Will the LTRO Plan Work?

There is little doubt that the stock market “feels” like it wants to go higher. And why not, we are entering a time of year that is traditionally filled with joy and good tidings (to the tune of about +1.8% on average on the S&P 500 from now until New Year’s eve), there is hope that 2012 will see better days (oh, and the prospect of hitting the “reset button” isn’t hurting anybody’s feelings right now), and then the economic data here in the U.S. has been nothing short of surprising. What’s not to like, right?

Another positive that has been bandied about lately is the idea that the ECB has effectively solved the Eurozone sovereign debt crisis. Some have even gone so far as to say that the latest moves by the ECB represent a “back-door bazooka” and that the risks of sovereign debt default AND bank failures are now OFF the table.

If this is news to you, don’t feel bad because assuming this upbeat, against-the-crowd stance requires an understanding of some intensely complicated stuff. But since my job in this often meandering morning missive is to identify the primary drivers of the market action, I’m of the mind that we’d best understand what the ECB has done and how it may (or may not) help the bull camp.

For starters, I think we can all agree that the ECB’s introduction of two 3-year LTRO’s (yep, here’s another FLA – four letter acronym – you’ll need to learn: LTRO = “Long-Term Refinancing Operation”) doesn’t sound all that exciting. And most will agree that it hardly looks or sounds like a bazooka. In short, the central bank operation sounds very technical in nature and might be something we would normally ignore.

But, au contraire mon frère, this could (the key word here) be something very big (or not). Here’s the deal. Everybody and their grandmother wants the ECB to “step up” and buy sovereign debt in order to create a “buyer of last resort,” which, in turn, would drive rates down. One side of this argument thinks this is exactly what the ECB has done.

The bulls argue that the 3-year LTRO from the ECB has effectively allowed the banks to do a “sovereign debt carry-trade.” For those of you not versed in such seemingly inane issues, this allows Eurozone banks to borrow from the ECB for three years at 1%. And since the ECB also lowered the quality level for collateral on such loans, banks can essentially put up debt they don’t want in exchange for shiny, new debt. From there, the bulls opine that the banks will take the proceeds of their 1% loans and buy higher yielding securities. And since the bonds being offered by both Spain and Italy are yielding over 6%, it seems like there is a mighty big spread to capture.

The thinking follows that capturing this spread would also help the banks improve their balance sheets, which is something that the recent stress tests require them to do. So in effect, banks can lock in the 5% spread, which could (assuming I understand my European banking regulations – lol!) then drop to the bottom lines of the banks. Boom (that’s the sound a bazooka makes, right?), problem solved.

The problem, as the bears are quick to point out, is that the banks might not want to buy Italian or Spanish debt with the proceeds. And the reason is very simple. Although EU officials have promised that the “haircuts” taken by Greek bondholders (which currently stand at 50% but Greece apparently is talking now about 60% to 75% write-downs) will be a one-time thing and that no other private bondholders (i.e. banks) will have to take any writedowns, would you really want to take that risk if you were a bank official? Would you really assume that in a crisis which seems to change directions daily, your bonds from a country that has serious debt problems will be bullet-proof? Hmmm… maybe not.

As one Barclays analyst opined, “It would be strange to see banks increasing the exposure to the very asset class that everyone is most worried about.” The same Barclays analyst adds, “If banks load up even more on SGIIP sovereign debt, this will make it harder not easier for banks to issue term debt.” And in case you are wondering (I was), the idea here refers to the banks rolling over their own debts, which is currently nearly impossible. Barclays further suggests that using the LTRO would actually make the banks more dependent on the ECB and that the region’s funding markets would remain frozen.

So, as you can see, the idea that the LTRO’s are really a bazooka in disguise may be a bit misguided. We should also note that the LTRO facility opens its window on 12/21 and then again in February. Thus, the questions of “Will it work?” may be answered shortly.

Turning to this morning… News of the death of North Korean dictator Kim Jong-il sent Asian markets lower. However, European markets and U.S. futures have since recovered and are pointing to a higher open on Wall Street.

On the Economic front… We will get the NAHB Housing Market index at 10:00 am.

David Moenning
Editor:  The Daily Decision