De-xia Vu

Something has been bugging TMM for a couple of weeks. Various bits of the market have been behaving in odd ways, that could have many different explanations in isolation. But when seen together, TMM reckon they have figured out what is going on.

First, as readers will know, the recent explosion of CVA desks, one-way CSAs and the like have resulted in large, relatively price-insensitve flows in many markets - but particularly in Euro 10s30s (see below chart). At first, TMM thought the recent sharp flattening was merely more of the same. But yesterday an unwind of a large and old asset swap drove 10s30s to the flattest it has been since 2008. This is very unusual behaviour for December when liquidity is not great.

Second, despite the very large take-up in the now very cheap Fed/ECB 3m $ Swap Facility last week, the 3m EURUSD Basis has rewidened (see below chart). As readers will know, TMM are of the opinion that the USD funding crisis is overhyped, but the new attractive terms have encouraged substitution from French banks (who issue their own USD CP in the US). As TMM's mates in the FX Forward market point out, there are still many smaller banks that are unable to access the Swap Facility due to a lack of collateral. Additionally, TMM remember from their old days working at investment banks that at year end, European real money - in particular Dutch pension funds - tend to do quite a lot of funding of their foreign assets via the FX Forward market. Again, at a time when liquidity in the FX Forward market is diminished due to most banks now either funding directly in the US or via the Swap line, this has not helped things, and when dealers have put on basis tighteners post the $ auction (catching them out). But it still does not completely explain why there has been pressure across the FX Forward curve. It seems that at least one bank has been somewhat price insensitive.

Third, even funding markets in places with relatively strong banking systems like Japan and Sweden have seen FRA-OIS basis widening (see chart below of Swedish FRA-OIS basis).

Fourth, usage of the ECB's Marginal Lending Facilty (see chart below) has spiked over the past few weeks. In the absense of other information, markets would not be incorrect in concluding that "something is very wrong"/"a bank is in trouble".

Now, TMM have scratched their collective heads, and suggest the following as an explanation...

TMM would ask readers to cast their minds back to February. Usage of the ECB's Marginal Lending Facility spiked (see the above chart), and it soon became clear that this was related to the winding down of the Irish banks and their transition to ELA funding. With the restructuring imminent, the usage of the ECB's lending facility turned out merely to be a stop gap until everything was in place for the transition.

The reason TMM bring this up, is that the splitting and wind down of Dexia - announced a couple of months ago - is of a completely different magnitude to that of the Irish banks. Dexia's balance sheet only recently still sat at over EUR 400bn (see below chart), and has quite large international exposures. It doesn't take too much to make the intellectual leap that a bank that is in the process of being split in two and wound down, that is quite big internationally, might have quite a large amount of international hedging/cleaning to do (which would explain a good chunk of both the cross-currency and FRA-OIS basis move). Dexia was also the rumoured counterparty unwinding the above mentioned asset swap at not-particularly-price sensitive levels. And given the bank was well-known to be having funding problems, but whose restructuring is imminent, it would not be a surprise to TMM if that ECB lending facility usage was in fact Dexia, as a stop-gap until its restructuring is completed. It is worth noting that when Depfa was wound down, Dexia's "sister" institution never had to go through this process, as it's a bad bank wholly owned by the Germans (FMS Wertmanagement now), who don't really have their own funding issues.

This is all speculation, but TMM reckon the latest market basis/funding worries could very well merely be part of Dexia's pre-restructuring clean up of the books ready for split-up and wind down. In which case, the deposit facility usage should soon come down, and perceived funding stresses roll-off.

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