A very intriguing analysis by Gary Jenkins at Evolution Securities, courtesy of FT Alphaville, looks at the huge liquidity injection by the ECB in June 2009 of 441 billion euros, and the possibility that it may have directly caused or worsened European banks' current exposure to PIIGS sovereign debt.
It makes perfect sense, so perfect that I can't help rephrasing it here with some modifications regarding the US: when banks have more liquidity (not capital) than they need, what do they do? They chase excess return. Usually this means more risky lending, like mortgages, loans -- lending to the "real economy." I bet this is at least part of what Fed had hoped for since 2008.
But, fresh from the pain and scare of the crisis and coupled with persistent weak demand, banks seek excess return in sovereigns. Hence the strong treasuries, especially at the short and intermediate segments. So far so not bad. Banks make risk-free money, but that's part of the plan to recapitalize them over who knows how many years; moral hazard is virtuous compared to the supposed Total Apocalyptic Ruin and Peril (TARP) if banks were not bailed out and continue to be bailed out for years to come.
But, finance being so global, would US banks be satisfied with just US Treasuries? If PIIGS sovereign debt looked very enticing to European banks back in 2009, it's impossible for US banks to miss it. And you have the negative carry cost on top of it. And EUR was up against USD the whole year. Or at least eurozone core and UK sovereign debt. While we're at it, why not do some USDAUD carry trades, too.
I haven't been able to find hard data on US banks exposure in the following areas but it's easy to imagine how they could be significant in at least some of them:
- PIIGS sovereign debt.
- Eurozone core sovereign debt. The dominant risk here is not credit, but rather FX. I guess the EUR slide since April must have caused some pain in US banks.
- Other sovereign debt? I was puzzled by the huge yield surge in Brazilian sovereign debt and failed auction in May. Now it makes sense.
- AUD and USD. The common view is its plunge in May was mainly due to hedgies derisking. I venture to guess TARP recipients have a big part, too.
- HY almost reached par in April.
- Munis yield barely more than treasuries. Another mini-bubble in the making?
Moral of the story is, unless and until housing prices stabilize and unemployment goes down, excess liquidity in the banking system will cause a perpetual flood in the world sloshing around seeking excess return, creating bubbles and exposing banks to unending risks in every corner of the world. It's only a matter of time before one brings about the next crisis.
What's Fed to do then? More excess liquidity, of course. It's the only tool they have left. When the only tool you have is a hammer, you either define every problem as nail or do nothing, which is not an option for Fed. Unless we solve the real problem of oversized financial intermediary and excess debt/spending, which we won't.