STOCK MARKET WATCH - Friday, 3 February 2012

[Demeter]

21. The perils of Mario Draghi's €1.5 trillion blitz By Ambrose Evans-Pritchard

http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100014543/the-perils-of-mario-draghis-e1-5-trillion-blitz/

The raging debate over Mario Draghi’s credit rescue has refused to die down...A disturbingly large number of credit experts warn that the ECB life-line is not the "game-changer" that the markets seem to think, cannot in itself can save Euroland, and may prove counter-productive – perhaps soon. This is not what I suggested in my Monday column. Since I have a special affection for the monetarist camp, I tilted to their view in that the ECB has indeed carried out a coup and may have pulled Europe of spiralling depression, just in the nick of time. (This does not mean it can ever save monetary union in its current structure, but that is another matter.) Yet we are in uncharted waters, so here is the critique of the other side.

Alberto Gallo from RBS said Draghi’s €489bn loans to banks at 1pc for three years (LTRO) is having all kinds of toxic side-effects, which is disturbing given that the Financial Times splashed today that the banks may draw down another €1 trillion at the second LTRO in late February The banks are certainly stepping up purchases of Club Med and Irish sovereign bonds, the so-called Sarkozy "carry trade". They also bought 62pc of the latest debt issue by the EFSF rescue fund in January, up from a quarter in the previous issue.

"Most peripheral banks now hold more government bonds than their equity, which makes them a levered option on sovereign risk. While earning more carry, banks holding more sovereign bonds than others also pay more in funding. The economics of the sovereign carry do not work in the medium term," he said.

The shortfall on the banks’ core Tier 1 capital ratios outweighs the extra yield from the sovereign bonds. That will aggravate the credit crunch over time. Mr Gallo expects €5 trillion in deleveraging by European banks before it is over. While the banks are buying more sovereign debt, they are cutting credit to the rest of the economy, with falls of 2.4pc in Italy and Portugal in December, and 0.8pc for the eurozone as a whole. The whole LTRO scheme increases "debt cross-holdings and systemic risk", and ultimately lowers recovery rates for creditors. Mr Gallo thinks the next spasm of the crisis may hit as Italy redeems €97bn in February and March, and Spain redeems €30bn, with Portugal sliding into ever deeper debt as the economy contracts violently.

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ANY WAY YOU SLICE IT, IT'S STILL INSANE