After the 3-year LTRO ECB funding operation saw banks borrow almost €500bn at 1%, the question has become where is this money going and how much more of it will they borrow from a similar operation in February? Estimates for the latter range from another €500bn to €1tn, but no one can really guarantee that it won’t be less or more. What we can know, though, is how counter-productive these operations are and how the first one has already begun producing unintended consequences.
The first thing to note is that the ECB takes on a preferred creditor status with banks that take out these loans, which acts to subordinate all other unsecured senior bondholders of the same banks over the course of 3 years. Adding insult to injury, these senior bank creditors also have a shrinking pool of collateral to rely upon for recovery in the event of default on covered bonds, as the collateral is pledged to the ECB in return for the 3-year loans.
All of that greatly devalues the value of the debt held by these creditors (mostly other banks and institutional funds), and makes them much less willing to continue rolling over credit or issue new credit to those banks which are generously sucking on the ECB’s teet. So that’s unintended consequence #1 – ECB loans further crowding out private inter-bank funding that was already strained to its limits. Here’s ZeroHedge with the report:
“However, the largest concern, specifically for bondholders of the now sacrosanct European financials, is if LTRO 2.0 sees heavy demand (EUR200-300bn expected, EUR500bn would be an approximate trigger for ‘outsize’ concerns) since, as we pointed out previously, this ECB-provided liquidity is effectively senior to all other unsecured claims on the banks’ balance sheets and so implicitly subordinates all existing unsecured senior and subordinated debt holders dramatically (and could potentially reduce any future willingness of private investors to take up demand from capital markets issuance – another unintended consequence).
The haircut structure and increased asset usage effectively means that further ECB liquidity is increasingly punitive, utilising ever more balance sheet. The more the facility is used the greater the degree of subordination to senior creditors, which previously would have partially relied on the assets, now pledged to the ECB, as security against senior debt. This problem is particularly pertinent given that banks have already been using the covered bond markets to raise funds, which require over-collateralisation in order to achieve higher ratings and to meet the criteria laid down by the ECB in order to be deemed eligible collateral for operations.”
Unintended consequence #2 is geared more towards the medium than short-term, and is certainly connected to #1, but is arguably much worse. The ECB loans that are recycled by banks into the sovereign debt of peripheral Eurozone members [mostly sub 3-year issues] creates increasingly leveraged and under-capitalized banking institutions, which, of course, is the problem that the Eurocrats are insanely attempting to deal with. Ambrose Evans-Prichard reports on this “toxic side-effect” of LTRO for The Telegraph:
“Alberto Gallo from RBS said Draghi’s €489bn loans to banks at 1pc for three years (LTRO) is having all kinds of toxic side-effects, which is disturbing given that the Financial Times splashed today that the banks may draw down another €1 trillion at the second LTRO in late February.
The banks are certainly stepping up purchases of Club Med and Irish sovereign bonds, the so-called Sarkozy “carry trade”. They also bought 62pc of the latest debt issue by the EFSF rescue fund in January, up from a quarter in the previous issue.
“Most peripheral banks now hold more government bonds than their equity, which makes them a levered option on sovereign risk. While earning more carry, banks holding more sovereign bonds than others also pay more in funding. The economics of the sovereign carry do not work in the medium term,” he said.
The shortfall on the banks’ core Tier 1 capital ratios outweighs the extra yield from the sovereign bonds. That will aggravate the credit crunch over time. Mr Gallo expects €5 trillion in deleveraging by European banks before it is over.”
While the banks are buying more sovereign debt, they are cutting credit to the rest of the economy, with falls of 2.4pc in Italy and Portugal in December, and 0.8pc for the eurozone as a whole.
Ralf Preusser at Bank of America is also cautious, warning that the diversion of LTRO credit towards government bonds is crowding out private loans.
“December saw the largest contraction in the provision of credit to non-financial corporates in the history of the time series. The flow of credit relative to GDP is now contracting considerably faster than in the midst of the post-Lehman phase“.
And that last part brings us to unintended consequence #3 (which is not to suggest that there aren’t more than three). The massive LTRO operations will also crowd out the issuance of credit to corporations and consumers in the real economy, as European banks simply cannot afford to issue credit to anyone who isn’t explicitly or implicitly backstopped by the EFSF, ECB, etc.
That, in turn, will make it impossible for peripheral countries to generate any economic growth whatsoever (in a system that requires credit to grow), especially if they are implementing austerity regimes at the same time. Which means their medium to long-term deficit pictures will only get worse, and the banks that have so wisely increased their leveraged exposure to sovereigns will have tumbled even deeper into their own graves.
So the Eurocrats better pray that the ECB’s February LTRO doesn’t see some ridiculous takedown of €500bn-1tn+ in funds, or it will be their economies’ funerals, and I’ll hazard a guess that they will all be opting for closed caskets.