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business newsCentral Bank Easing: Why the ECB's LTRO (Mostly) Worked
Massive lending by the ECB has staved off disaster -- for now.
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Last month I wrote an article about how I believed this would be a stealth QE, and I think that the trickle-down effect has been pretty in line. While sovereign credit yields are not tighter, they certainly aren’t wider, and they have enjoyed a healthy curve steepening. European banks have been depositing record amounts at the ECB's overnight facility because they are withholding a healthy chunk of capital to strengthen their balance sheets. This is not banks trying to undermine the ECB; this is the banks trying to strengthen their own foundation with the first LTRO so that they don't have to continue massive layoffs and asset sales at fire-sale prices.
What the LTRO is: First off, let’s break down what the ECB’s LTRO is. The long-term refinancing operation effectively lets European banks within the ECB’s system borrow money from the bank at an interest rate of 1% over a three-year period. Previously the duration on these loans was one year and for a higher interest rate. Now, the ECB allows banks to also borrow with less than perfect collateral, or assets that do not carry higher credit ratings, such as Italian sovereign debt (currently rated A by the S&P).
Why the ECB started the LTRO: In the eurozone in 2012, sovereign countries need to roll over between 1.1 trillion and 1.3 trillion euros in debt, amid a global need for $7.6 trillion. The biggest loser here is Italy, a peripheral country with 10-year yields north of 7%. Italian banks such as Unicredit and Intesa have also been in trouble and are dangerously short of capital, due to the potential need to write down bad debt. To make sure these countries are able to roll over this debt effectively, European banks need to have access to cheap funding to be able to take up these auctions.
The collateral effects: Previously, European banks had reported that they were having issues obtaining dollars from US money market funds. In return, the Federal Reserve eased its dollar swap lines with the ECB and other major banks so that the ECB could offer special 84-day dollar loans. As such, the three-month EURUSD basis swap – a proxy for a European bank’s ability to obtain dollars – has markedly improved since these operations began. The same can be said for longer duration swaps.
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Two other equally important measures of funding costs are the London Interbank Offered Rate (Libor) and the Euro Interbank Offered Rate (Euribor). The three-month Euribor/overnight indexed swap spread was beginning to wander into the twilight zone in late November, likely on its way toward the rates seen during the 2008 financial crisis when credit markets seized up.
However, now we’ve put on the brakes, and Euribor fixings have been consistently lower over the past month and a half. The same can be said for the USD Libor spread. One thing that Libor and the Euribor show is that some of the larger “core” banks don’t have any funding issues, whereas the smaller banks on the outer fringes are still stuck in the twilight zones of tough funding.
3-month Euribor/OIS Spread
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3-month LIBOR/OIS Spread
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For sovereign bonds, notes that have a maturity shorter than three years have seen a healthy improvement, but the reaction in 10-year bonds has been muted. Below is an example of Italy and Spain’s sovereign bonds.
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The end result is that the ECB has effectively enabled governments to “fix” things, or at least lay the groundwork for things to be fixed in Europe, by punting to the politicians.
One thing that has come in the aftermath of the first LTRO is European banks issuing debt that is guaranteed by their government. Before there was that invisible line that couldn’t be crossed, but I guess governments have pulled out all the stops now. The first case was Italian banks issuing 40 billion euros of bonds backed by the Italian government. The next was Portugal's Banco Espirito Santo, and most recently the Greece National Bank issuing preferred shares to the Greek government. These occurrences are certainly not going to be the last of their kind.
These tactics only lead to the further nationalization of banks. Banks and sovereign nations will not be allowed to fail because the two are woven so tightly together. I think this will be a predominate theme as we make our way through the mire in Europe.
Twitter: @MichaelSedacca
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