All That Glitters / The New Game of the European Bankers

Experienced traders know that periods of crisis and violent market swings create opportunities for investment. Take, for instance, the interest rate deal every European banker is talking about.

Experienced traders know that periods of crisis and violent market swings create opportunities for investment, sometimes opportunities that are practically risk-free. Take, for instance, the interest rate deal every European banker is talking about.

It began when French President Nicolas Sarkozy declared a special credit window for European banks. They could get credit for three years from the European Central Bank, under a program called Long Term Repo Operations.

Spanish Roulette, gambling, casino - Bloomberg (sourced 18.12.11)

The idea was to extend liquidity to the banks to get them through the lean times. The mechanism allowed banks to use a broader range of assets to secure the loans, including of course bonds issued by their own government.

There's the rub. Say you're a Spanish bank. You'd love the chance to buy Spanish government bonds on the market, dead cheap. They're currently generating yields of 5% to 6% a year. You pay for them using the credit line, which costs all of about 1%. Your interest rate profit, or carry trade in market argot, is about 4% a year, which is a bonanza in these horrible times. Just about everywhere else banks are losing money hand over fist.

And that is apparently exactly what happened in Europe's bond markets on Friday. Spanish bonds maturing in five years soared in morning trading to a price level reflecting a return of "only" 4.26% - nearly 50 points less than at the start of the week. Something similar, if less extreme, happened with Italian government bonds before a late sell-off wiped out some of the gains.

What caused this? Buying by European banks, as well as by speculators and hedge funds that read the map and jumped on board. We can expect the banks to close the circle this week, when the ECB special window opens for business.

Bypassing Berlin

To what extent could this lift the battered European bond market? To a degree, it bypasses German opposition to letting the ECB lend money directly to the euro bloc nations. The ECB isn't buying the rickety government bonds itself, but the banks borrowing from it are doing that very thing.

At present, the volumes taken through that special ECB window are a mere few tens of billions of dollars. But the European leaders could decide that expanding it would be is a good thing, and that could take it anywhere.

But is this deal really risk-free? Buying government bonds from bruised, debt-ridden countries like Italy and Spain now seems very risky indeed. There is a real fear of default, or of a "haircut," in which bondholders would only get back some of their money.

It's no coincidence that yields on these bonds soared as high as 7% in the recent past. Yields reflect precisely that risk. Moreover, as last week drew to a close international credit rating agencies warned of a massive European downgrade - including even France and Germany - if the latest efforts to rescue the continental economy prove fruitless.

Could that glittering 4% gain from interest rate gaps get wiped out, and worse, if the euro bloc falls apart?

All or nothing

This is where another consideration comes into play, which we could call "all or nothing." Here's how it goes: If the euro bloc disintegrates, as many have suggested could happen, the credit ratings of many countries will crash. Haircuts will be the order of the day. Europe's banks will be utterly ruined. Some will collapse while the survivors will consolidate, fueled by massive injections of government money. They will, in effect, be nationalized.

Which puts Europe's bank managers in a strange position. If Europe ends up collapsing it doesn't matter what they do now. Many will probably find themselves jobless anyway. But if Europe steadies and recovers, then what they need to do is buy government bonds on the cheap, such as those of Spain and Italy.

Is there a moral hazard of the bankers, who are responsible for the public's money? Is this some sort of blip caused by incentives? Sure, but that's how it goes in times of crisis.

So far this is a story about European bankers. Private investors can't go to a central bank and get a 3-year credit line at 1% a year.

But the basic concept of all-or-nothing applies to investment managers everywhere, here in Israel too. Take an investment manager who's lost a ton of money for his clients this year. He's afraid they'll cut their losses and bail on him. What can he do? Risk all, that's what: Go for broke. All or nothing. Either he makes a killing and his happy clients stay on, or he's no worse off than he had been.