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European Banks Running Out of Options to Raise Liquidity

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As the ECB has been draining excess liquidity out of the European banking system, their money supply is shrinking along with it.

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Peter Atwater's piece (see Why European Banks Are Issuing Debt in America) was a good primer on what (or who) has been driving a large piece of the issuance action, European banks. It was so good in fact, I'm going to refer to it at various points here as I expound upon what he wrote. And by refer, I of course mean I'll use it prolifically, but attributing his piece all along the way. It's just good manners and it boosts my word count effortlessly.

First, let's start with the debt issuance itself: Yankee bonds. Yankee bonds are dollar-denominated bonds issued by foreign borrowers. And as Atwater noted, Yankee bonds have made up a large portion of the issuance so far this year. More than two-thirds, in fact.

So I was curious. I started trying to find data on Yankee bond issuance, in the hopes I could put something into a neat, groovy chart. I stumbled across this article from the Financial Times from August of last year, and it had this infographic:

Cheap Dollar Debt Chart

So, what does this show us? Well, Yankee bond issuance was rising before the crisis, and that European banks were also relying on Yankee bond issuance more heavily. Then the crisis hit. And now? It's gotten even more pronounced and another dependency: cheap dollar-denominated funding. Like a cokehead trading in his or her local coke dealer for the crack dealer and a crack pipe, our European banking counterparts have a new drug, and judging by the chart, they likey.

But here's the key: By issuing bonds, the banks are looking to raise long-term funding instead of just taking advantage of uber-cheap short-term funding at ultra-cheap funding rates. Indeed, one of the issues talked about in the credit crisis was the reliance on brokered deposits by banks. Brokered deposits are deposits that are too big to get deposit insurance and are usually provided by large corporations and money market mutual funds. They fall into a broader category of bank funding known as wholesale funding, which also includes short-term financings like fed funds transactions and possibly repos.

And if you take a look at money supply, you can see there's reticence out there in wholesale funding. Still. This is a chart of year-over-year growth in M2 and MZM.

M2M Money Stock and M2 Money Stock Chart

MZM is M2 plus money market funds, which the Fed started tracking when they stopped tracking M3. M3 was M2 plus large time deposits, institutional money market funds, short-term repos and other liquid assets. But what you see here is the rise in money market funds in '07 was higher than M2 and the collapse was greater as well. Bigger swings in risk appetite and a more volatile funding base as a result. Not what you want to hang your hat on for funding.

But the lack of wholesale funding explains one thing: the lack of stress we see in traditional funding markets. Take a look at these charts, which compare Euribor and Libor as well as the spread between the two rates:

Euribor vs Libor Chart

Euribor Libor Spread Chart

While the Euribor-Libor spread never went back into negative territory the way it was in the aughties expansion (The Fed raised rates while European funding rates lagged behind, creating a negative spread between the two rates), we're not seeing the stresses we saw in the credit crunch either. The world we live in now is indeed very different than it was before. Funding risk is now The New Phantom of the Opera, both beautiful and tragically flawed, afraid of revealing its identity or location. In effect, the world is riskier now because the risk is less apparent.

But if you look at the spread chart, you see it is indeed rising again. And as Atwater succinctly states, "European banks, particularly those with strong names and high debt ratings, have come here to issue, hoping that US investors -- particularly retail investors -- are unaware." So the risks are increasing, but only if you care to look.

But what is the risk? Simple: liquidity. Because as the ECB has been draining excess liquidity out of the European banking system, their money supply is shrinking along with it. The last chart I will leave you with is a chart of M3 in Europe:

Eurozone M3 Chart

The parabola that characterized money supply growth is no more. So this corroborates Atwater's remarks about reduced wholesale money supply in Europe as well.

Which has led to a stronger euro. So in short, the euro strength is not a sign that the sovereign debt issue is closer to resolution; it's a sign that European banks are running out of options to raise liquidity.
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