Conclusion: The proceeds from the borrowings from the LTRO by European banks are seemingly being deposited into the ECB liquidity facility and not being used to purchase sovereign paper. This is validated by three key measures of risk: German short term bund yields, the TED spread, and Italian 10-year yields.
The most recent purported panacea to emerge in the European sovereign debt crisis was the recently announced Long-Term Refinancing Operation, or LTRO. The LTRO, by mandate, provides 3-year loans to European banks at a 1% interest rate. Initially, the program was deemed a massive success as 523 banks “oversubscribed” and took 489 billion euros from the LTRO.
Unfortunately, the actual injection of liquidity was substantially smaller than 489 billion euros. According to our preliminary analysis, the roll over of short term debt, from 7-day to 3-month paper, actually took up the majority of the LTRO and, in fact, the actual incremental liquidity increase was likely closer to 210 billion euro, a far cry from the original headline number.
Aside from injecting much needed liquidity into the European banking system, which on the margin the LTRO did do, the consensus perspective at the time was that the LTRO was in effect a back-door bazooka. As such, this facility would be utilized by the banks to purchase European sovereign debt, which would in turn alleviate some of the funding pressure in the sovereign market. Based on the most recent data from the ECB, the LTRO does not appear to have been used for this purpose.
In the chart below, we’ve highlighted the ECB liquidity facility going back one year and in the inserted chart going back roughly one month. The key takeaway is that the ECB liquidity facility, which is used by European banks to effectively park money, hit a new all-time high at 411 billion euros this morning and has been increasingly rapidly since the inception of the LTRO just over a week ago. In fact, the day before the LTRO was put into effect, the ECB facility was at 265 billion euro and as of this morning has increased by 146 billion euro, or more than 70% of the incremental liquidity from the LTRO.
So, not only is the LTRO not being used as a bazooka by the European banks, but these banks are parking the borrowed LTRO money with the ECB rather than using it to buy sovereign debt, and thus are experiencing a negative yield on the trade. As noted above, European banks borrow at 1% from the LTRO, but when parking money with the ECB only get paid a 0.25% yield. So rather than taking any risk in buying European sovereign debt, the banks are, seemingly, willing to take a 75 basis point negative carry trade on this liquidity.
Not surprisingly, given the actions that European banks are taking, which signals they see more and not less risk on the horizon, the TED spread hit a new YTD high this morning, which in our view is the most appropriate measure of systematic risk in the banking system. As well, we’ve highlighted in the charts below that German 1-year Bunds are approaching close to YTD lows, at less than 0% yield, and Italian 10-year bonds are approaching YTD highs in yield, at north of 7%. The later point is the most disturbing in the face of sizeable Italian bond auctions this week, but together highlight that risk aversion is heightening in Europe.
The LTRO is certainly not a panacea and, clearly, not even the fabled Bazooka. In reality, the market is actually looking right through the LTRO and looking directly at the estimated 800 billion euro of Eurozone sovereign debt that needs to be refinanced next year and the 230 billion euro of European bank debt that needs to be refinance in Q1 2012.
Daryl G. Jones
Director of Research