Why An Outsized LTRO Will Actually Be Bad For European Banks

Tyler Durden's picture

The post-hoc (correlation implies causation) reasons for why the initial LTRO spurred bond buying are many-fold but as Nomura points out in a recent note (confirming our thoughts from last week) investors (especially bank stock and bondholders) should be very nervous at the size of the next LTRO. Whether it was anticipation of carry trades becoming self-reinforcing, bank liquidity shock buffering, or pre-funding private debt market needs, financials and sovereigns have rallied handsomely, squeezing new liquidity realities into a still-insolvent (and no-growth / austerity-driven) region. Concerns about the durability of the rally are already appearing as Greek PSI shocks, Portugal contagion, mark-to-market risks impacting repo and margin call event risk, increased dispersion among European (core and peripheral) curves, and the dramatic rise in ECB Deposits (or negative carry and entirely unproductive liquidity use) show all is not Utopian. However, the largest concern, specifically for bondholders of the now sacrosanct European financials, is if LTRO 2.0 sees heavy demand (EUR200-300bn expected, EUR500bn would be an approximate trigger for 'outsize' concerns) since, as we pointed out previously, this ECB-provided liquidity is effectively senior to all other unsecured claims on the banks' balance sheets and so implicitly subordinates all existing unsecured senior and subordinated debt holders dramatically (and could potentially reduce any future willingness of private investors to take up demand from capital markets issuance - another unintended consequence). We have long suggested that with the stigma gone and markets remaining mostly closed, banks will see this as their all-in moment and grab any and every ounce of LTRO they can muster (which again will implicitly reduce all the collateral that was supporting the rest of their balance sheets even more). Perhaps the hope of ECB implicit QE in the trillions is not the medicine that so many money-printing-addicts will crave and a well-placed hedge (Senior-Sub decompression or 3s5s10s butterfly on financials) or simple underweight to the equity most exposed to the capital structure (and collateral constrained) impact of LTRO will prove fruitful.


The spread between senior and subordinated financial risk has compressed off crisis wides but remains elevated at prior crisis peaks. While not cheap explicitly, it would be a most direct way to hedge an oversize LTRO's impact on bank's balance sheets and obviously is a quite contrarian play.

Notably, even with spreads rallying today, this spread started to leak back wider as perhaps smart traders are seeing this opportunity.


LTROs are increasingly punitive and lead to subordination of senior unsecured bank debt.

The haircut structure and increased asset usage effectively means that further ECB liquidity is increasingly punitive, utilising ever more balance sheet. The more the facility is used the greater the degree of subordination to senior creditors, which previously would have partially relied on the assets, now pledged to the ECB, as security against senior debt. This problem is particularly pertinent given that banks have already been using the covered bond markets to raise funds, which require over-collateralisation in order to achieve higher ratings and to meet the criteria laid down by the ECB in order to be deemed eligible collateral for operations.


Nomura: How big will the next LTRO be?

The next 36-month operation is likely to be big; the question is how big? It should be bigger than the shorter LTROs as the long-term operations have a major advantage with regards to the timing of the payment of interest on borrowings. Besides the haircut taken on the collateral, the interest cost, from a cash perspective, is only settled at the end of the term of the repo meaning a reduction in interim funding cash flows. This is a major advantage over the 1w/1m/3m funding roll to cash-strapped banks.

Upside reasons to consider:

  • The inclusion of a broader spectrum of loans should lead to a significant amount of additional balance sheet available for repo through the ECB operations. The downside to this is the significant haircuts on these assets.
  • With the reduction in credit criteria on loans eligible. There is perhaps potential for funds drawn through the ELAs in Greece and Ireland to transfer to the mainstream ECB LTROs.
  • Deposit levels in peripheral countries, and the degree to which they have been fluctuating, may be instructive as to the amount of funding that may be taken down. The higher the volatility of these deposits the more attractive the ECB insurance option should be.

Factors that could weigh on the overall size of the next operation:

  • Banks have taken a significant amount of ECB funding already, with a marked increase from Spanish and Italian banks. According to national central bank data, an incremental €26bn and €57bn was taken by banks domiciled in those countries respectively. The Spanish take at the end of December 2011 was €132bn against the €210bn borrowed by Italian banks. We think the funding taken will cover 2012 bank redemptions to a significant degree.
  • Decreased volume of liquidity rolling from old LTROs and MROs :-> For the December operation €50bn rolled for the October 12-month operation as well as from the 3-month.
  • The ECB dropping its reserve ratio from 2% to 1% means liberation of funds, though this should largely affect MROs on the margin, but funds that were not provided through liquidity operations will now be available to banks increasing available liquidity.
  • Bigger picture, the level of deleveraging in the banking sector as well as the private sector could lead to reduced funding requirements.

In aggregate we think that the total level of funds taken down through the ECB operation will be less than the previous round. In our estimation this is likely to be in the €200-300bn range.

If the size is bigger than this, perhaps in the range of €500bn or greater, the effect on bank balance sheets in Europe will be distinctly negative in our view, and would make future wholesale and term funding from private sector sources significantly more difficult.

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bugs_'s picture

subordinating senior bond holders without asking is almost as good as inflating away the common man's savings.

FinHits's picture

I have read this Nomura piece and I disagree with its negative tone. They should observe that unwinding the LTRO trade is not that hard and LTRO is not that long-term, so who cares about the bank investors in the short term. They were not that eager to invest anyway. I understand the first official break point is one year from now. If the bank in question can get cheaper 1-3 year money than that ECB 1% from other investors, they can repay ECB and take that other funding. No big deal.

The low priced ECB funding for the bank is good for the other bank investors, as obviously the profits will be higher.

I think it would be very positive if the LTRO2 is maxed out, since those loose Euros will push Euro fx rate down, and those BBB- to AAA collateral papers parked to ECB will reduce supply of quality fixed income asset available to investors, tightening prices and lowering yields accross at least the investment grade. If investors cannot put their money in investment grade, perhaps at least cross over or even high yield will get a pick up. Alternatively, that loose money could go to equities, or outside Eurozone.

I like the LTROs, they look like taxpayer-safe QEs to me.

KingPin 999's picture

"The unwinding the LTRO trade is not that hard"--I call bullshit on that. Just like QE will never unwind (FEDs balance sheet will never materially decline). If banks take the cash and they actually use it; they will have to sell those assets in the future to repay the loan. This will never happen voluntarily. The ECB can't have people dumping bonds either now or in the future just like the FED can't dump treasuries to decrease its balance sheet. Rates would rise which can never happen again because all Federal revenue would go to interest payments. Can't and won't happen. This is the terminal phase of ponzi. 

FinHits's picture

I agree the banks will likely get addicted to LTRO. So far, however, the LTROs have been one-off. I believe there was a similar one in 2009 and it was fully repaid?

The critique of Nomura was that LTRO replaces the normal funding sources of a bank and subordinates those left in the balance sheet. I disagree, it monetises the investment grade part of the bank balance sheet with very low cost of funding (1%). This monetisation, currently at €489 billion, is much healthier than a QE, which like the ECB's €220 billion SMP, just gets stuck in the all the wrong places like Greece.

LTRO gives cheap money to banks, improving their profits, making issuance of unsecured bonds much easier for them. Once the bank balance sheet derisks more (LTRO only accepts BBB- to AAA assets, so it won't add risk to banks), things can get to normal funding pattern.

There is no need to dump bonds, I think investment grade bonds are easily sold in a normal market.

I expect investment grade in the Eurozone to rally and tighten a lot. LTRO2 should be a further positive in this trend. 

What's not to like?

KingPin 999's picture

I agree in the short term that this will make it easier to finance all kinds of things (gov;t debt especially). However, this is covering up the problem the market is screaming at these people. If you let Italy have another $300 Billion in cheap debt what on Earth does that accomplish--they are already bankrupt--is you're goal to make sure they have an even bigger bankruptcy so stocks can ramp for another 16 months? 


Look--these countries have the same income they did last year and will have the same amount in three years. Whats the point in letting them borrow more money cheaply--they have no income to support it for Christ sake.

lineskis's picture

Pardon my ignorance, but may someone explain in english terms why "Why An Outsized LTRO Will Actually Be Bad For European Banks"?

And in particular may someone translate the following in english?
"The more the facility is used the greater the degree of subordination to senior creditors, which previously would have partially relied on the assets, now pledged to the ECB, as security against senior debt.

Thank you.

satan2liberals's picture

The gist from what I gather is that the money borrowed from the ECB will take top priority when it comes time for  repayment.


Therefore if the banks gorge themselves on borrowing to the hilt: those who previously were 

the first in line (senior bond holders) will be left holding an empty bag of worthless notes.


IOW: It's like a bank run where  govt agents cut in line in front of you right before you get to the teller window.

lineskis's picture

Thank you for the explanation! :)

Ropingdown's picture

More than likely it was intended to say "subordination OF senior creditors."  The scheme appears to me as a major turn towards "financial repression."  It's natural effect will be to drive down rates, make attractive investment grade bonds less available, and boost equities relative to whatever level they would have otherwise achieved.  It doesn't answer the eurozone imbalance and debt facts.  It seems like a Bernanke QE applied to an unintegrated currency union.  I'll tune in next month.

Xanadu_doo's picture

I'm not a trader. Nor an economist. I barely understand half of what's going on, but it seems to me the CHEAP MONEY from central banks to primaries and others IS THE PROBLEM. They DO NOT HAVE that money. They just made it up. So in this way I agree, it helps to have this fresh blood, except it's nto real. So while they'll probably be OK if they can continue to get new fresh cheap blood money all will be good. This keeps the pinzi going longer. It is not the right answer from my reading of WTF is really going on. So, what's not to like is that this is more criminal, crony bs designed to sheer more sheep. .

andrewp111's picture

Something to think about - LTRO could be the slickest way to recapitalize EU banks ever devised. --- Bank borrows a trillion at 1% from the ECB. Bank buys gold with the money. Gold prices are forced up. Now bank has gold assets worth many times the original trillion. Because gold is considered money and Central Banks are allowed to own it and keep it forever, the ECB just buys up all that gold in the bank's vaults, and the bank pays back the original trillion. The net effect is trillions in pure profit to the bank and a huge pile of gold bars in the ECB's basement.

He_Who Carried The Sun's picture

Of course, of course, and it will be good for the squid, right?

KingPin 999's picture

Does anyone else find it odd that we still don't know who is buying these peripheral bonds. If the banks are taking LTRO and redepositing with the ECB. Who is buying---someone is? And did these persons have a tacit or explicit understanding that someone else would buy the bonds from them when they got pushed to this level? 

Nobody For President's picture

"...all is not utopian."





The 100 Trillion Dollar Man's picture

Hey bro, you can borrow as much as you like at 1%. Think of a number and add a few zeroes.

What could possibly go wrong?

Schmuck Raker's picture

Whenever Tyler uses the word 'Obviously' I know I'm in over my head.

jiggerjuice's picture

Which Tyler? I guess you can call this one Obviously Tyler.

youngandhealthy's picture

Yeeez.... Tyler. You are so wrong. Everything you say about LTRO and Central Banks smack of incompetence (or more likely a silly 29 yr old figthing the FED/ECB). Grow up.


Sometime U R good sometimes you are just a lunitic.



KingPin 999's picture

He is pointing out their stupidity and the consequences. His main advice is to buy gold and silver. Very few ways to lose when you refuse to play their game by buying hard assets. 

Everybodys All American's picture

Which banks should I then invest in genious? Lunitic (sp) ... is that the same as lunatic?

youngandhealthy's picture

Well....Societe General did a giant 59% gain over 10 days. But you anglo-saxons are so nationalistic that you can not invest oversees. Spelling errors you are good to spot though....you moins talenteux

Raynja's picture

any major corporation whose stock moves either direction by 59% in ten days is not healthy.

snowlywhite's picture

59% gain from 10 days ago? 5 years ago it was 125, 1 year ago it was ~45, now it's 20.Even a dead cat will bounce if you throw it from high enough, right?


for humanity's sake I hope that you're not so healthy... and no, I'm not anglo-saxon. Basic addition ain't something reserved to anglo-saxons only(and you need only additions to figure out the european banks are broke). I don't necesarilly agree with the analysis, but you're obviously clueless.

jm's picture

The derivatives liabilities these banks carry make senior subordinate anyway.  Pretty sure this includes all debt issue unless it is secured. 

Buyer beware.

ZeroPower's picture

Excellent point. And lets not forget when youre dealing with mezz, you may as well be an equity bagholder.

youngandhealthy's picture

Obviuosly you talking US banks here

jm's picture

I don't think anybody can speak in a definitive way about the coutnerparty exposures in the financial system, but sure, I'm all for equal opportunity.

alien-IQ's picture

The market seems to perceive any and all interventions to be a good thing.

I think we can use a Stephen Colbertism to sum up how the market will view this LTRO nonsense:

LTRO: A "Great" thing for European banks or the "Greatest" thing for European banks?

(Can't you just picture Larry Kudlow saying that?)

Ropingdown's picture

The LTRO:  Finally, a central bank that has actually created a true Liquidity Trap: "We provide the banks with enormous liquidity that is senior to your bonds.  Now you are trapped!"  Simple.

youngandhealthy's picture

And your proposal is that US MM funds should dictate the world? or?  

And don't give me the free market shit but cause that siezed to exist long long tim ago when Clinton et all got rid of Glass-Steagal.

Ropingdown's picture

youngandhealthy:  Agree with the Glass-Steagal comment.  My remark about Liquidity Traps was intended ironically, given the dithering of economists about the meaning of a so-called liquidity trap, in this spirit: "You call that a liquidity trap.  That's not a liquidity trap.  THIS IS A LIQUIDITY TRAP!"   As for US MM's, They shouldn't rule, but also don't.  They just run away from questionable credits.  The ECB has jumped in to finance those credits.  The credits are still questionable.  Since Germany ultimately is paying for those ECB risks, though, I have no problem with them.  I'm not a peripherals bond holder.  I own no SocGen stock.  I'm not German.  Hope it all works out.

youngandhealthy's picture

Ropingdown: And the "real" truth is that Germany is net beneficiary of a lower EUR and the drag the PIIGS have brought to Europe. Merkel has a domestic "educational" problem. She is solving this step-by-step as we speak.

The flip side is that US would be the loser. Its the debasing war we are watching.

AldoHux_IV's picture

The LTRO is a scam in which liquidity is provided for the sake of dealing with the bigger structural problems of the funding mechanism within the EU. The biggest problem to the structure is that as liquidity is provided, the fallacy of solvency is even bigger masking the truth that insolvency is actually greater and thus you have not only real capital but central bank created capital thrown into the blackhole that is the European banking system which is ultimately now the sovereign financing system.

The risk can not be shifted away infinitely as the specter of solvency and restructuring become 'real-er', the fraud will be exposed on top of leaving many 'investors' screwed.

Ropingdown's picture

Aldo:  I've been advised by a reputable NYC newspaper that if you just can help them owe much more, that they'll eventually owe much less.  I'm a bit vague on the details.  That didn't work when they tried it on my brother. As far as I can tell it has to do with the proposition that financial elites can create instant liquidity, but creating technological innovation and market penetration for goods is, well, just too much work and takes too long.  Also, if I say that the 2.9 trillion euros owed by peripherals to the major european banks is impossible to pay back, I get laughed at in public by some very fashionable people, which is painful.

youngandhealthy's picture

You tell me exactly WHEN liquidity becomes a solvency problem? Who is pulling the strings and why?

For sure many Hedge and Banks involved with PIIGS (Greece) CDS and Bonds are sweating now but for very different reasons

Ropingdown's picture

OK, I'll tell you.  I live in not-europe.  My vacation house is in a Spanish south coast beach town.  The town's government is extremely broke and still diving.  They recently offered house owners who are actually Spanish city residents a 1/2 off sale on their RE taxes if they'll just 'declare' themselves as actually living in the beach town.  Why?  So the town can claim a per-resident subsidy from the Regional government. The Regional government is also extremely broke, and still diving.  Most of this debt, town and region, has not shown up on the national debt accurately yet.  Oh, and the value of bad loans hasn't been written down yet at my bank there, or any others in the region.  Tax collections are getting worse.  Unemployment for most young men 16 to 24 is over 50% and starting to show up in crime.  And this whole gaggle built huge rail and road networks with EIB money, which roads and rail, are lovely, but entail maintenance they can't afford. The country is insolvent, but for the fact that they can roll their current loans with new essentially-free ECB 3 year money.  That insolvency only becomes a problem when the inevitable happens and the German-backed ECB-provided liquity provision slows down in the midst of the new (that's right, double-dip) recession. I hope it doesn't happen, but as they say "hope is not a plan."

youngandhealthy's picture

@ropingdown. You are right these commuities exist and it is a shame (BTW I'm a non-Euro citizen) but that is not the main prevailing situation i Europe. Germany, France, Dutch, and even Italy (eventhough that is not the common understanding since public debt in Italy is high but has been since the 80s and mostly by domestic lenders. The reason for my retoric question when a liquidity problem become a solvency problem. ) are rich and developed nations. They represent the major part of the EUR zone.  

Ropingdown's picture

I completely understand the basis of the European dream.  My problem is that when I speak with europeans, I get a different version of that dream depending on whether I'm lunching with a Spaniard, a German, a Swede, and so on.  I don't have any answers.  I just see the incongruity.  Yes, Europe as some sort of whole is rich and productive.  The imbalances are so large, though, and the language barriers so persistent, that I don't see how they can achieve more labor mobility.  Without that, the nationalist bit endures.  I wish them well, but so far my wishes haven't had any apparent effect...

falak pema's picture

that's cos the banks run the world, not the people. You, like them, are barking up the wrong tree; this world is run by runaway banks and we have to wait untill they hit the zero return on liquidity injection wall. its now accelerating due to Euro zone+ US banking bubble feeding the Euro sovereign bubble feeding the derivatives CDS OTC bubble, feeding the corpocracy profits bubble feeding the stock exchange bubble feeding the investors bubble feeding the ZIrp lending bubble feeding the printing press feeding ...etc. You get it now, its circular and ever growing, as it can't afford to stop or the wheels come off, and all hanging in the air, until someone puts a pin to it and then it goes pop!...

nyse's picture

This is freedom. Losing all hope is freedom.

Ropingdown's picture

Yep, "fresh start,"  "reset,"  "creative destruction,"  "hey, we told you it was a loan, pal,"  "you want $14 per hour?  What's the China price?"   "We'll get through this!"  Freedom is being a banker with FIDC insured deposits, an overnight Fed facility to turn to, and a house in the Hamptons.  They have no hope either.  They're too busy printing money to bother with 'hope' routine.

Debeachesand Jerseyshores's picture

This new "razzle-dazzle" LTRO for 2012 is just what the doctor ordered.

ObungaBoy's picture

I am not really sure what you are talking about

EU promised 200 billions to IMF – so far IMF have seen nothing, nor even cracked coin

The last EU meeting is over and the idea for leveraging  LTRO was not even been mentioned

Germany will not pay, don’t you understand

q99x2's picture

If I'm one of the ones that is ultimately susposed to be paying for QE then I think my bank should raise the limit on my credit card so I can make my next payment.

falak pema's picture

Ltro is QE in eurozone. Period. Like coming QE3 in USD/FED zone.

Heyoka Bianco's picture

Man, I hate junkies.

EZYJET PILOT's picture

Whats all this talk of having to pay the ECB back for LTRO, the fact they've pledged useless collateral from the outset is enough for the ECB. The crime of this is that Greek debt is only 400 or so billion, they have to suffer austerity yet banks can just off load bad debt and claim almost half a billion, how unfair is that! I saw the comment above "whats not to like", whats not to like is that banks are being bailed out yet again, this time more slyly.