Photo: (Photo by Pablo Blazquez Dominguez/Getty Images)
BofA Merrill Lynch believes the “stars are aligning for an ECB intervention in the Spanish bond market.”Rates strategists Sphia Salim and Max Leung write in a note to clients this morning that the surge in yields in the Spanish bond market recently are “not really reflective of increased short-term default risk for Spain but rather the result of poor liquidity conditions in the bond market, and the pricing in of further liquidity deterioration on the basis of potential haircut increases for repo trading on LCH Ltd, and repo operations at the ECB.“
BofA believes the ECB will reactivate the Securities Markets Programme (SMP) to address further stress in the Spanish bond market because “it is necessary to prevent a potential collapse of the SPGB market, with serious consequences for the euro zone banking system.” They also note that it would serve as a complementary measure to the recent bailout of Spanish banks, as the composition of balance sheets becomes increasingly comprised of Spanish sovereign bonds.
Salim and Leung explain that the Spanish treasury has recently been targeting smaller amounts and shorter maturities of new paper issuance at sovereign bond auctions because of the increased yields in the secondary market, but this in turn has the effect of further damaging liquidity in the bond market.
The BofA rates strategists say an LCH haircut on Spanish sovereign debt could come as soon as today due to the high yield levels it has traded at recently:
On 18 June, the Spanish 10y benchmark closed at 510bp above the AAA index (a simple average of German, French and Dutch 10y yields). The spread has been trading above 450bp since 11 June, closing at 455bp on that day. Accounting for that data point (uncertain, as it may not be considered “convincingly” above 450bp), a haircut increase could be announced as soon as today, assuming spreads do not tighten back (a tightening made more unlikely by the scheduled SPGB auction on Thursday).
Further, pending further action from ratings agencies, an ECB haircut on Spanish sovereign debt of up to 5 percentage points could be right around the corner as well, possibly from rater DBRS:
Although DBRS has only just recently (22 May) placed Spain on negative watch, the rating agency can conclude the assessment before the usual three-month deadline. If Spain is downgraded by three notches or more, then SPGBs would fall in the other bucket (BBB) and their haircut at the ECB would increase by 5ppt. Other Spanish collateral might also be affected by the sovereign downgrade and subsequently suffer from even larger increases in haircuts.
A simplistic estimate suggests that in such a scenario, over €30bn in additional collateral would be demanded by the Bank of Spain, with the assumptions that Spanish banks’ collateral composition is the same as the euro-area average in 2011 and that the securities all lie in the 5-7y residual maturity bucket (without accounting for the impact on ABS, “other marketable securities” and “non- marketable assets” that might have been put forward). Even if banks could mobilize their buffer collateral to meet the requirements, more securities (e.g., SPGBs) would be locked up at the ECB, which would further affect the liquidity of the bond market.
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