extent, unfounded fears about the future of the euro area.
For example, a loan to a family in Germany for a house purchase with a five- to-ten-year maturity had an interest rate of 3%; the rate for a comparable borrower in Spain was 7.5%. At the same time, the average firm in Germany paid around 3% for a new loan over five years, while the average firm in Italy paid above 5.5%.
In these circumstances, monetary policy cannot work properly. This is because a key channel through which the ECB ensures price stability is through the cost of credit, in particular bank credit. Bank credit accounts for about 70% of external financing of euro area firms, and that ratio is even higher for smaller enterprises.
But if we are unable to influence borrowing costs in some parts of the euro area, this channel is disrupted. Firms and households have less access to financing, economic growth stalls and these regions are faced with a risk of deflation. In other words, our ability to ensure price stability for the whole euro area is compromised.
The ECB’s Governing Council therefore faced a choice: to accept this situation and allow the singleness of its monetary policy to be undermined; or to take actions within its mandate to restore the normal transmission of monetary policy across all parts of the euro area. We decided in favour of the latter."

Mortgage Rates in Spain

"For example, a loan to a family in Germany for a house purchase with a five- to-ten-year maturity had an interest rate of 3%; the rate for a comparable borrower in Spain was 7.5%." 

The ECB picks the red line to demonstrate the presence of convertibility risk:

The ECB chose a persistent outlier to make this point. Both longer and shorter maturities had much lower rate differences than did their category.

Strikingly, the chosen maturity category has de minimis volume in Spain:
(Source: Banco de Espana)

The fact that most new Spanish mortgages appear to have maturities of up to one year should not surprise us. As the European Mortgage Federation observes, the vast majority of outstanding mortgages have rates that float to Euribor. The Banco de Espana notes, "a 15-year loan at an annually revisable rate is classified under the term 'Up to one year'." 

While the difference between five-to-ten year Spanish and German mortgage rates in July was 4.5%, it was between 0% and 1% for the categories with reasonable volume in Spain.  We can fit both convertibility risk and "individual credit risk" into a 4.5% spread, but less easily into a 1% spread.

Corporate Loan Rates in Italy

"The average firm in Germany paid around 3% for a new loan over five years, while the average firm in Italy paid above 5.5%"

To demonstrate the existence of a convertibility risk premium, the ECB again picks the widest spread. 

Though the chosen series has meaningful volume, the over five-year spread, 2.5%, is twice as large as the up to one-year spread. 

The ECB has pointed to Spanish mortgages and Italian corporate loans as cases of a convertibility premium. Such a premium should manifest in all Spanish rates, including corporate loans.  

We present the spreads of corporate loans in Spain over Germany, which the ECB did not discuss. Notice that there are no outlying series. 

Now let us compare the spreads of both countries to Germany:

The ECB's choice of the 2.5% spread in Italian over five-year loans looks even more like cherry picking when one sees that the weighted average rate spread of new loans is around 1%, and has been all year. 

The data starting in the fall of 2008 show that Spanish and Italian borrowing costs declined vis-a-vis Germany through 2009, and did not start rising from negative levels until spring, 2010. The period of negative spreads in 2009-10 might make one question the ECB's numbers, or recall how German landesbanken had an unsolved problem of toxic assets and a shortage of equity capital, while Spanish authorities were the paragon of thoughtful banking regulation. 

Note the recent spread levels: Italian banks have loaned euros to corporations at 100 basis points over Germany rates since December, 2011. And while Spanish corporations saw their rates rise as high as 125 basis points over German corporations in May, the first quarter was lower, and rates did not persist at that high point. Indeed, the same problem from the mortgage example applies here: a 100 basis point spread is simply not wide enough to capture both convertibility risk and "individual credit risk". 

Thus these comments should not be taken as skepticism of a convertibility premium in these rates**. However, we do not think the data presented justify such a finding. 

* Probably unintentional. Cf. confirmation bias.

**There are aspects of the data that we do not understand. For example, initially floating-rate mortgages of all maturities are categorized as 'up to 1 year' mortgages. We do not yet know the maturities or structures of such loans, and how they can be compared across countries. This is also true for corporates. 

Friday, October 12, 2012

Spanish Deposits

A chart from the Bank of Spain showing average rates paid on new deposits by banks in Spain through August 2012 (term and overnight).  Do these rates evince a banking system desperately trying to hold onto fleeing deposits?