Westend Brokers AG
Silvia Quandt & Cie. AG, Merchant & Investment Banking: In-between the lines – Bernhard Eschweiler

– Tracking the impact of the ECB longer-term liquidity operations

– ‘Money for nothing and the bonds for free’

– Businesses are more confident that Euro debt crisis is stabilizing

A commentator of the Financial Times wrote following the recent downgrades of Euro-area sovereign ratings by S&P: ‘The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades. [.] And no, the European Central Bank’s huge liquidity boost is not going to fix the problem either. [.] We have moved beyond the point where a technical fix would work. The toolkit is exhausted.‘

This rather grim assessment of the Euro debt crisis stands in sharp contrast with the response of financial markets following the downgrade announcement. Euro-area stocks are up 4.6% since January 13, most sovereign spreads are down – Italian 10-year spreads have dropped 58 bps – and the Euro is 3.5% stronger versus the Dollar. Is the market too optimistic or are the pessimists too much in love with their Euro-crash scenario? In our judgment, the crisis is not about to be solved, but the probability of a crash seems to be falling and not rising. Several factors are contributing to this change, not least the ECB’s liquidity injections.

Three birds with one stone?

The stated purpose of the ECB’s two 3-year longer-term refinancing operations (LTRO) is to ease banks’ liquidity problems. In addition, the ECB is hoping that banks use the extra liquidity to buy government bonds, especially in the periphery of the Euro zone. Third, the resulting positive carry should help banks accumulate capital. In the first tender on December 21st, banks borrowed EUR489.2 billion from the ECB. The second tender will take place in February and the amount to be borrowed by banks from the ECB is widely expected to double. It is too early to declare success on all scores, but the evidence so far is encouraging.

– Bank liquidity: The December 3-year LTRO has not yet restored normality in the interbank market. Most banks prefer to park their excess funds with the ECB rather than lending to other banks. However, the ECB has averted a liquidity crunch. Banks that need liquidity get it from the ECB. Furthermore, there are some signs of improving confidence. Cash parked with the ECB fell below EUR400 billion from a peak of EUR528 billion on January 18. Second, the 3-month Euribor-OIS spread, an indicator of perceived interbank risk, declined to 79 bps from 101 bps on December 7th.

– Bond yields: The decline in government bond yields despite an ongoing flow of bad economic and fiscal news from the crisis countries is the most surprising development over the last two months. Some of that is due to a general improvement in confidence (most notably the decline in long-term bond yields), but much of that is due to the ECB’s liquidity push (most notably the decline in shorter-dated bond yields). The decline in cash parked with the ECB may as well be a sign that banks are shifting into government bonds. The demand for government bonds also suggests that banks are less worried that more write-offs loom. However, not all bond markets are benefitting from this shift in the same way. Italy and Spain have seen yields drop the most over the last two months, although Spain made little progress recently following disappointing fiscal news. In Portugal, on the other hand, yields rose across the curve except for the very short end.

– Bank capital: That the ECB’s liquidity injections will help banks rebuilding capital is just a forecast. Evidence will emerge only over time, but the math is compelling since banks are not yet required to hold capital against government debt holdings. For an investment of EUR1 trillion in government bonds with an average carry of 200 bps, banks would earn EUR20 billion per year, about one fifth of the current funding gap. The rally in bank stocks as well as the decline in bank CDS spreads shows rising market confidence that the banking sector will over time restore balance-sheet health.

It’s all about confidence

The final success of the ECB’s liquidity operations will be a matter of confidence. Banks need to trust each other and believe that policymakers will not force them to take more losses on their sovereign bond holdings. Given recent bad experience, including the last round of debt negotiations with the Greek government, it is surprising how much confidence the banks have already regained. Policymakers should be careful not to destroy this change in sentiment.

Signs of improving confidence are not only limited to the banking sector. They are also visible in the real economy and financial markets. Most business sentiment indicators for the Euro area show an improvement in January after a stabilization at the end of last year. For

the Euro area as a whole, business sentiment has moved from contraction territory toward stagnation mode. In Germany, business sentiment is back in expansion territory. The details of the German IFO survey show a small decline in the assessment of current business conditions from a still high level and a visible improvement in the expectation component. The latter shows that companies notice an improvement in global business conditions and are more confident that the Euro debt crisis is stabilizing. This change in sentiment is still young and fragile. Instead of a downward spiral, however, an upward spiral of rising confidence and improving economic news may well be in the making.

Disclaimer

This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor, and was first published 26 January 2012, Silvia Quandt Research GmbH, Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439 Frankfurt.

Publication according to article 5 (4) no. 3 of the German Regulation concerning the analysis of financial instruments (Finanzanalyseverordnung):

Company disclosures

Article 34b of the German Securities Trading Act (Wertpapierhandelsgesetz) in combination with the German regulation concerning the analysis of financial instruments (Finanzanalyseverordnung) requires an enterprise preparing a securities analysis to point out possible conflicts of interest with respect to the company or companies that are the subject of the analysis. A conflict of interest is presumed to exist, in particular, if an enterprise preparing a security analysis:

(a) holds more than 5 % of the share capital of the company or companies analysed;

(b) has lead managed or co-lead managed a public offering of the securities of the company or companies in the previous 12 months;

(c) has provided investment banking services for the company or companies analysed during the last 12 months for which a compensation has been or will be paid;

(d) is serving as a liquidity provider for the company’s securities by issuing buy and sell orders;

(e) is party to an agreement with the company or companies that is the subject of the analysis relating to the production of the recommendation;

(f) or the analyst covering the issue has other significant financial interests with respect to the company or companies that are the subject of this analysis, for example holding a seat on the company’s boards.

In this respective analysis the following of the above-mentioned conflicts of interests exist: none

Silvia Quandt Research GmbH, Silvia Quandt & Cie. AG, and its affiliated companies regularly hold shares of the analysed company or companies in their trading portfolios. The views expressed in this analysis reflect the personal views of the analyst about the subject securities or issuers. No part of the analyst’s compensation was, is or will be directly or indirectly tied to the specific recommendations or views expressed in this analysis. It has not been determined in advance whether and at what intervals this report will be updated.

Equity Recommendation Definitions Silvia Quandt Research GmbH analysts rate the shares of the companies they cover on an absolute basis using a 6 – 12-month target price. ‘Buys’ assume an upside of more than 10% from the current price during the following 6 – 12-months. These securities are expected to out-perform their respective sector indices. Securities with an expected negative absolute performance of more than 10% and an under-performance to their respective sector index are rated ‘avoids’. Securities where the current share price is within a 10% range of the sector performance are rated ‘neutral’. Securities prices used in this report are closing prices of the day before publication unless a different date is stated. With regard to unlisted securities median market prices are used based on various important broker sources (OTC-Market).

Disclaimer This publication has been prepared and published by Silvia Quandt Research GmbH, a subsidiary of Silvia Quandt & Cie. AG. This publication is intended solely for distribution to professional and business customers of Silvia Quandt & Cie. AG. It is not intended to be distributed to private investors or private customers. Any information in this report is based on data obtained from publicly available information and sources considered to be reliable, but no representations or guarantees are made by Silvia Quandt Research GmbH with regard to the accuracy or completeness of the data or information contained in this report. The opinions and estimates contained herein constitute our best judgement at this date and time, and are subject to change without notice. Prior to this publication, the analysis has not been communicated to the analysed companies and changed subsequently. This report is for information purposes only; it is not intended to be and should not be construed as a recommendation, offer or solicitation to acquire, or dispose of, any of the securities mentioned in this report. In compliance with statutory and regulatory provisions, Silvia Quandt & Cie. AG and Silvia Quandt Research GmbH have set up effective organisational and administrative arrangements to prevent and avoid possible conflicts of interests in preparing and transmitting analyses. These include, in particular, inhouse information barriers (Chinese walls). These information barriers apply to any information which is not publicly available and to which any of Silvia Quandt & Cie. AG and Silvia Quandt Research GmbH or its affiliates may have access from a business relationship with the issuer. For statutory or contractual reasons, this information may not be used in an analysis of the securities and is therefore not included in this report. Silvia Quandt & Cie. AG and Silvia Quandt Research GmbH, its affiliates and/or clients may conduct or may have conducted transactions for their own account or for the account of other parties with respect to the securities mentioned in this report or related investments before the recipient has received this report. Silvia Quandt & Cie. AG and Silvia Quandt Research GmbH or its affiliates, its executives, managers and employees may hold shares or positions, possibly even short sale positions, in securities mentioned in this report or in related investments. Silvia Quandt & Cie. AG in particular may provide banking or other advisory services to interested parties. Neither Silvia Quandt Research GmbH, Silvia Quandt & Cie. AG or its affiliates nor any of its officers, shareholders or employees accept any liability for any direct or consequential loss arising from any use of this publication or its contents. Copyright and database rights protection exists in this publication and it may not be reproduced, distributed or published by any person for any purpose without the prior express consent of Silvia Quandt Research GmbH. All rights reserved. Any investments referred to herein may involve significant risk, are not necessarily available in all jurisdictions, may be illiquid and may not be suitable for all investors. The value of, or income from, any investments referred to herein may fluctuate and/or be affected by changes in exchange rates. Past performance is not indicative of future results. Investors should make their own investment decisions without relying on this publication. Only investors with sufficient knowledge and experience in financial matters to evaluate the merits and risks should consider an investment in any issuer or market discussed herein and other persons should not take any action on the basis of this publication.

Specific notices of possible conflicts of interest with respect to issuers or securities forming the subject of this report according to US or English law: None

This publication is issued in the United Kingdom only to persons described in Articles 19, 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 and is not intended to be distributed, directly or indirectly, to any other class of persons (including private investors). Neither this publication nor any copy of it may be taken or transmitted into the United States of America or distributed, directly or indirectly, in the United States of America.

Frankfurt am Main, 26.01.2012