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October 10, 2011 7:07 pm
Jean-Claude Trichet, the European Central Bank’s departing president, last week offered a farewell gift to Europe’s troubled banking sector – cheap money.
The ECB, Mr Trichet announced, would offer to lend to European financials through two longer-term refinancing operations. The new LTROs, as they are known, come less than a year after the expiry of the central bank’s last such refinancing operation, in December 2010.
LTROs are meant to provide the banks with more stable, longer-term funding, helping pacify nervous investors and boost liquidity. However, in practice banks can use the funds any way they want. So the offer of more LTROs begs the question of how financial companies will choose to use them this time – and also whether the operations will actually improve conditions for Europe’s banks.
The original LTROs, for instance, allowed some banks to go on a buying spree – using inexpensive ECB funds to snap up higher-yielding assets in a classic “carry trade”. Unfortunately many of those investments appear to have taken the form of government debt from the region’s weaker nations, strengthening the link between troubled sovereigns and banks which Europe is trying desperately to break.
“The banks pretty much used the last opportunity of getting cheap money to invest in sovereign debt they thought was even cheaper,” says Gary Jenkins, Evolution Securities head of fixed income. “Of course, it turned out to cost them even more.”
With the latest LTROs, the ECB will offer to lend money to banks at an interest rate tied to the central bank’s main rate, currently 1.5 per cent.
The central bank’s previous set of three one-year LTROs, offered in June, September and December of 2009, lent a total €614bn at a rate of 1 per cent. Banks used about half of the ECB’s first LTRO, worth €442bn, to buy higher-yielding assets, according to Deutsche Bank estimates. Barclays Capital says German banks tapped €126bn in the first LTRO, followed by the French at €85bn and Spanish banks with €53bn.
Fuelled with inexpensive cash that would last for just one year, banks went about identifying liquid investments – those that could quickly be sold at the end of the year – but which would yield more than the 1 per cent borrowing rate.
“At the time, banks were comfortable leveraging up their balance sheet ahead of the tender, loading up on short-dated peripheral government bonds, as well as bonds issued by other banks,” says Ralf Preusser, rates strategist at Bank of America Merrill Lynch.
Banks could borrow at a 1 per cent rate, buy the still liquid but higher-yielding government paper, and then pocket the difference. According to Morgan Stanley, Europe’s banks have about €700bn worth of European peripheral debt, including Italy and Spain, sitting on balance sheets.
Analysts expect banks will tap €225bn-€440bn from the two new operations, but seem divided on how much of that will be used to improve funding. Banks’ ability to source financing is likely to have deteriorated since the first LTROs, some say, meaning banks will be trying to deleverage and sell assets rather than buy new ones.
“Banks’ attitudes towards their own balance sheets have changed,” says Laurence Mutkin, Morgan Stanley’s head of European interest rate strategy. Moreover, he adds, so have banks’ attitudes towards the government bonds they purchased in 2009. “Back in 2009 the collateral was understood to be nearly unimpeachable, whereas now sovereigns in euroland have a credit premium attached to them.”
Nomura strategists Guy Mandy and Laurent Bilke agree that more European bonds are in a “distressed state”, limiting banks’ desire to buy them. Still, they suggest Italian and Spanish government debt with short maturity dates could be prime contenders for a new ECB-funded carry trade.
That thought is echoed by BofA’s Mr Preusser, who notes Spanish and Italian banks are “natural holders of large amounts” of their countries’ government debt.
Most analysts believe the LTROs will help take pressure off banks’ funding, helping them over the hump of government-guaranteed financial debt due to expire early next year. Still, many doubt that they will do much to boost the amount of liquidity sloshing around the eurozone, already at about €650bn.
“A new round of very long LTROs isn’t the solution to financial market stress this time, because this time an absence of liquidity isn’t the main problem,” notes Mr Mutkin. “Banks are suffering not so much from insufficient liquidity as from insufficient solvency.”
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