Crisis Averted: Understanding LTRO2


Fundamentally, the ECB is trying to keep the ongoing sovereign debt crisis from turning into a full-fledged bank credit crisis.

First, the looming maturation of about 700 billion euro in bank debt, and the likely difficulty of refinancing that debt in private markets, given unresolved questions about underlying bank solvency. With 530 Euro this time, on top of 489 Euro last time, I’d say we can stop worrying about that one for three years, notwithstanding continuing questions about solvency.

Second, the increasing reliance of banks, finding themselves shut out of private capital markets (at any reasonable price), upon short term money market funding from national central banks and the clearinghouse, a reliance that casts a cloud over the interbank payments system, not at some distant future moment but at the daily clearing, every single day. Here too, I think we can be hopeful that the LTRO has been successful in regularizing the debt, lengthening its maturity and removing it from the payments system.

Third, the ongoing credit crunch as European banks prepare for higher capital and liquidity ratios, preferring to shrink the denominator rather than increase the numerator of the ratio in order to avoid diluting existing stockholders. Here, I’m afraid, the jury is still out.

Let it be stipulated that there is enough refinance to keep banks from having to liquidate current asset holdings, and this in itself is likely to prop up asset prices (most importantly sovereign debt prices) that have been artificially beaten down by necessitous selling. (Market discussion about price moving because of new debt purchases financed by cheap LTRO money seems to me exaggerated; the stock of debt already on bank balance sheets is the big thing to watch here.)

Aggressive refinance seems thus likely to be sufficient to keep a sovereign debt crisis from morphing into a bank credit crisis. But it is not likely to be enough to get the economy moving again, especially in face of the austerity headwinds coming from the fiscal side. Even were banks flush with money, it is not clear that they would lend it, concerned as they must be with their own survival. And even if banks were willing to lend, it is not clear that viable businesses in the real economy would be willing to borrow it, concerned as they must be with their own survival.

The ECB has bought some time, three years in fact, but no more than that.

One final thought. As I look at the trillion euro LTRO, it strikes me as analogous to the American Fed’s trillion dollar purchase of legacy mortgage-backed securities, beginning in March 2009. Initially, the Fed wanted simply to lend short-term, through TALF, to others who would buy the securities, but the Fed could not get the program to work. So instead it facilitated the refinance of legacy mortgage-backed securities by committing itself to buy new RMBS for its own account, 1 trillion dollars worth. The ECB, having dabbled in outright purchase of sovereign debt, decided instead to use its big guns to refinance bank debt, in effect purchasing 1 trillion euro of 3-year notes, substituting its own balance sheet for the frozen market in bank paper.

In both the US and Europe, central banks have had to go beyond the familiar lender of last resort backstop, and in effect to embrace a new role as dealer of last resort; as one-sided dealer in RMBS in the US, as one-sided dealer in bank bonds in Europe. The reason, in both cases, is the transformation of the modern credit system from a bank lending system to a capital market credit system.

We now have two examples of how to conduct last-resort rescue in the modern credit system. Apparently we know how to avert crisis. The problem is that we have yet to figure out how to generate prosperity. For that, monetary measures are likely not enough.

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