Is The Eurozone Saved?

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by: Lance Roberts

Overnight European banks swamped the ECB's first-ever three-year liquidity operation to the tune of (and much larger than expected) €489.2 Billion. That is the LARGEST EVER single refinancing operation in the ECB's history. The three-year loans are expected to ease liquidity strains across Europe as the region has been locked out of public funding markets recently on fears of the worsening sovereign debt crisis. The Long Term Refinancing Operation (LTRO) was offered at an interest rate that will be the average of ECB's main interest rate over the next three years. That benchmark rate is, after a rate cut earlier this month, at a record low of 1.0 percent. For some banks, that could be more than 3 percentage points cheaper than they can get on the open market.

Previously banks have been reluctant to go to the ECB for assistance to avoid being seen as weak. However, French banks have almost quadrupled their intake of funds since this past June to €150 Billion, with banks in Italy and Spain each taking in more than €100 Billion. Of course, as a consequence, those are the poster children for the media headlines of late. However, this was not the case overnight, as 523 banks lined up with their hands out for these extended loans.

This is not the first time, by the way, that long-term loans have been granted by the ECB. In June of 2009 a then record of €442 Billion one-year loans were offered, with the majority of those extremely low-cost loans used to buy higher yielding sovereign debt known as a "carry trade." This was very profitable for the banks ... until the sovereign debt issues started to become a problem. With more than €720 Billion worth of bonds needing refinancing next year, banks scrambled to take advantage of long-term cheap money. The hope is that the ultra-cheap and ultra-long funding operation will help bolster confidence in the banking system, particularly since much of the take up of the loans came from the eurozone's most debt-laden states.

So, with a stroke of a pen on the dotted line the euro-crisis is solved....right?

Not So Fast

There is no denying that this does help ameliorate short-term risks of a "Lehman-style" liquidity crisis. However, while an interbank lending crunch may have been avoided, it is much less certain banks will use the money to buy Italian and Spanish government debt, as French President Nicolas Sarkozy has urged, given the competing pressures on them to cut risk, rebuild capital and lend to businesses. The bankers, being sharp financial people, took advantage of the long-term offering to swap out of €280 Billion of shorter-term facilities and loans, including €46 Billion from the 12-month LTRO just this past October. Therefore, once you do that math, the net increase in liquidity is about €210 Billion.

The hope is that, with the ECB lengthening maturities on loans, and with its encouragement, the ultimate allure of the "carry trade" (and its shear profitability), banks will purchase new sovereign debt and lend money to businesses. In turn, it is further hoped that this will change the tide in the European debt crisis, since there will be buyers for every new issue that comes to market, providing plenty of liquidity into the system and allowing business to return to normal. There is a lot of "hope" going on here.

The real issue, however, is that without the ECB providing a liquidity option, the euro crisis still remains unsolved. The ECB's role of being the "lender of last resort" and aggressively buying the sovereign debt directly from Italy and Spain is something it has been, and remains, reluctant to do. Without that "bazooka," the recent operation is very likely to come up short of intended goals. Furthermore, the demand for loans by businesses is woefully anemic, and with the eurozone quickly pushing into recession that demand is likely to fall further.

In my opinion, the more realistic outlook is that the banks have been burned now badly enough that they will likely use the long-dated loans to continue to de-risk their portfolios and balance sheets and reduce their borrowing. While it will take some pressure off of money market assets, as banks won't be scrambling daily for liquidity into the end of the year, it will likely not lead to a massive surge in new asset purchases by banks. The banks are already struggling with a recessionary economy, weak loan demand, and lower profitability, and they know that the markets will ultimately punish them if they load up on debts of insolvent countries along with the underlying mark-to-market risks. Furthermore, the looming threat of the European Banking Association (EBA) "stress tests" coming next year will act as a major disincentive. Why? Because they fear the EBA will require more capital for banks holding peripheral debt, which will dilute existing equity.

So, while these operations once again postpone the inevitable, they do not fix the economic problems of the debt-laden countries. There has been no resolution that gets these economies growing again, reduces their debt-to-GDP ratios or increases their economic prosperity. With the near-term needs of the eurozone roughly €2.5 Trillion, the recent LTRO barely covers 20% of what is ultimately going to be needed. The first quarter of 2012 is loaded with refinancing needs for the banks, which is why there is a second LTRO planned for February 29.

This brings up a final point. The ECB is lending money to the banks in exchange for collateral, which is the same basic program that the Fed ran domestically. This is when we saw the banks packaging up toxic loans into a AAA rated securities and pledging them to the Fed as collateral for loans. Those assets still reside in the dark crevices of the Fed’s “off-balance sheet” accounting. The recent LTRO has pushed the ECB's balance sheet to a record €2.7 Trillion, with the February LTRO pushing it well over €3 Trillion. The “Bernanke Plan” has gone global.

Currently the belief is that the world’s central banks have an unlimited balance sheet as long as they can print their own currency into infinity. However, I question that belief, because no one really knows the unintended consequences of these “bailout” operations and the massive expansion of balance sheets with near-toxic assets. What happens if there is a sharp rise in interest rates that is unable to be countered by central bank programs? Or an eventual default by a sovereign country? It’s my guess that it will ultimately be the citizens of euroville who will find out that the Grinch stole their Christmas.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.