LTRO: Will wave of cheap money fend off credit crunch?

The European Central Bank is expected to pump half a trillion euros into the eurozone’s troubled financial system for the second time in as many months today in what it hopes will be the last such operation to fight the eurozone crisis.

Banks can stock up on as much of the ultra-cheap, 3-year loans as they like at the second of the twin funding operations - a ploy the ECB unveiled late last year to dampen tensions on euro zone bond markets that threatened to tear the bloc apart.

ECB President Mario Draghi, whose native Italy was at the epicentre of the crisis when the bank announced the measure late last year, said after the first of the LTRO operations, known as LTROs, that “a major, major credit crunch” had been averted.

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[caption id=“attachment_229304” align=“alignleft” width=“380” caption=“Banks used much of the 489 billion euros they borrowed at the first LTRO to cover maturing debt. Reuters”]  [/caption]

Banks used much of the 489 billion euros they borrowed at the first LTRO to cover maturing debt. Draghi has urged them to lend out the funds they tap at Wednesday’s operation to households and businesses, helping strengthen economic growth.

The LTROs, or longer-term refinancing operations, have sucked much of the heat out of the eurozone crisis and given governments time to work out sustainable budget and growth policies for affected countries on the periphery of the bloc.

Financial markets are watching their progress carefully.

“Once the liquidity is injected, what will count is if the periphery countries generate growth,” said Andrew Bosomworth, senior portfolio manager at PIMCO. “Without growth, the LTROs are a bridge to nowhere.”

The ECB will publish results of Wednesday’s operation at around 1020 GMT. A Reuters poll of 30 euro money market traders on Monday showed expectation of a 500 billion euro allotment, with forecasts ranging from 200 billion to 750 billion euros.

Rating agency Fitch said on Tuesday that a larger number of relatively strong European banks are likely to profit from the second wave of cheap money. It added, however, that it was unlikely to drive strong lending growth given weak demand.

The LTROs are unleashing a wall of money just as the U.S. Federal Reserve and the Bank of England have with their “quantitative easing” programmes.

“SARKOZY TRADE”

Banks appear confident there is no stigma to taking the cash and say the cheap loans are too attractive to pass up.

“We do not blush to say we bid for 11 billion euros in the first tender and now we shall ask for a similar amount. Other competitors have said they will go for more,” BBVA Chairman Francisco Gonzalez said.

Italian banks, including UniCredit , Intesa Sanpaolo and smaller Monte dei Paschi, took 116 billion euros in December’s offer, and Spanish and French banks around 100 billion euros each, according to analysts and sources.

But some banks are still holding back, and some executives and investors reckon the stronger banks should show they can stand on their own feet.

The ECB funds are “like methadone for junkies,” said one senior European banker.

If banks used the first LTRO to plug their funding needs and fend off a credit crunch, ECB officials hope they will use the second to issue loans and to buy higher-yielding bonds more aggressively, especially from Italy.

Anecdotal evidence suggests banks especially in Spain but also in Italy used the first LTRO to make most of this “Sarkozy trade” - a term adopted by markets after the French president suggested governments look to banks that tapped the ECB operation to buy their bonds.

Spanish banks bought net 23.1 billion euros of government debt last month and Italian ones 20.6 billion, both record increases.

Italy faces a debt issuance hump in the next few months and could do with the second LTRO fuelling demand for its debt. It needs to sell around 45 billion euros of its bonds a month in both March and April versus 19 billion in February.

The ECB operations differ from QE in that they provide liquidity against guarantees instead of intervening directly in bond markets. They achieve a similar result while allaying the concerns of some policymakers - led by the Germans - about funding governments.

ECB policymakers in Germany and beyond are nonetheless worried that the central bank risks storing up problems for the future by releasing the wave of cash through the LTROs.

Bundesbank chief Jens Weidmann said earlier this month that “too generous” supply of liquidity could create risky incentives for banks, which could in turn store up future inflation risks.

Ewald Nowotny, a member of ECB’s 23-man Governing Council, went further on Tuesday and said the bank should think about an exit strategy after its massive cash injections.

“We do engage in the liquidity provision, but we are concerned about the longer-term consequences,” Nowotny said in London. “For the time being we think that we are on the right track but … what we are doing now does not have to repeat several times.”

Reuters