Euro Zone Capital Flight - NY Fed Blog Post - Award for Solving the Riddle

The New York Fed, on its well-written blog, Liberty Street Economics, has posted Capital Flight in the Euro Area - NY Fed Research.   The post describes capital flight in the euro area during the crisis, and the accommodation of the flight in the Target2 payment system.   Their description is hard to square with the graph below which shows capital flight from Spain to be negatively correlated with the level of stress.   For example, capital flight in a low stress month, March, was four times as large as during November, the highest stress month in the period shown.  The data for all of 2011 and 2012, for Spain and Italy, more broadly show unexpected timing of capital flight.

We will pay $5,000 to the first person who, in the next week, correctly explains the conceptual error in the blog post that is highlighted by this riddle.  (Persons who have heard the explanation from us aren't qualified for payment but are most welcome to respond.)   Please submit answers to wolfgang@antehoc.com.  

From the Archives, this circulated in April, 2010 - A Parody of the SEC's Goldman Sachs Complaint. (The footnotes are factual, as is the Bloomberg quote on Paulson and the graph of subprime prices.)

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We select sublime securities for our clients and ourselves.  We have dedicated substantial resources to the analysis of sublime securities and have one of the world’s largest portfolios, outside of Federal Reserve System regulated banks.  We are proud of our record, having taken no write-downs on any of the securities we have purchased.²

We seek to purchase entire portfolios of sublime securities opportunistically with particular focus on motivated sellers.  We believe that the ability to purchase entire portfolios provides us a significant price advantage because of the certainty it provides the seller.  We prefer to negotiate directly with sellers in order to garner detailed information on their analysis from the process of suggesting, discussing, deleting and replacing securities in the prospective sale.³ 

We value our reputation.⁴   We believe in our analysis and we often invest more in a transaction than all of our clients combined.⁵

While all investment strategies have risks, our strategy has some unusual risks.  Clients should carefully review the Risks section.

Bundesbank Letter to German Constitutional Court - English Translation

The following is an English translation of the Bundesbank's letter to the German Constitutional Court that was published by Handelsblatt.  We welcome comments on translation issues and otherwise.

Bundesbank                                                                                              December 21, 2012

Statement to the Federal Constitutional Court of Germany regarding the lawsuits with file reference 2 BvR 1390/12, 2 BvR 1421/12, 2 BvR 1439/12, 2 BvR 1824/12, 2 BvR 6/12

A.  Introduction

Within the Monetary Union of the European Union, the monetary policy framework is given by the Maastricht Treaty and the legal acts based thereon. The general principle is a stability-oriented monetary policy with the goal of price level stability which is implemented by independent central banks and to whom monetary government financing is prohibited. This reflects the experiences of those central banks which prior to the Monetary Union were independent, and able to ensure monetary stability  with a focus on price level stability. The narrow and clearly defined mandate of the central bank system recognizes the  particular constellation of the Monetary Union: a community of countries which have assigned responsibility for monetary policy over to the supranational level, but which continue to decide on fiscal and economic policy primarily at a national level, and which deliberately did not enter into a liability or transfer union. Within this scope, the protection of the common monetary policy, from, for example unsound government financing of some member states,  is ensured by the exclusion of liability for other member states, the prohibition of monetary government financing as well as the independent role of markets in the evaluation of the solvency of member states of the Monetary Union, which derives from their individual fiscal responsibility. The latter is expressed by the respective risk premia governments incur when borrowing on capital markets.

The financial and economic crisis since 2007 as well as the debt crisis in some member states of the common currency area since 2009 witnessed a considerable enlargement of the range of monetary policy instruments employed, and a strong expansion of the balance sheets of Eurosystem central banks. With these measures, the Eurosystem has made a substantial contribution to the containment of the crisis. The Bundesbank endorsed many  of the measures taken. However, the Bundesbank considers some decisions as very problematic, and has also publicly stated its criticism.

Against the background of the arguments and views newly presented during the cases at the Federal Constitutional Court of Germany, the Bundesbank hereby completes its statement. This statement focuses on the purchase of government bonds by the Eurosystem, the  TARGET2 balances, and the resulting risks of losses for the federal budget.

Why is the Legal Documentation for OMT Important?

In today's ECB Press Conference, the FT's Michael Steen asked whether the legal documents for OMT were available.  

Draghi's answer:

The second point, about the legal documentation on the OMTs, is that it is ready and is about to come out. Not today, no, but frankly, you ask me this question every time and I cannot really see the issue. What is the issue about that? Anyway, if it becomes an issue it is ready to come out. If it has to be an issue it is ready to come out. We never thought that it would be an issue.

You can also see Draghi's response here at around 29:45. 

In connection with the Greek bonds that the ECB bought, the ECB claimed an inability to accept pari passu status as a result of the prohibition on monetary financing.  However, the ECB claimed to be able to be pari passu in OMT.   So the documentation is important.   In its original press release on OMT the ECB commented:

Creditor treatment

The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

The ECB has yet to "clarify in the legal act concerning [OMT]" in what way it will accept pari passu treatment with private creditors.     

Since it may require analysis and feedback, a release earlier than possibly during a crisis is sensible.   What is the benefit of the ECB's opacity on this straightforward matter?

[Update 2013.6.9:  Perhaps the ECB doesn't want to provide clarity before the BVerfG decision.   FAZ reports that the ECB has communicated to the court that the program is limited.   The ECB is also trying to create rules that keep OMT from appearing to circumvent the prohibition on monetary financing that could be triggered by buying right after a primary bond issuance.]

Three-Year LTRO - Claiming Undue Credit

Speaking in London Thursday (at 8:53), ECB President Draghi made the following claims about the impact of the three-year LTROs  (deviations from the ECB published text are in red  (published text): 

"In late 2011 and early 2012 we launched two 3-year long term refinancing operations which we called LTROs. These operations [Our LTROs]  gave banks sufficient reassurance that access to liquidity will not be a problem over a relevant planning horizon. We injected about €1tr, gross injection of liquidity with two operations which took place, one in January [sic] and the second in February of 2012.  60% of this has been repaid already. Without these operations, banks would have defaulted on their maturing obligations or would have discontinued and withdrawn existing credit lines to companies. One should remember that in the first quarter of 2012 €230bn of bank bonds were maturing and more than €300bn of soveign bonds were maturing.  That's why banks in fact stopped giving credit starting in July of 2011, and that's where a good deal of the current credit crunch comes from.  The LTROs therefore helped to avoid a major credit crunch."

This is consistent with previous claims Draghi made about how the LTROs prevented a credit crunch due to refinancing difficulties in the first quarter of 2012:

• "[E]specially the LTROs, basically avoided major disasters which were looming ahead of the funding crunch that characterised the first quarter of this year. As I have told you many times, there were bank bonds worth about €230/€260 billion falling due." December 2012
• “Let us not forget that in the first quarter of this year, more than €200 billion of bank bonds fall due. So this decision certainly prevented a potentially major funding constraint for our banking system, with all the negative consequences this might have had on the credit side.” January 2012
• “[W]ith the first LTRO, we avoided a major credit crunch.  I have already said that  €230 billion worth of bank bonds were coming due in the first quarter… [t]he LTRO addresses the quantitative shortages and liquidity constraints of certain parts of the euro area financial and banking system.” February 2012

ECB Revenue in the Case of a Low Risk Balance Sheet

In order to assess the ECB's ability to replenish capital in the event of a large loss, we estimate the ECB's low risk revenue going forward. This measure excludes interest income from the purchase of sovereigns, but also the potential losses from those purchases. The result is expressed in terms of a function of the MRO rate (the policy rate).

The low risk income consists of:

• The MRO rate applied to 8% of the Eurosystem's outstanding banknotes (€73 billion* at the end of 2012).
• Interest income on its all-in equity of €39bn; this includes capital and reserves, provisions and the revaluation account, at the MRO rate.
• Interest on foreign exchange reserves minus remuneration of the NCBs at .85% of the MRO rate for those reserves. This totals about zero. (The ECB lost around €100 million on this in 2012.)

The low risk revenue of the ECB is €113 billion x MRO rate.

This is about €.85 billion at the current MRO rate.

TARGET2 Income

There is net income of zero to the ECB on its offsetting TARGET2 assets and liabilities to NCBs, except in the case of a TARGET2 loss to the ECB (e.g., from a country departure and repudiation). (The ECB does report an imbalance in its TARGET2 assets and liabilities that is derived from fx swap transactions, but these transactions are matched  and should earn the ECB no income; see note 6.2 in the annual accounts, link below.)

*ECB 2012 Annual Accounts

TARGET2 Loss Sharing - Applicable Treaty Provisions

A TARGET2 loss to the ECB might occur with the departure of a Eurosystem member accompanied by an expectation of less than full recovery of the TARGET2 liability.   

A loss recognized by the ECB would first be offset against the ECB's capital, reserves, provisions and perhaps the revaluation account.  Recognition of a large loss, such as might have resulted from a departure of the Bank of Greece from the Eurosystem, could leave the ECB with negative equity.   

ECB losses can be shared by the NCBs under Article 33.2 of the statute, pursuant to a Governing Council vote, in an amount up to the Eurosystem's monetary income for the year of the loss.   (It isn't clear whether the ECB can recognize parts of the loss each year in order to expand NCB loss sharing beyond the "relevant year" specified in the treaty.)

If the ECB has negative equity after an Article 33.2 vote to share losses, an addition to ECB capital might be considered.   Under Article 28.1 of the statute, a capital increase requires votes by the ECB's Governing Council and the 27 finance ministers of the EU, sitting as Ecofin.   The ECB vote requires a qualified majority: two thirds, capital key-weighted and half of the shareholders (Article 10.3).  Assent of Ecofin also requires a qualified majority.  Under simplifying assumptions, until March 31, 2017, a qualified majority for a proposal by the European Commission would require at least half of the countries, with 75% of weighted votes and 62% of population.   In contrast, a recommendation from the ECB would require two thirds rather than half of the countries (TEU, Provisions Concerning the Qualified Majority, Article 3).   Starting April 1, 2017, the Ecofin vote will require 55% of the countries with 65% of the population if proposed by the European Commission, and 72% if proposed by the ECB (TFEU, Article 238).

In the event of a Eurosystem dissolution, since no obligation to share TARGET2 losses among NCBs precedes the dissolution, there is no claim to make after dissolution.   Rather, TARGET2 is just a claim against the ECB.  As a result, in the event of a dissolution, TARGET2 claims are shared among NCBs only to the extent those losses could be offset against paid-in ECB capital.

Article 32.4

It has been argued by the Austrian Central Bank, Buiter/Rahbari and perhaps others that since TARGET2 liabilities resulted from monetary policy operations, they should be shared under Article 32.4.  This wouldn't be true for:

- ELA amounts, which can be large for a departing NCB.

- In the case of an exit, where the NCB's losses result from redenomination of its TARGET2 liability rather than from losses on collateral resulting from loans to failed banks.   A country might be exiting in part to preserve the viability of its banks in which case there wouldn't be 32.4 eligible losses.

- In addition, using 32.4, which pertains to member NCBs, to compensate for losses at a non-member NCB would be open to legal challenge.

Loss Sharing in the Eurosystem - Excluding Target2 Losses

Monetary Policy Operations Loss Sharing Among NCBs

Monetary policy operation losses are not automatically shared among Eurosystem NCBs.  They are shared only pursuant to an ECB Governing Council vote, which need not be pro-forma.

Article 32.4 of the ESCB Statute:*

...

The Governing Council may decide that national central banks shall be indemnified against costs incurred in connection with the issue of banknotes or in exceptional circumstances for specific losses arising from monetary policy operations undertaken for the ESCB. Indemnification shall be in a form deemed appropriate in the judgment of the Governing Council; these amounts may be offset against the national central banks' monetary income.

Despite the plain language that a vote is required, Eurosystem official publications claim that this loss sharing is automatic:  

Updated as of Q3 2012** French/German bank exposure to Spain and Italy

With data through the third quarter of 2012 the trend remains the same - French and German banks continue reducing exposure to Spain and Italy.  As a reminder - Data is from the BIS consolidated banking statistics table 9D which shows exposure on an ultimate risk basis.  The value is reported in dollars but it includes claims in all currencies.

Eurosystem Seniority in OMT?

At the announcement of the ECB's "Outright Monetary Trasanctions" (OMT) in September an accompanying press release stated that any purchases by the eurosystem would not be senior to private creditors:

Creditor treatment

The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

As of yet, there has been no clarification.  

Subsidized Haircuts in Eurosystem Refinancing

In his November 26 speech to the Hyman P. Minsky Conference in Berlin, ECB Executive Board Member Peter Praet said that the Eurosystem's collateral framework lets the private market decide which assets to post as collateral.  In contrast with the Fed's asset purchases, he argues, Eurosystem refinancing operations do not favor certain assets over others.

Asset purchases directly create scarcity in the instrument being purchased. This exerts an upward pressure on prices, and, through portfolio rebalancing effects, may also affect the prices of other assets. However, direct asset purchases involve a difficult choice for the central bank: it must take a decision on which assets to buy, necessarily interfering with relative asset prices and income distribution.

Collateralised lending involves such decision only at the level of the definition of the collateral and its eligibility conditions. This can also influence the prices of collateral, but the role of selecting which assets to buy or sell is essentially “outsourced” to the banking system, that is, to many private agents. Hence, collateralised lending leaves the price discovery process and the allocation of savings to market mechanisms.

Praet's description minimizes the Eurosystem's role in favoring certain assets over others.   The Eurosystem expresses a variety of preferences in the selection process for collateral.  Many of these preferences, expressed by the size of haircuts, may be similar to the private market.  But as the Euro area has seen increased volatility in its sovereign debt markets a haircut gap with the private market have emerged.

As an example, Spanish 2 year debt is haircut 3.5% at LCH and only 1.5% at Eurosystem operations.  Spanish 8 year debt is haircut 10.25% at LCH and only 4% by the Eurosystem.  If the LCH is any proxy for the rest of the private market it is not difficult to understand why Spanish banks have done more of their refinancing at the Bank of Spain as volatility (and thus private market haircuts) in Spanish sovereign debt began to rise late last year.  The subsidy, in comparison with the private market, is evidence that the Eurosystem does not "essentially 'outsource'" decisions on asset purchases.

Haircuts in eurosystem refinancing operations

LCH Haircuts as of 11/30/2012

Link - debt default as solution to euro crisis

A good analysis from last Wednesday's Irish Times by Ashoka Mody of Princeton

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 preference" two 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. 

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:

(Source: ECB Statistical Warehouse. Spain: Up to 1 year, Over 1 and up to 5 years, Over 5 and up to 10 years, Over 10 years; Germany: Up to 1 year, Over 1 and up to 5 years, Over 5 and up to 10 years, Over 10 years)

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. 

(Source: ECB Statistical Warehouse. Italy: Up to 1 year, Over 1 and up to 5 years, Over 5 years; Germany: Up to 1 year, Over 1 and up to 5 years, Over 5 years)

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. 

(Source: ECB Statistical Warehouse. Spain: Up to 1 year, Over 1 and up to 5 years, Over 5 years; Germany: Up to 1 year, Over 1 and up to 5 years, Over 5 years)

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

(Source: ECB Statistical Warehouse. Spain: Total maturity, total amount; Italy: Total maturity, total amount; Germany: Total maturity, total amount)

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. 

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?