LTRO only masks insolvency, says Old Mutual bond manager

Some managers call LTRO, the European Central Bank’s cheap loan program, ‘Mario’s Magic Medicine’, after European banks took advantage of Mario Draghi’s offer of unlimited three-year finance, to the tune of more than €1trn.

But for Christine Johnson (pictured), manager of the Old Mutual Corporate Bond fund, the ECB president’s offer is “unlikely to be enough to resolve the underlying insolvency” that could affect European banks soon.

Johnson is investing more in UK banks as a result of her views, and highlights Nordic banks as another good example of a healthy system.

She acknowledges that LTRO was “a critical moment certainly for Europe and probably for the global economy”. Without it, “the financial system as a whole and indeed a number of sovereign states might well have collapsed for lack of funds”.

The relief rally on equity markets early this year and in bank yields suggested investors were also grateful.

“However, as we learnt from Greece, liquidity will only mask insolvency for a short period of time. For our own part, we expect more problems from our Continental cousins in fairly short order,” Johnson says.

Many banks used the cheap cash in the so-called ‘Sarkozy trade’ of borrowing at 1% and lending to peripheral European governments at 5% or more.

As a result, eurozone bank holdings of Italian sovereign debt increased by 13% and of Spanish sovereigns by 29%.

“These are substantial increases, and tighten the bank/sovereign umbilical cord in these countries,” Johnson says.

However, it has helped the sovereigns as the 10-year Italian bond yield fell 2% so far this year to around 5%, “well within the critical 7% mark”.

“But the assumption has to be that this net new money has gone a long way to being spent already and we may well see the effect wear off in the Spanish and Italian sovereign bond markets fairly soon.

“At a simplistic level banks are a levered version of the economies in which they operate. As austerity bites and both households and corporates experience rapid debt deflation, banks in the GIIPS countries will suffer the brunt of the economic strain.

“Add to this the increase in their sovereign debt holdings and it becomes apparent that banks in the GIIPS are a toxic mix of poor quality loan books, low and decreasing levels of solvency, falling house prices, increasing unemployment and questionable sovereign debt holdings.”

In Johnson’s view, ECB president Mario Draghi has “tried his hand at reflation, however, with such a poor economic outlook it seems unlikely that the credit officers at banks in the GIIPS will suddenly start increasing lending to a dwindling pool of credit-worthy borrowers.”

She describes the previous attempt at banking M&A in Spain to “cleanse the system” as “a dismal failure”.

She expects bank lending in Spain to contract for a second year running in 2012.
Spain now has a non-performing loan ratio of 7.9%, and house prices falling 11% over the year to January, and unemployment at 23%.

“For these reasons we prefer to stay ‘closer to home’ when it comes to investing in European banks. The relative safety of UK banks versus their eurozone peers is striking. Debt deflation in the UK is not nearly as pronounced, in part due to the extent of the Bank of England’s quantitative easing policy.

“Add to this the limited exposure of the UK banking system to southern Europe and the aggressive recapitalisation and restructuring of banks that took place here in 2008, and UK banks look even more attractive relative to their European peers. Asset quality in the UK is on a positive trajectory which will lead to improvements in profitability and capitalisation in the next few years.”

She also mentions Nordic banks as a relatively isolated example of a healthy banking system in Europe, with Nordea deserving specific mention.

“In time, the current financial crisis may also produce banks of similar quality to Nordea in countries we currently avoid. But for now we feel it prudent to acknowledge that the added liquidity of the LTRO has not resolved the crisis. It is only masking insolvency.”


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