The LTRO continues to attract attention. With another tranche coming up on February 29th, pundits relish in writing about how much money the banks will make by buying sovereign debt and funding it via the LRTO. We are sure some banks, encouraged (or not) by government officials, will make that “free lunch” investment. (We would be remiss if we didn’t draw a parallel between the LTRO financing and MF Global’s sovereign “Hail Mary” play.) But it is hard to believe that any bank beyond the most desperate will use all that cash just to buy sovereign debt.
The numbers don’t really support it. The cost to tap the LTRO is not just the 1%. A portfolio of loans with maturities of 5 years or more, according to Guy Mandy at Nomura London, will suffer a 29% haircut on top of a capital charge, for an all-in cost of 2.7%. Not to mention, the initial margin could also go up if the collateral is downgraded – again a parallel to MF Global and LCH.Clearnet raising their haircuts on repo. This is on top of variation margin too. Italian 3 year paper recently yielded 3.60%. Is the risk/reward really worth it?
Economists were surprised about how much money was borrowed in the first LTRO round – nearly half a trillion Euros. So what are the predictions for the next tranche? Well, like most people the economists will predict the take down will repeat at another half-trillion Euros. We wonder if this might mean scraping the bottom of the barrel for collateral for some borrowers and if the risk might be that the drawdown is lower?
Some notable banks were missing from the fray, probably trying to signal to the market they had their house in order and/or believed, no matter what the ECB says, that there still is a stigma to the borrowing. If the February drawdown is lower than the earlier one, the signal that it creates will be very different if the reason is that the banks have all the cash they need versus not having adequate collateral. Diametrically opposite we’d say.
The impetus to borrow is not, we suspect, the sovereign arbitrage that makes for such tasty sound bites. If that was the case, why would there be over Euro 500 billion of cash re-deposited by the banks at the ECB, earning a mere 25bp and creating a negative carry position? Instead we think the key driver is the need to have cash on hand to pay off the banks (and their key clients) maturing debt. As yours truly said in a recent Bloomberg article “the LTRO isn’t so much of a backstop for the banks, it’s more of a front-stop” (link to the article is here). This is a way for banks to prepare for what could be a very tough year for capital raising. They are getting in front of the ball with the help of the ECB.