The ECB’s LTRO was a stunning success. Or was it? Certainly rates dropped in Italy and Spain. However, all that really happened is the ECB became the buyer of first resort in which banks front-ran the trade, buying sovereign bonds for sure profit, plowing back into the same problem that created the European mess.

The ECB’s balance sheet skyrocketed in the process, and banks that plowed into those 3-Year LTROs (long term refinance operations) at cheap rates will face a huge rollover problem when the program ends, if not substantially before then.

Should something go wrong (and it will), then the ECB (or rather EMU member countries, especially Germany) will be on the hook for losses.

Consider the enormous mess over the past few weeks caused by a measly 40 billion euro holding of Greek debt by the ECB. Now take a look at the ECB’s Balance Sheet expansion recently.

ECB Balance Sheet

Since July 8 2011, the ECB’s balance sheet has expanded from 1.92 trillion Euros to 2.66 trillion Euros, a rise of 740 billion euros. €489 billion of that that was taken by 523 banks in the ECB’s long-term-refinance-operation LTRO.

Round two is scheduled for February 29, and the ECB is rightfully getting nervous.

ECB Transmission Mechanism is Broken

FT Alphaville explains in the “Diagram Du Jour” How the ECB Transmission Mechanism is Broken

Courtesy of Nomura’s euro area economics and strategy team:

Nomura explains In a normal functioning money market a rate cut by the ECB should trigger a tick up in money (i.e. deposits) and credit growth.

But, in abnormal times the interest rate and the bank lending channel can break down. And when banks are shut out of the money markets, they are forced into asset fire sales; the pressure on bank balance sheets can be severe, preventing banks from expanding the supply of credit.

It doesn’t appear that the interest rate channel has improved since 2008; a worrying conclusion given the myriad ECB unconventional policy interventions in that period.

ECB Buyer of First Resort, Banks Still Aren’t Lending

Simply put, banks aren’t lending and funds pile up at the ECB just as excess reserves have piled up at the Fed.

The ECB is in worse shape than the Fed because rules prevent it from taking losses. When, not if, Spanish rates head back up, the ECB is going to have a pile of losses it will have to force onto member countries.

The ECB is already sitting on small stack of losses on Portuguese bonds, but for now the ECB supposedly has a profit on Spanish bonds, just as it supposedly had a profit on Greek bonds.

Salivating Over LTRO Round Two

On January 30, I commented You Ain’t Seen Nothin’ Yet; Another Trillion (or Two) Euro LTRO Coming Next Month

Last month, European banks tapped the ECB for €489bn in a long-term refinance operation dubbed LTRO. On February 29, another round of LTRO is coming up and expect banks to go for the gusto. Banks like cheap money to speculate and that is exactly what they will do.

Several of the eurozone’s biggest banks have told the Financial Times that they could well double or triple their request for funds in the ECB’s three-year money auction on February 29.

“Banks are not going to be as shy second time round,” said the head of one eurozone bank at last week’s World Economic Forum in Davos. “We should have done more first time.”

Unlimited Money for Three Years at One Percent

The ECB is offering unlimited money to banks for three years, at one percent. Banks are salivating because the first round went well.

The money is supposed to go for bank lending but it won’t. Why should banks lend? They have a guaranteed profit by speculating in Spanish or Italian bonds, assuming of course Spain and Italy do not need bailouts coupled with a writedown on government debt.

However, that’s quite a risk, and in my opinion Spain will need such a writedown. If so, Germany will be on the hook once again.

 Money Supply Will Soar, Lending Won’t

Don’t expect the next LTRO to make it into the real economy. It won’t. Rather the LTRO will fuel more bank speculation and more leverage in government bonds. Money supply will soar, lending won’t and this rates to be good for gold.

Money supply did soar, gold rose, lending didn’t, and the ECB is getting nervous.

Shutting Down the Liquidity Spigot

Reuters reports ECB Preparing to Close Liquidity Floodgates

The European Central Bank wants its second offer of cheap ultra-long funds next week to be its last, putting the onus back on governments to secure the euro zone’s longer-term future.

Powerful members of the central bank’s 23-man governing council are privately hoping demand at the February 29 auction will fall well short of the 1 trillion euros some expect, backing their view that it should be the last.

Central bank sources say they are worried that banks will become too reliant on ECB funds, removing the incentive to restart lending between themselves.

The ECB first offered banks low cost three-year money in December to stave off a freeze in interbank lending that threatened to make the region’s debt crisis much worse.

Banks flocked to take advantage of the offer, filling their coffers, and ECB President Mario Draghi said “a major, major credit crunch” had been averted.

The ECB funneled banks nearly half a trillion euros in cash at the first operation on December 21. A Reuters poll of over 60 economists showed a mid-range expectation for it to allot another 492 billion euros next week with some expecting up to a trillion to be taken.

ECB officials accept they have to help the banking sector but they also want to send a message that the unprecedented liquidity provision will end.

Bundesbank chief Jens Weidmann has warned that “too generous” supply of liquidity could create risky incentives for banks, which could in turn store up future inflation risks.

Bank of Finland chief Erkki Liikanen is also worried about ample liquidity provision leading to future problems and has said the ECB must think about how to unwind the extraordinary measures. Other senior policymakers are concerned too.

Anecdotal evidence suggests banks in Spain used the first LTRO to make most use of this “Sarkozy trade” – a term adopted by markets after the French president suggested governments look to banks that tapped the ECB operation to buy their bonds.

Italy faces a debt issuance hump in the next few months and could do with the second LTRO fuelling demand for its debt. It needs to sell around 45 billion euros of its bonds a month in both March and April versus 19 billion in February.

Temporary Fix

Market News International reports ECB 3-LTRO Cut Funding Crisis Risk But Won’t Stoke Loans

The European Central Bank’s new three-year refinancing operations have reduced the risk of a major funding crisis in the Eurozone, but they will not prevent banks from shrinking their balance sheets and constricting loan growth, Standard & Poors said in a study released Tuesday.

The rating agency also warned that the ECB’s massive long-term lending has only deepened the divide that already existed between healthy banks and those that are more dependent on ECB funding. The ECB pumped E490 billion worth of three-year loans into the banking system in late December and is expected by some analysts to inject a similar or even larger amount at the second three-year LTRO to be held next Wednesday.

“The increase in ECB loans to banks and in bank deposits at the ECB reflects a deepening divide of the European banking industry. The gap is between the liquid, more credit-worthy banking groups that stockpile liquidity at the ECB and those that are less credit-worthy and relatively dependent on central bank funding and on government support programs in general,” S&P; noted. “The larger role of the ECB reinforces the credit tiering in the industry, in our view.”

The reported cited “high dependence” on ECB funding for the banking industries of Greece, Ireland and Portugal, with “growing net use” by banks in Italy and Spain, and a “relatively neutral” position for French and Belgian banks. The banks in Germany, the Netherlands, Finland, Austria and Luxembourg, on the other hand, are net lenders to the ECB, the study showed.

The report also noted that the historically high volumes deposited by banks with the ECB — a total of E730 billion as of February 3, in the overnight deposit facility and in one-week term deposits used to sterilize the central bank’s sovereign bond purchases — shows that the interbank market is still on very tentative footing.

“In our opinion, the huge amount of very low yielding deposits (25 basis points in the deposit facility, roughly 30-40 basis points on the fixed-term deposits) indicates that the top-tier banks prefer the safety of the ECB due to the uncertain conditions in the bank funding markets,” S&P; said, though it conceded that required risk weightings on interbank loans might also be a factor behind the large bank deposits at the ECB.

S&P;’s assessment of the ECB’s three-year lending program is strikingly less upbeat than the central bank’s own view. ECB President Mario Draghi and other top ECB officials have repeatedly argued in recent weeks that new cash is beginning to circulate in the economy and that the high level of deposits at the ECB was not necessarily evidence to the contrary.

Liquidity Floodgate Set to Backfire

  1. The diagram above shows banks are hooked on LTROs
  2. Those LTROs have created an exit problem for the ECB
  3. Banks still are not lending so there has been no help to the real economy
  4. Reserves are piling up at the ECB
  5. The ECB is on the hook for losses, rather the net lenders to the system are: Germany, the Netherlands, Finland, Austria and Luxembourg

The widely touted “success” of the program will be fleeting. Look for huge stress on the system the moment rates in Spain and Italy head back up. A mess in Portugal (100% guaranteed) may trigger a catastrophe long before then.

Mike “Mish” Shedlock
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