Draghi's bazooka: subordinating or bailing out unsecured Eurozone bank debt holders

By re-affirming its right to avoid a write-down on its Greek sovereign debt holdings, the ECB has triggered a long second look at Mario Draghi's bazooka, also known as the Long Term Refinancing Operation (LTRO).

In his Telegraph column, Ambrose Evans-Pritchard observed

ECB boss Mario Draghi has sparked a blistering rally in global asset markets by lending banks as much as they want for three years at 1pc, but bond experts say the side-effects are toxic and the benefits are wearing off. 

"It's a sugar rush," said Alberto Gallo, European credit chief at RBS. "It lowers the risk of defaults, but also lowers recovery rates if things go wrong." 

Lenders must provide the ECB with collateral, at a haircut of up to 65pc, using up ever more of their balance sheets. The ECB has first claim on these assets, pushing other creditors down the pecking order. The longer it goes on, the worse it gets. 

"There is no such thing as a free lunch. Liquidity today comes at the price of subordination tomorrow," said Mr Gallo, warning that BBVA, BNP, Commerzbank, Intesa, Santander and Unicredit are all vulnerable....

I am not sure that I accept Mr. Gallo's analysis.

Remember that the event that triggered the need for the LTRO program was the freezing of both the interbank lending market and the unsecured bank debt market.  These markets froze because no one can evaluate the solvency or risk of any of the Eurozone banks.

The freezing of these markets was important, because the Eurozone banks have billions of euros of interbank loans and unsecured debt maturing.

The primary use of funds from the LTRO is to replace the maturing interbank loans and unsecured debt.

Clearly, as a senior secured lender, the ECB has a higher priority in a bankruptcy proceeding than the unsecured debt.  As Mr. Gallo observed, the unsecured debt holder has been subordinated.

However, this is a short term concern.  So long as the interbank and unsecured debt markets remain frozen, banks will continue to increase their LTRO exposure and pay off the maturing debt.  In the medium to long term, it is not too difficult to imagine the situation where the banks will have replaced all their interbank loans and unsecured debt with LTRO funds.

In addition, the concern over subordination assumes that each bank is solvent (the book value of each bank's liabilities minus the market value of each bank's assets does exceed the current book value of its equity).

If the banks are not solvent, subordination is not a problem as the banks do not have the capacity to repay the unsecured debt holders if the banks were liquidated instead.

Said a slightly different way, the unsecured debt holders are holding positions that are worth less than the par value they receive as a result of the LTRO funding.  In this case, the LTRO is actually a bailout of the unsecured Eurozone bank debt holders.

Back to the Telegraph column.

Mr Gallo said the LTRO has badly eroded the capital structure of banks, pushing many over the edge towards junk status....

In the absence of ultra transparency, it is not clear that the capital structure of the Eurozone banks is not already junk.  That is what the frozen interbank lending and unsecured debt markets are telling us.

Huw Van Steenis, Morgan Stanley's bank strategist, said the bazooka is no panacea even though it has averted a shock as lenders slash loan books in a frantic rush to meet core tier one capital ratios of 9pc by June. "The LTRO will not stop the Great Deleveraging," he said.