Image: Daniel Goodman / Business Insider
All eyes will be focused on Europe tomorrow, when the European Central Bank publishes statistics about a new, 3-year bank funding operation (LTRO) meant to ease liquidity for the banks.
Bulls have been hoping that this funding operation will amount to a back-door bailout vis a vis the banks, as more liquidity could drive down sovereign borrowing. However most analysts and even ECB president Mario Draghi are less than optimistic about the true impact of the financing measures.
The plan
The new plan expands the list of eligible collateral banks can put up in return for funding from the central ban. Most notably, they've expanded the list of eligible collateral to include credit claims (i.e. loans) and asset-backed securities issued at "A". Banks will—as usual—be forced to pay a penalty for using riskier assets, but they'll be able to use less collateral than previously required after the ECB cut the reserve ratio in half, from 2% to 1%.
Bulls' hope is that banks will capitalize on the long term operation and the low price of funding to use in a carry trade—they'll by Italian and Spanish sovereign bonds in big quantities because yields have been so elevated lately, and they'll make a killing off the difference between the sovereign bond yields and the price of ECB financing.
We've seen this idea manifest lately in the popularity of short-term sovereign debt, as evidenced by the demand for 2-year Spanish bonds (at left). Yields have plummeted as banks buy Spanish debt in preparation for the trade. Italian 2-year yields have also fallen sharply, back down to levels not seen since November.
But will it work?
Despite the dramatic decline in yields and market optimism, however, analysts are less than optimistic that the gamble will actually work.
They cite a few different reasons for this cynicism:
- There's absolutely no obligation for banks to use this new funding to purchase more sovereign bonds.
- Increased availability of bank funding doesn't actually alter the inherent sustainability of sovereign debt.
- The European Banking Authority's stress tests make available information about how much sovereign debt banks hold. If market sentiment turns sour again, investors will speculate against the banks that buy peripheral sovereign debt in large quantities.
- Rising borrowing costs have made EU leaders take action to try and fix the crisis. Removing the pressure will only harm momentum towards debt sustainability.
So while banks could hypothetically end the crisis of confidence right here and now, they probably won't. Citi's Steve Englander summed up this paradox nicely:
ECB reliance on banks to restore stability in the euro zone debt markets could continue to be plagued by a collective action problem in the economic sense of the term ‘collective action’. Market participants know that by buying peripheral debt they could help reduce the risk of sovereign default. Yet, the contribution of each individual investor may not be sufficient to solve the problem. In turn, any debt purchase will be only adding to the individual investors’ default risk exposure. As a result, the negative feedback loop between bank deleveraging and growing risk of sovereign default remains firmly in place.
General sentiment does indicate that this plan will buy EU leaders more time to make tough decisions and (hopefully) move towards ending the crisis. While we will probably see a repeat of these rising yields in Italy and Spain all over again, these liquidity support measures offer a respite from the high cost of short term borrowing.
The numbers
Banks will submit bids by early Wednesday morning, and the results of the ECB operation will be published
here at around 9:30 AM EST, according to
MNI. The important information will be the allotment (all.), detailing how much money was sought and how many banks participated.
If the plan surprises analysts and actually "works" to ease the crisis, we'll see an exorbitant number of bidders and a huge allotment. Problem is, success is really undefined here—it will be difficult to tell what is a "good" or "bad" number for borrowing.
ZeroHedge
reports that Barclays expects a take-up of €250-300 billion euros ($327-392 billion), Unicredit expects €300-330 billion ($392-431 billion), and RBS expects as much as €550 billion ($719 billion).
A shorter-term operation (a three-month LTRO conducted early last week) saw 42 bidders for €41.15 billion ($53.76 billion). We'd need to see numbers that are drastically higher to indicate a "success."
We'll be watching market sentiment closely tomorrow to see if the move has restored confidence.
