LTRO: Savior Or Distraction?

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by: James A. Kostohryz

Considering the fact that back in December Europe was facing major bank failures and a systemic financial crisis in very short order, the implementation of LTRO1 was a "game changing" event.

At the same time, many financial commentators have tended to exaggerate the importance of LTRO, claiming that this facility essentially eliminates the prospects of a major economic and/or financial crisis in Europe.

It is important to understand the benefits of LTRO as well as its limitations.

What LTRO Was And Is Able to Accomplish

First and foremost, it is crucial to understand that LTRO emerged as the ECB's response to a massive run on European banks.

During a bank run, bank creditors (e.g. depositors, interbank lenders and investors in short term debt securities) withdraw their funding faster than the banks are able to raise cash through asset sales to meet these redemptions. It is generally agreed that in the absence of LTRO, one or more major European banks would have collapsed within ten days.

LTRO essentially ended the run on European banks. Once the providers of bank funding understood that the ECB was prepared to provide virtually unlimited funding to European banks, the private providers of bank funding no longer needed to "rush to the exits." Once everybody knew that banks would be able to obtain unlimited LTRO funds that would enable them redeem the investments of providers of bank credit at par, the providers of bank funding no longer had such a strong incentive to rush to withdraw their funding.

Having said that, in providing LTRO the European Central Bank (ECB) was merely doing what central banks are supposed to do: Act as lender of last resort to banks. Acting as a lender of last resort means providing emergency financing to banks to replace lost deposits or other sources of bank funding such as interbank lending.

By putting a halt to the contraction in bank funding and avoiding bank failures, the ECB was able to accomplish various other related objectives:

  • Halt forced sales of assets. The first objective of LTRO was to halt the forced sale of assets by banks desperate to raise cash to meet redemptions. The forced sale of assets can have very negative effects on the financial system and economy such as rising interest rates and a reduction in available credit.
  • Reverse the spike in interest rates. A related objective was to lower interest rates since the collapse of the prices of fixed income instruments such as sovereign bonds caused their yields to spike, putting upward pressure on interest rates across the board. LTRO meant that banks no longer had to sell. At the same time, market participants that were previously inclined to sell or short sell also knew that banks no longer had to sell. All of this changed the supply/demand balance amongst investors and potential investors in sovereign debt. Reduced supply + marginally higher demand = higher prices = lower rates.
  • Support sovereign bond market. Many analysts speak of LTRO as if the "carry trade" that it enabled was responsible for massive purchases of sovereign debt that in turn lowered their yields. This is not the case. What LTRO did was to halt the deleveraging process. Once banks were able to secure unlimited funding, the banks were able to stop selling sovereign bonds. Many banks are not necessarily taking on additional credit exposure; but at least they are not selling. Furthermore, many investors were persuaded to purchase sovereign bonds once they understood that banks would not be selling.
  • Prevent credit contraction. Another objective accomplished was to prevent a collapse in the volume of credit available in the economy; if funding for banks shrinks, the credit provided by banks financed by these funds must also shrink. And if the volume of available credit shrinks, economic activity will shrink.

In sum, LTRO halted highly negative dynamics in many areas. For example, sovereign bond yields eased, credit contraction abated, the dumping of risk assets halted and the risk of bank failures was greatly reduced. All of these things are major positives relative to the alternatives facing policy makers at that time.

What LTRO Cannot Do

It is one thing to say that LTRO prevented a disaster. It is quite another to say that LTRO can lead Europe out of its economic problems. For example:

  1. LTRO cannot correct current account imbalances. Trade imbalances stemming from accumulated purchasing power parity (PPP) distortions are at the heart of the PIIGS problems. LTRO does absolutely nothing to address this issue.
  2. LTRO cannot balance fiscal budgets. At best, LTRO could facilitate funding to finance fiscal deficits. However, LTRO can do absolutely nothing to prevent or improve these fiscal deficits.
  3. LTRO cannot bridge the North-South divide. The cultural, linguistic, political social and other differences that distinguish the southern Mediterranean countries from the northern European countries are at the heart of the Eurozone's current problems. LTRO can do absolutely nothing to bridge these divides.
  4. LTRO cannot convince the Germans to support more bailouts. Europe needs more bailouts. Lots more. If the Germans cannot be convinced to bankroll these efforts the economies of the PIIGS countries will collapse, much as is currently occurring in Greece. If anything LTRO makes it less likely that the Germans will be generous with bailouts. The Germans feel that they are somehow paying for LTRO since they are presumably on the hook through the ECB. Furthermore, many German's feel that with the ECB pumping money into the system like crazy through LTRO, why should they need to put up even more money for bailouts and firewalls?
  5. LTRO cannot improve the solvency of European banks. LTRO can provide funding for European banks, it can't improve the quality of asset portfolios. European banks face massive write-downs of credits of all sorts. At some point, projected write-downs can exceed expected capital. When this happens, private creditors will stop lending to banks since they know that the ECB will have priority in a bankruptcy/liquidation. In fact, after a certain point, LTRO can even become counterproductive to the extent that the capital of private lenders is continually pushed further down on the priority totem pole and they become more and more subordinated to the funds provided by the ECB.

Conclusion

LTRO cannot cure what ails Europe.

Certainly, LTRO prevented the collapse of the European banking system by acting as lender of last resort. That was a positive thing; but it should have been expected. That is the function of a central bank.

The problem is that LTRO does not address the fundamental problems that caused the European crisis (e.g. current account imbalances) nor does it address the fundamental issues upon which solutions depend (e.g. German policy toward bailouts).

For this reason the European crisis will continue despite LTRO.

There has been much speculation regarding how much money the banks will borrow in LTRO2. I do not think that it really matters. Europe's problems were never about the availability of funding for banks. In this regard LTRO is a distraction. If anything, a higher uptake on LTRO2 merely suggests that organic funding problems are greater than expected. The notion that a large uptake suggests that banks are eager to expand their balance sheets, increase risk exposures and lend more to the private and/or public sectors is simply not serious.

If anything the data suggests that banks in Europe continue to shed risk, lower leverage and shrink their balance sheets. The mere availability of LTRO cash does not mean that banks will increase lending to the economy. It means that banks will not be forced to reduce lending. But LTRO does not force banks to lend either.

If you were the CEO of a bank -- knowing what you know about the PIIGS fiscal situation as well as their structural economic difficulties including their lack of competitiveness -- would you want to lend more money to the private and public sectors in PIIGS countries right now?

If you are one of those folks that thinks it would be a good idea for European banks to lever up and increase loans to PIIGS private businesses and government, then by all means, I suggest that you load up on global stocks and ETFs such as Exxon Mobil (NYSE:XOM), IBM (NYSE:IBM) or Citigroup (NYSE:C) or equity index ETFs such as (NYSEARCA:SPY), (NYSEARCA:DIA), or (NYSEARCA:EWP). Because if it is a good bet to invest in PIIGS private and public debt, there are plenty of other things that could be sold to you which will probably look even better.

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