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ECB’s Second Three-Year Loan May Be Last

Published: February 29, 2012 | 11:08 am
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The European Central Bank may decide all good things must come to an end after today’s allocation of long-term loans.
The ECB’s three-year lending may approach a total of 1 trillion euros ($1.35 trillion) when the second Long Term Refinancing Operation is allocated at 11:15 a.m. in Frankfurt. Banks will ask for 470 billion euros, according to the median of 28 forecasts in a Bloomberg News survey, after taking 489 billion euros at the first tender in December.

While the flood of three-year cash has been credited with fueling a rally on Europe’s crisis-roiled bond markets and safeguarding the region’s banks, the ECB will be reluctant to issue a third tranche, according to Deutsche Bank AG and UBS AG. Doing so would fan tensions among ECB policy makers and reduce pressure on governments and banks to fortify balance sheets themselves, the analysts said.
“There will only be another LTRO if markets really turn sour again,” said Gilles Moec, co-chief European economist at Deutsche Bank in London and a former Bank of France official. “If we stay on the current course in markets, there is no necessity to risk dissent.”

Council Tensions

The size of the December loans prompted German ECB council member Jens Weidmann to warn that the central bank mustn’t “lose sight of its mandate” to control inflation by taking on “excessive risks.” Austrian council member Ewald Nowotny said on Feb. 27 he would “warn against the idea” that very long- term loans will become “a regular feature” of ECB policy.
“If number one was a success and number two was a success, that doesn’t mean there has to be number three,” Nowotny said.
In the wake of the ECB’s first three-year loan on Dec. 21, the central bank’s balance sheet ballooned to a record 2.74 trillion euros. It may reach another record after the second tranche. Banks are likely to roll about 100 billion euros of existing ECB loans into the new facility; anything above that would represent fresh lending.
The level of demand will provide insight into the health of European banks and their investment intentions.
Economists at JPMorgan Chase & Co. say an allocation of 400 billion euros or more would signal banks are borrowing in order to lend and invest. Credit Suisse Group AG economists say anything below 200 billion euros would imply banks are less willing to use the ECB cash to buy into bond markets, potentially hurting so-called peripheral governments by driving up their borrowing costs.

Sarkozy Trade

While the aim of the loans is to relieve liquidity strains in the region and get credit flowing to companies and households, a byproduct has been the so-called “Sarkozy trade,” where yield-hunting banks use some of the cash to buy sovereign bonds — an idea first floated by French President Nicolas Sarkozy.
Since the December loans, yields on the two-year bonds of Spain and Italy have fallen to less than 2.5 percent from 3.6 percent and 5 percent respectively. Bloomberg’s Europe Banks and Financial Services Index has rallied 15 percent this year and the Euro Stoxx 50 Index of stocks is up 8 percent.
The three-year funds cost the average of the ECB’s benchmark interest rate, currently at a record-low 1 percent, over the period of the loans and banks have the option of repaying them after a year.

‘Every Incentive’

For all their success, no more three-year tenders are currently scheduled beyond today.
The ECB has “every incentive” not to offer any more long- term funding, UBS analysts including Alastair Ryan said in a Feb. 22 note to clients. Providing money for so long against a broad range of collateral threatens its balance sheet and could encourage politicians to slow their austerity pushes, they said.
The cheap money also masks a failure by the region’s banks to bolster capital, said Huw van Steenis, an analyst at Morgan Stanley in London. He estimates European banks must cut leverage by about 2.5 trillion euros over the next 18 months and by as much as 4.5 trillion euros by 2018.
“History suggests that European banks have a long way to go and the LTRO will slow, but not stop the process,” van Steenis said.
ECB council members from Germany, the Netherlands, Finland and Luxembourg would probably oppose an extension of the LTRO for fear of over-reaching their mandate or distorting markets, said Moec at Deutsche Bank. Some officials have already questioned the ECB’s willingness to widen the pool of collateral it accepts for the loans.

Job ‘Not Done’

“It’s probably at the top of what the central bank can do,” said Moec. “It wouldn’t make sense to push things to a heated debate internally.”
Marchel Alexandrovich, an economist at Jefferies International Ltd. in London, is less convinced and says another LTRO could be delivered in a couple of months if the economy weakens. “They’re trying to put out the fire, but the job’s not done,” he said.
For now, the lack of a follow up means the positive effect of the initiative on stocks “will peter out soon,” according to equity strategists at HSBC Holdings Inc., who say they’re cautious about the 2012 outlook for global equities.
Fixed income analysts at Nomura International Plc predict bond yields in peripheral euro countries will begin “drifting higher” once the support fades.


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