Wednesday, November 10, 2010

How bad is the Irish liquidity squeeze?

I am trying very hard to get my head around the Irish situation (see FT story below).

Is there a run on the Irish banking system and, if so, what stands between the banks and default? I assume that the ECB will continue to lend to Irish banks against Irish government bonds, but how much liquidity is needed and how much Irish exposure can the ECB take on?

What would be the terms of an IMF/EU bailout? Will Anglo-Irish Bank bondholders be protected? Will Merkel bail out Anglo-Irish? Will Trichet?

Will Irish government bondholders (the largest of which is most likely the ECB) be haircut?

I’ll bet euros to scones that the conference call wires are burning up in Brussels, Frankfurt, Berlin and Paris right now. “Europe” will have to come up with a solution to the Irish bank liquidity problem very quickly.

My best guess: the ECB will bridge the Irish banks pending the IMF/EU bailout. But, if the Germans say no, look out!

FT: Bond sell-off takes Ireland closer to tipping point

In the eyes of bond market investors, the prospect of an Irish bail-out, similar to that of Greece, is growing by the day. Yields on Ireland’s 10-year sovereign debt saw their biggest one-day surge since the launch of the euro on Wednesday, jumping more than half a percentage point to 8.64 per cent.
The extra cost of borrowing over the “risk-free” rate of Germany spiked to 6.19 percentage points, also a record since January 1999.
At the heart of the volatility in the eurozone bond market, according to investors, was a decision by one of Europe’s biggest clearing houses, LCH.Clearnet, to require banks or institutions wanting to use Irish bonds as collateral in the repurchase markets to raise cash to pay an extra margin of 15 per cent.
This, traders said, forced Irish banks to sell government bonds as they scrambled to raise the cash to meet the new margin requirements, sending a shudder through the market. The latest market moves comes at an awkward time for Dublin and the rest of the eurozone as financial markets move to price in renewed fears that one of the peripheral countries of Ireland, Portugal and Greece could default on their debt.
Don Smith, economist at Icap, said: “Irish bond yields keep on rising and today was yet more bad news. Investor confidence has been shaken in Ireland and the move by LCH.Clearnet is a very bad sign. It is potentially a tipping point that the Irish may find difficult to recover from.”
The repurchase, or repo, markets allow banks to access cash quickly and is fundamental to the way the banking system operates. In this market, banks sell their holdings of bonds to other banks in exchange for cash and a commitment to buy the bonds back for a marginally higher price at a determined point in the future.
At times of stress, banks can find themselves shunned by their peers because of fears over their solvency or else fears over the riskiness of the bonds that are being sold and repurchased.
Ireland, after the collapse of its property market in 2008, was one of the first eurozone countries to address the hole created in its public finances. But while bond markets reacted favourably at first, sentiment has since turned negative as the scale of its banking sector problems has been exposed
The LCH.Clearnet move means market participants would have to deposit cash with the clearing house equivalent to 15 per cent of their transaction as an indemnity against the risk of default. Market participants estimate that Ireland’s banks could have anywhere between €4bn and €8bn of bonds cleared through LCH.Clearnet.
One large hedge fund manager estimated that the banks would have to lodge between $1bn and $1.5bn in cash with LCH.Clearnet in order to avoid default and the forced unwinding of repo transactions. Some banks dumped bonds into the market in order to raise cash and buy other bonds that they could still repo.
The cost of insuring Irish government bonds against default, measured by credit default swaps, did not rise as sharply, however. Some participants, such as hedge funds, tried to exploit the arbitrage opportunity thrown up by this.
Any further impact may be limited. Some traders expect Irish bond yields will stabilise. If Ireland’s banks have been able to close out enough of their LCH.Clearnet repo transactions, they can turn to the European Central Bank, which only has a 5 per cent haircut.
“This has been a technical rather than a fundamental move,” said one macro hedge fund trader. But Ireland’s fundamental problem of anaemic economic growth and a troubled banking system that may need an increasing amount of money – more than a projected €50bn – to save it from collapse remains.
Even, if Irish bond yields have overshot, traders were drawing comparison with Greece in the run-up to its €110bn bail-out by the European Union and the International Monetary Fund.
As one fund manager said: “Economic reality will catch up with Ireland. Maybe in the new year. Then, it may well have to turn to the international community for help.”

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