Perseverating About the LTRO

Randy Waldman at Interfluidity has a post up titled "The Eurozone’s policy breakthrough?"  Now, Randy is one hell of a smart guy, and I pay close attention when he posts something - at least when I can understand it, as some of it goes way over my head.  So, given how important I feel this issue is, I want to look critically at his argument.

Waldman first notes the degree of confidence reported to be privately present in the German policy establishment.  I say that's fine, confidence is good, but is it well placed or is it a manifestation of denial?

He then goes on to bring up the arguments put forward by Tyler Cowen of Marginal Revolution.  These are arguments largely based on the potential attractiveness of the carry trade the ECB is offering, as well as on the recent very favorable bond market reaction in shorter term French, Italian and Spanish paper.

ITALIAN 2 YR

SPANISH 2 YR

FRENCH 2 YR

Looking at these yields, this is certainly an early indication that, despite denials, somebody is doing some buying.

Waldman then moves on to make the desperation argument for bank participation, stating that peripheral European banks are "mortally dependent" on ECB liquidity.  If the ECB says jump, these banks are simply going to ask "how high?"  Rather than just being about a carry trade profit, Randy argues that the ECB has these banks so far over the barrel as to be able to force them into these trades.  For Randy, potential bank insolvency is more of a motivator for these banks to double down and participate than not.  Can't say as I disagree.  However, as Rik pointed out in comments, participation in this program could come to be seen as a public marker of extreme desperation, leading to potential speculative attack.

He further argues that the ECB will be able to rather surgically command what these banks will buy and sell based on collateral haircuts offered at the LTRO.  This last point raises the obvious question of instability raised by collateral haircut manipulation.  If the amount of collateral required for a given sovereign's bonds is in constant flux based on ECB targeting, does this inspire confidence?

Randy concludes with some criticisms of the power en obscura such a program could give to the ECB - an argument that I completely agree with and have made before.

So, in summary, I will concede the following points:

1. Short term sovereign funding markets certainly do seem to be signalling adoption of the ECB carry trade.
2. Desperate banks may be willing to do desperate things.
3. The ECB may be able to "direct" funds towards the bond issues it wishes to target.

I will begin my rebuttal with the following quote from Randy:  "It’s the same as direct ECB lending to sovereigns, except ECB gets added security (in theory) by interposing banks as guarantors, and pays a fee for the privilege."  To me, this is rather like sending your children into your burning house to put out the fire.  As I indicated in an earlier post, this is indeed ass-backwards QE.  Unlike real QE, in which the risky assets end up on the central bank's infinite balance sheet and the banks' balance sheets are cleared, this only serves to further encumber bank balance sheets and increase leverage.  It is a doubling down - a desparate Martingale type approach to supporting sovereign bonds.  From my earlier post:

"With the FED, the PD's buy the bonds, and then the FED buys them in the secondary market from the PD's. In the end, it is the FED, with its "infinite" balance sheet that becomes leveraged. In the SARKO variety, the ECB extends non-loss bearing loans to banks which then have to lever up their own balance sheets even more to buy these instruments. In the FED case, bank get capital injections and the CB gets HTM paper. In the ECB case, banks take on senior loans, offering very volatile sovereign paper as collateral."

Furthermore, this approach to QE increases concentration risk enormously.  By providing incentives to Eurozone banks to conduct this carry trade, they become the willing buyers of EMU sovereign debt holdings put on offer by foreign banks, and crowd foreign banks out of the bid on new issues.

Another concern has to do with domestic lending within the EMU.  If bank balance sheets become even further encumbered with sovereign debt, how much funding does this leave remaining for non-governmental lending?  After all, how does growth return with governments hell-bent on austerity and credit being allocated towards a carry trade instead of business expansion?

Bank refinancing is also a concern, as is leverage.  European banks face considerable debt rollovers next year, and the bond market remains largely closed to them.  From the IFR, "Indeed, the European banking industry collectively needs to pay back or refinance about €650bn of liabilities next year – Lloyds, UniCredit, BNP Paribas, RBS and HSBC face the most, each having €30bn or more of instruments maturing, according to estimates from Nomura.  With bank debts coming due and most firms unable to raise fresh funds in bond markets – which remain largely closed – bankers say it is much more prudent to use ECB loans to pay off their own creditors rather than speculate that European governments pay back all their debt. 'Banks need this liquidity to get them through the wall of refinancing they are facing next year,' said the capital markets head. 'That’s where the money is going to go. Banks need to deleverage rather than re-leverage. It’s just wishful thinking that they will pile back into government bonds.'"  Will re-leveraging bank balance sheets with even more sovereign debt make the bank-funding markets more, or less, accomodative?

Bank credit ratings are another concern.  I find it implausible that a concentrated doubling down on riskier sovereign assets would go unnoticed by the rating agencies.

Sovereign ratings are also a concern.  These ratings are not simply based on prevailing interest rates, but also on growth prospects and long term debt sustainability.  With Europe in a recession and growth slowing, funding a sovereign debt carry trade may cause growth to slow further.  Furthermore, other than possibly by buying time, this maneuver does nothing to address long term debt sustainability in Europe. 

Potentially, one could even envision success in this effort causing German yields to come into the spotlight.  Until now, German bunds have been in scarcity, as they have been in extreme demand as collateral for repo operations.  If this is no longer the case, and France looses its wholly undeserved AAA, do the implied demands on Germany come center stage?  Obviously, German yields have a long ways to go to become worrisome, but the failed bund auction of November should make us wary.

I won't even begin to delve into the topic of North-South wage and productivity mismatches, and how this ECB program does absolutely nothing to address these longer term issues.  In fact, if anything, success here would simply lead to reversion to the status quo.  I won't touch the concept that a broken model of socialism, which works just fine until you run out of other people's money (OPM), has, indeed, run out of OPM.

So, has my opinion changed?  Is the ECB's LTRO is a "comprehensive solution" to the Eurozone debt crisis?  I will answer that with a question - did the Kamikazes win Japan the war?

For some other perspectives, not necessarily supportive of my point of view, I suggest:

THE HOTTEST QUESTION IN EUROPE: Did The ECB Just Pull Off A Back-Door Bailout That Will End The Crisis?  (Business Insider)

It is finally being recognized that the eurozone made a major policy breakthrough  (Marginal Revolution)

What is the difference between LOLR to banks and LOLR to governments?  (Marginal Revolution)

ECB Backdoor Bailout  (Modelled Behavior)

The Corzine Trade Vs French Downgrade   (ZH)

Why ECB lending won’t solve the euro crisis  (Felix Salmon)

EU/IMF halt Hungary talks after c.bank row  (Reuters)  This is pretty much unrelated, but looks important enough to track as a bogey.