The ECB Is a Pawn Shop

 | Dec 21, 2011 | 4:57 PM EST  | Comments
  • Comment
  • Print Print
  • Print

The ECB's announcement Tuesday of its Long Term Refinancing Operation was well received by the markets and much more so than I was expecting as it was not a surprise.

The LTRO option has been available since the ECB was created and has been used regularly. 

The issue that made this operation unique, the extension from a 1-year to 3-year hold period, is what the markets focused on, albeit to an extent that inferred much greater positive significance than is justified.

The size of the offering was large, but expected, and the quality of the collateral was still held to be investment grade. 

What should be alarming to investors is the need for this facility at all. The fact that the ECB had to become the lender of last resort because member banks would no longer accept their own countries sovereign debt as collateral for repurchase agreements is an emergency situation that is not solved by the LTRO. 

When the Federal Reserve began accepting illiquid mortgage paper in 2008 in swap-for-cash it was a dire situation, but it was necessary because member banks would not accept the paper in swap for new loans for very a good reason. It was indeed junk and rated as such by then.

In the European situation, by refusing to accept sovereign debt at PAR as collateral for loans, the banks were telling the governments that their promise to pay was no longer considered to be absolute.

In other words, the banks in Europe don't trust the governments of Europe. That has not changed. Further, the LTRO is a repurchase agreement requiring the banks to buy the sovereign paper back from the ECB within three years. So the issue of trust and confidence in the European governments by the banks is still at the core of the issues facing Europe.

A 3-year LTRO of roughly $500 billion dollars immediately does essentially nothing to relieve the fundamental structural and real financial problems facing Europe.  It relieved the immediate panic exhibited in pricing for sovereign debt throughout the Union. That's all. 

When a company finds itself in a crisis financial situation one of the conventional first avenues of approach by management is to sell their highest valued assets as they will command prices closest to real value. 

The problem with such is that it leaves the company then with its worst-performing assets. A company in such a situation is considered in many cases to be in what is called run off mode. That is the process of liquidation and shutting down. 

Obviously the countries of Europe are not going into run-off mode. But the Union itself may be. The fact that the LTRO through the ECB was necessary to support sovereign debt values and then bank balance sheets is an indication that the Union is advancing steadily toward dissolution. Not the other way around. 

This is akin to an individual having to resort to putting the family silver in hock to the local pawn shop in order to access desperately needed cash now.

The next question that needs to be addressed is what will the banks do with the new liquid capital. 

The reaction of the global equity markets to the announcement of the LTRO indicates that speculators anticipate more of the capital moving stocks and bonds than into new loans.

If the banks park the capital in stocks or some other asset they may unilaterally unwind within the next three years they will be entering a carry trade that does very little to help the real economy. 

But it is probable that this is what will happen, at least until the banks become more confident that real structural changes to the EU's monetary and fiscal rules are being pursued by the governments. 

In the absence of indications that the EU is moving to resolve these issues sovereign yields will widen again and by next Spring Europe could be right back in the same situation it was in a few days ago.

Columnist Conversations

GS has cleared the important hurdle on the way up which increases the odds for an eventual rally towards the 1...
A good quarterly report has sent shares of Calamos Asset Management (CLMS) sharply higher. CLMS was up about ...
Electronics distributor Ingram Micro (IM) reported better than 16% growth in its Q3 sending the stock up about...
Market posting decent day considering Ebola getting headlines again. Believe investors have learned not to pa...

BEST IDEAS

REAL MONEY'S BEST IDEAS

Columnist Tweets

BROKERAGE PARTNERS

Except as otherwise indicated, quotes are delayed. Quotes delayed at least 20 minutes for all exchanges. Market Data provided by Interactive Data. Company fundamental data provided by Morningstar. Earnings and ratings provided by Zacks. Mutual fund data provided by Valueline. ETF data provided by Lipper. Powered and implemented by Interactive Data Managed Solutions.


TheStreet Ratings updates stock ratings daily. However, if no rating change occurs, the data on this page does not update. The data does update after 90 days if no rating change occurs within that time period.

IDC calculates the Market Cap for the basic symbol to include common shares only. Year-to-date mutual fund returns are calculated on a monthly basis by Value Line and posted mid-month.