Changing Rules of Engagement

(For more on this topic check out this piece I wrote about what Europe can learn from the Mets)

Europe has set some difficult targets for itself in terms of fiscal targets, all the more challenging given the recessionary conditions, and bank capital requirements. There is increasing pressure on officials to relax the targets. Investors need to be aware of the changing rules of engagement.



Currency in Crisis

The Bank of Italy, for example, issued new regulations in recent days regarding bank buyback rules of hybrid securities. The apparent technical adjustment is worth about 25 bp of Tier 1 capital, according to some industry estimates.

Ireland is proposing new personal insolvency laws that appear to allow the banks to move quicker toward foreclosure. Recall that about 3/4 of the household de-leveraging in the US is a function of foreclosures.

The ECB has also changed its collateral rules. At the end of last year, the ECB expanded the list of acceptable collateral to include 10,000 new instruments. It has now moved to retract nearly a third of those instruments because they do not really meet the requirements.

Almost 3200 instruments were removed from the acceptable collateral list, mostly French certificates of deposits. The CDs that are not acceptable are those that link the interest paid to some variable indices, like equities. Therefore in principle, these CDs could generate a negative return.

The ECB's collateral rules are implemented through the national central banks and the BdF withdrew those assets for the pool of acceptable collateral as a precautionary move, but it is embarrassing for the BdF and the ECB.

Separately, the Bundesbank has indicated that although the ECB says it is wiling to accept some bank loans as collateral, the Bundesbank does not think it is necessary for its banks. Since the ECB collateral rules on implemented through the national central banks on a voluntary basis, the BBK is simply opting out.

That said, the next round of collateral liberalization by the ECB is expected to go into effect before the next 3-year LTRO at the end of the month. The new rules will allow a wider range of asset backed securities (mortgages and small business loans) to be used as collateral.

Many market observers belatedly now recognize the significance of the LTRO, but few appear to have understood how important the liberalization of the collateral rules are to allow access to the LTRO and other ECB funding. They are interesting separately, but the real import is in the combination.

Another change that seems looming is in Spain. The budget minister last month called on the EU to ease Spain's fiscal target this year, recognizing the measures already taken and the fact the economy is entering its second recession since 2009. This is of course after last year's deficit appears to have surpassed its target by a bit more than 2 percent.

Yesterday the head of Catalonia said after meeting with Prime Minister Rajoy that Spain cannot reach this year's budget goal without "destroying the welfare state." Incidentally, Catalonia is the biggest state in Spain and pays twice the sovereign yield and is run by a pro-business party that often supports the now ruling center-right Popular Party.

Prime Minister Rajoy officially continues to support the 4.4% deficit target this year after a 8%+ shortfall last year, but this too can change.