- By Region
As Spain’s debt crisis deepens, investors are warily eyeing a trigger that could send yields on the country’s sovereign debt into bailout territory.
The number to watch is the difference between Spanish 10-year yields and that of a basket of triple-A rated European debt. If the premium demanded to hold Spanish government bonds stays at more than 450 basis points – it has been trading above that since Monday – the situation facing Madrid could deteriorate.
The reason is LCH.Clearnet, Europe’s dominant clearing house. At that level, LCH could decide to impose additional margin requirements on banks using Spain’s government debt as collateral to secure short-term funding in repurchase – or “repo” – deals. Such a move risks aggravating the liquidity issues affecting Spanish lenders.
LCH is expected by analysts to raise the margin payment, or extra deposit, it demands, possibly in days. It typically imposes an additional margin requirement of 15 per cent when the yield spread rises above 450bp. On Thursday Spain was trading at 470bp.
Past margin increases on Irish and Portuguese debt unnerved bond markets, exacerbating problems at the sovereign level, and helped push Dublin towards a rescue. Some banks sold government bonds in an effort to raise more cash to meet the margin requirements, driving yields even higher. With Portugal and Ireland, LCH raised margins within five days of the spread rising above 450bp.
“Spanish banks’ funding costs through repo are on the verge of increasing,
possibly very sharply. That’s important, not least because it would increase reliance on European Central Bank or other sources of eurozone funding,” says Don Smith, an economist at ICAP.
Margin increases for Portugal and Ireland had at times made the cost of repo funding for their domestic banks “eye-wateringly expensive”, he says.
Eurozone banks faced a liquidity crunch at the end of last year when the sovereign debt crisis hit public bond markets. A €1tn-plus injection by the ECB into the euro area’s banking system plugged the funding gap for hundreds of banks across Europe, with lenders in Spain and Italy using a chunk of the three-year money to buy government bonds. But as the impact of the ECB’s money has worn off and worries about Spain have grown, sovereign bond yields have jumped.
Spanish banks are finding it difficult to raise money in public bond markets at affordable levels as investors demand higher returns to compensate for additional risk. Yields on Spanish 10-year government bonds have risen sharply, taking them this week almost to euro-era highs hit last autumn. A rise to 7 per cent, from Thursday’s 6.56 per cent, is seen as unsustainable.
LCH says the yield spread is one of many factors it considers when determining whether to increase margin required for European government bonds and that it is constantly evaluating margin cover.
While a material increase has typically involved a payment of up to about
15 per cent of a transaction as an indemnity against the risk of default, additional costs would be incurred should individual banks see their credit rating fall below a minimum BBB.
That is a real risk. Policy makers and analysts are concerned about Madrid’s ability to meet economic targets and address problems in banks which lent heavily in the country’s property boom and are now sitting on a mountain of bad debts. Many have already suffered rating downgrades, and plans to inject billions into Bankia via the state bank bailout fund have met with a tepid response.
Some analysts have suggested the fact Spanish lenders had been heavy users of the ECB’s three-year loan programme may mean they had become less dependent on accessing short-term markets. The European repo market was estimated to be worth about €6tn at the end of 2011, with at least a third cleared by central counterparties.
Richard Comotto, senior visiting fellow at the ICMA Centre at Reading University, says the use of clearing houses to process repos offered a lifeline for Spanish banks, enabling them to access term funds in a way that would have become almost impossible. “It’s kept the term market open,” he says.
He adds that, while he expected LCH to be more cautious in raising margins in Spanish sovereign debt after seeing the impact on bank funding in Ireland and Portugal: “There would be no mileage in getting it wrong.”