Tuesday, May 28, 2013

"The banking crisis as a giant carry trade gone wrong"

Bank failure is always and everywhere a mismatch phenomenon .
(apologies to M. Friedman)
A pernicious aspect of the Eurozone crisis is the ‘doom loop’ linking European banks and governments. This column argues that poor European policy choices in the wake of the 2008 Global Crisis worsened the problem. Rather than being forcefully recapitalised as in the US and UK, many Eurozone banks were left undercapitalised and free to gamble for redemption. In what may be the greatest carry trade ever, they borrowed cheap, first in short-term debt markets and then from the ECB, to invest in high-yield but risky sovereign debt. Substantial bank recapitalisations against sovereign-bond losses is the way forward.

The health of the European financial system is intimately tied to the health of European sovereigns through the holdings of the sovereign debt (Angeloni and Wolff 2012; Acharya, Drechsler and Schnabl 2013). Traditionally, banks have been major holders of domestic sovereign debt, but in Europe there are substantial cross-country sovereign holdings.

For several years until 2008, credit markets did not reflect substantially the economic differences between the countries in the Eurozone. This resulted in a high co-movement in, and very similar levels of, borrowing costs for these countries. This apparent ‘convergence’ of the Eurozone countries, however, reversed itself starting 2008. Figure 1 shows this time-series patterns for Spanish and German government bond yields as an example. The vertical red lines indicate that the divergence in the borrowing costs arises substantially before the actual rating downgrades of Spanish government bonds by Standard & Poor’s in 2010 and 2011.
As the health of the sovereigns became a concern, investors also questioned the health of the banking system. The rising sovereign yields threatened the solvency of European banks and caused a flight-to-quality of bank investors as they became unwilling to refinance the banks’ sovereign portfolios. Figure 1 illustrates this flight-to-quality through the drop in German bund yields particularly in 2011 as the Spanish yields widened – a strong negative correlation unlike the positive co-movement earlier. This in turn created significant liquidity problems for banks that were heavily reliant on short-term wholesale funding (such as from the money market funds in the US).

Why were banks so exposed to this risk of divergence between the southern periphery sovereigns and the other Eurozone countries?

Figure 1. Government bond yield spreads: Spain vs. Germany

New research: The carry trade interpretation

Acharya and Steffen (2013) explain that some banks were ex ante willing to take this downside risk by investing in long-term risky sovereign debt of the Eurozone’s periphery (Greece, Ireland, Italy Portugal, and Spain – GIIPS) and financing these investments with short-term wholesale funding.
  • If this trade is successful, the banks pocket the ‘carry’ (consisting of greater interest income from risky debt as well as an increase in value of the risky sovereign bonds when their yields decline).
  • If the trade fails, as it did in 2011, they lose as GIIPS sovereign-bond yields increase further and in response the access to short-term funding dries up for those holding these bonds.
Figure 1 shows that yield spreads between GIIPS’ sovereign debt and German bunds had widened to 50-100 basis points already as of mid-2008 and eventually diverged by more than 400 basis points in 2011.
Acharya and Steffen (2013) show that banks were actively managing their portfolio of GIIPS sovereign bonds by increasing positions until the end of 2010, even as the relative spreads between GIIPS and German bund yields had already widened. We focus below first on the case of Dexia and then on the overall evidence for Eurozone banks.

A carry trade gone wrong
Dexia SA (Dexia) is a quintessential example of this carry trade behaviour...MORE
HT: naked capitalism