Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

5 Things You Should Know About the ECB's LTRO


What it is, how it works, and what's in it for banks.

As if the financial headlines needed another acronym. Like it or not, you can expect to hear about LTRO for some time -- until the eurozone crisis stabilizes. Here are five things you need to know about how it works.

1. What is LTRO?

LTRO stands for Long Term Refinancing Operations. The European Central Bank actually conducts these operations monthly, and they typically mature in three months. Over the past few years, the ECB has done refinancing operations for longer maturities like the ones from a few days ago and from December, but those have been rare. Going back to 1999, only two (you know which ones they are) have been longer than a year. It is one of five types of open market operations the ECB engages in.

2. How does LTRO work?

The LTRO is a collateralized loan. Typically, after a central bank announces such an operation, if a bank is going to participate, it needs to make a bid both in terms of size and rate. The ECB made it easy this time because it didn't have an allotment (it was unlimited) and it fixed the rate at 1% so there was no bidding. Regardless of how the operation is structured, a bank needs to make sure it has enough collateral to hand over to the central bank and must be aware of what haircuts may be applied to it. Because at the end of the loan, it gets its collateral back and has to pay the central bank the money it got from the operation -- plus interest.

3. Hmm. What's in it for the bank?

The bank can borrow from the ECB for three years at 1%. If it's a European bank that has significant funding needs because it has debt that is maturing -- deposit outflows and what have you -- this gives the bank the chance to fix its funding costs for three years. No variable rates, no rollover risk, nothing. This allows the bank to keep its branch doors open and the lights on at headquarters, and it fixes the cost of its funds so that it can invest in higher-yielding bonds or lend out money at rates higher than its funding costs.

4. Well, given the high yields on sovereign debt, that should give the banks a big return, right?

Yes, and in fact, some politicians were hoping the banks would borrow from the ECB and go into the market and buy high-yield sovereign debt. I took a look at Italian and Spanish government bond yields from Reuters, and judging by the shapes of the yield curves across two-year, three-year, five-year, and 10-year bonds before and after the first three-year LTRO operation, it looks like some politicians will be happy with the result. But, I think it comes with a catch.

5. So, what's the catch?

Ah yes, the catch. I mentioned the shape of the yield curves. If you take a look at the yield curve's shape pre-LTRO in December compared to where it is now, you can see it has changed.

The two-year and three-year points have responded rather well, with yields being reduced in half since pre-LTRO levels. The five-year and 10-year have not moved that much lower.

What I sense is happening is that while the ECB is looking to "firewall" Spain and Italy from the contagion in Greece (and to lesser extents, do so for Portugal and Ireland), there is now a "maturity firewall" being formed as well. Think about it: If you borrowed three-year money at 1% and lent it at higher yields on other assets with a similar maturity profile, you have no roll risk.

But, if you borrowed three-year money and lent it out for five years, you'd need to roll that money again if you wanted to keep your funding and lending profiles in sync from a maturity perspective. Or, you could sell your five-year assets off to pay for your three-year liabilities. Welcome to the world of funding mismatches. I don't think that kind of mismatch is something many European banks want to mess around with given their capital needs and dodgy assets.

The possible side effect here is that while the ECB has helped lower yields of assets inside the "LTRO zone," longer-dated sovereign paper may be less liquid. And if it's less liquid, you'll see a liquidity premium tacked on to those longer maturity rates. It doesn't mean Spain and Italy can't roll longer-dated debt, just that the high costs they've had to endure may not be going away very soon.

Twitter: @japhychron
< Previous
  • 1
Next >
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Featured Videos