ECB's 3-Year LTRO Funding Facility Met With Strong Demand at 489 billion Euros

The much anticipated introduction of the ECB’s 3-year, unlimited LTRO funding facility which offers funds to member banks at 1%, met with strong demand Wednesday. The central bank reports that it took in €489 billion at the first of two such offerings (the second offering will take place in February), which was well above the expectations.

The stated purpose of the ECB’s new lending program is to increase liquidity among the continent’s banks. Uneasiness over sovereign debt has caused interbank lending to all but dry up. As a result the ECB has provided a facility to try and attempt to ease the frozen short-term interbank lending markets.

According to the ECB, a total of 523 banks borrowed Euros at the offering, with the total borrowing well above the €310 billion level that analysts in a Reuters poll had anticipated.

The hope in the market is that banks will put on what is being referred to as the ‘Sarko Trade’ which was first introduced by French President Nicolas Sarkozy. The idea is for banks to borrow from the ECB at 1% and then buy sovereign bonds that yield as high as 6% with the proceeds. This plan would allow the banks to lock in a massive profit spread, which, in turn, would help the banks with their balance sheet problems.

The thought process continues that if banks buy sovereign debt, demand for debt would increase and drive yields lower, thus ending the credit contagion. In addition, should the banks decide to buy sovereign debt, they could then turn around and pledge that debt as collateral again at the next LTRO offering in February.

However, the trade is not without risk and the banks may use the money borrowed for purposes other than buying sovereign debt. Remember, there are no strings attached to the ECB loans and banks are free to do whatever they please with the proceeds.

For its part, the ECB says that the LTRO is not intended to be a “backdoor bazooka” designed to allow banks to buy up sovereign debt. The central bank has reiterated that the move is designed solely to increase liquidity in the banking system and to thaw interbank lending in the region.

The WSJ reports that the bulk of loan demand from the LTRO is likely to replace existing loans on bank books. The Journal report estimates that Eurozone banks have €372 billion of bonds maturing between December and the end of March 2012 and failed to roll over €90 billion of funding in the second half of 2011, notes Barclays Capital. Against this, the banks over-issued €120 billion of bonds in the first half of 2011 and raised €64 billion in new deposits net of new loans. Adding these figures up, the data suggests that banks could need at least €280 billion in order to assure that current debt levels can be maintained.

At € 489 billion, the offering is being hailed as a success Wednesday morning. However, it will be some time before we know what banks are actually doing with the money. We will be watching the yields of Spanish and Italian sovereign debt for clues.

 

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