MONEY MARKETS-Italian troubles seen boosting banks' ECB reliance

LONDON Wed Nov 9, 2011 11:55am EST

LONDON Nov 9 (Reuters) - A decision by two key clearing houses on Wednesday will make it more expensive for European banks to use Italian bonds as collateral to borrow in the secured-lending market, potentially increasing their reliance on ECB funding.

The cost of using Italian bonds to raise funds rose after clearing houses LCH.Clearnet SA and Italian CC&G increased the margin on repo trades using debt from the euro zone's third largest country, as Italian yields hit unsustainable levels.

The move means it will be less expensive for banks to borrow using Italian bonds as collateral at the European Central Bank than between each other.

This is likely to increase demand for ECB funding from banks, and in turn the liquidity in the banking system putting downward pressure on overnight Eonia rates for example.

"The associated margins for the ECB repo (repurchasing) operations are considerably less than with LCH. The immediate response to the ... increase in the initial LCH margin call is to shift funding further towards the ECB, thereby pushing up excess reserves and placing further softening pressure on short-term rates," Simon Peck, rate strategist at RBS said.

Three-month Italian general collateral (GC) was bid at around 1.65 percent early on Wednesday, up from 1.5 percent in the previous session, according to ICAP. That compared the German equivalent which was little changed on the day at 0.39 percent.

LCH.Clearnet SA raised the initial margin call applied to Italian debt by between 3.5 and 5 percentage points across all maturities of BTP and inflation-linked BTP government bonds.

The changes, which include raising the initial margin call on 7- to 10-year debt by 5 percentage points to 11.65 percent, will come into effect on Nov. 9 at the market close and will affect margin calls from Nov. 10, Paris-based LCH.Clearnet SA said on its website. The margin at the European Central Bank on the equivalent Italian bonds is percent.

Italian domestic clearer Cassa di Compensazione e Garanzia (CC&G) raised its margins to the same level.

"Banks that have huge holdings of Italian bonds will increase borrowing from the ECB instead of going to the repo market because now it is more expensive for them to borrow through LCH," said ING rate strategist Alessandro Giansanti.

Demand for ECB funding from Italian banks may also increase as they struggle to raise cash in money markets, a trader said.

NEXT VICTIM?

For months now investors were fearing that Italy -- the euro zone's third largest economy -- could become the next victim of the euro zone debt crisis and the market moves and margin increase were beginning to confirm their worst fears.

Yields on Italian 10-year bonds soared above the psychologically important 7 percent to 7.5 percent, prompting the ECB to step in and "aggressively" buy the paper.

The 2- 10- Italian government bond yield curve inverted as the yield on 2-year government bonds surged above those of their 10-year counterparts to 7.66 percent, indicating the market was increasingly pricing in the risk of a credit event.

The yield curves of Greece, Portugal and Ireland also inverted before they were forced to seek bailouts.

Italy's inability to finance itself could become a systemic risk to the euro zone given the size of its economy, the size of its bond market and the heavy exposures that German and French banks have to their bonds.

Lenders are not deemed to have enough to bail it out if it were ever to default on its debt.

The increase in margin was smaller than the initial 15 percentage points that were applied across the board to Portuguese and Irish bonds, before they were shut out of commercial markets.

But analysts said today's moves were likely to be the beginning of a series of margin increases if yields kept rising, while the massive increase in Italian bond yields would add to the costs of banks to borrow in commercial markets.

"Italian repo markets have been under pressure for some time now... If you are holding Italian paper and need to raise cash the ECB will increasingly look like the best place to go," Chris Clark, rate strategist at ICAP.

"If you are holding Italian bonds and you want to raise cash in the repo market, the sell-off in the cash market this morning is more detrimental to your position than is an additional increase in the margin."

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