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Did the Three-Year LTROs Really Cause Bond Yields to Decline? Jacob Goldfield, Will Levine, Spencer Salovaara

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LTRO Collateralized, daily variation margin, floating rate, non-fixed haircut loan from the ECB. [1] http://www.ft.com/intl/cms/s/0/87157274-4676-11e1-89a8-00144feabdc0.html#axzz1raGTF6XO [2] http://www.reuters.com/article/2012/01/27/europe-banks-funding-idUSL5E8CR1UV20120127 [3] http://www.concertedaction.com/2012/01/19/bidding-behaviour-in-the-eurosystems-december-3-year-ltro/

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Lehman Moment the ECB provided a flood of ultra-cheap, long term cash just four days before Christmas [i]t is a game changer its taken away the risk of funding for the banks and given the market some confidence, said a senior banker at a European bank. [2] the consensus is that the ECBs 489bn three-year loan liquidity shot last month has averted a credit crunch for the regions banks [t]he LTRO, Morgan Stanley estimates, has helped Spanish and Italian banks meet between 50 and 150 percent of their 2012 pre-funding needs. [1] in the first quarter of this year, more than 200 billion of bank bonds fall due. (The LTRO) prevented a potentially major funding constraint for our banking system. [3]

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Stress Rises in Italy Its a very serious situation. Theres one scandalous episode after another, theres the economic crisis, were being observed very critically by the world at large [b]ut as long as Berlusconi can hold his majority together in parliament, the situation remains, unless there is some outside shock from the bond markets or something similar. Renato Mannheimer, one of Italys leading pollsters.

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Cohesion is Strained

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Contempt Is a Bad Sign

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November Government Change, Confusion Berlusconi resigns, or not. Returning, or not. Broad-based calls for unlimited ECB buying as the only solution but ECB resists. Parties delay support, rates rise, ECB resists buying Parties approve complete cabinet, Monti says serious budget announcement Dec 5.

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December 4: Monti details specific reform package (including pension reforms) The Berlusconi government was all about jokes and personalities, Mr. Bagnoli said, and they didnt always seem to know what they were talking about. For a long time, he concluded, Italy had a government that was detached and out of touch. This is the opposite, and it has become the symbol of the moment. Monti Passes Reform Market Reaction to Budget Announcement LTRO

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High rates create a crisis atmosphere which leads to change ECB: magnificent inaction

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Bank CDS

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MRO + LTRO: Collateralized ECB Financing 13-month LTRO announced Oct 6, superseded by 3-yr LTRO announced Dec 8, both scheduled for same date, Dec 21 Hard to have a short-run financing problem solved by an identical overlapping 3-yr LTRO but not by the 1-yr MRO: weekly, one-week, collateralized, Single List haircut, daily margin. Main instrument for monetary policy. 3 yr-LTRO same as MRO No fixed haircut: Haircuts in LTRO change when Single List changes. Floating Rate (Undefined) Why not just do rolling MROs? Full allocation since 2008, guaranteed to July 2012, so far. MRO could become fixed allocation. Assess probability assuming 3-yr LTRO not done If fixed allocation is low then MRO rate rises which is the LTRO rate. If LTRO is average of minimum accepted bid then the advantage is c..2%, assuming historical auction mechanism choice. If LTRO is average of min bid rate or MRO fixed rate, as applicable, then advantage is c..2%+marginal rate-min bid rate. (Except for pathological cases) MLF: 1%; stigma or reverse stigma.2% x 500bn = 1 bn / yr MRO is short-term repo, but LTRO is not long-term repo

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LTRO Symbol

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MRO fixed allocation auction cost

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Risks to Banks, Some Systemic Subordination of unsecured debt; subordination spiral risk; systemic; Martin Schmalz spiral Need to fund losses, eg Spain purchases since the LTRO announcement; margin spiral systemic Private repo often < MRO rate. Cant get out for a yr if do LTRO.

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Why the high uptake? NCB nagging? Reverse stigma (which grows from Dec) End of Feb is low stress, yet net uptake (adjusted for Greece ELA) is 75% larger. Chasing the bond market

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Bond Buying by Banks Italian banks started with c. 15% of outstanding Italian bonds. Standard market reaction to news of slow moving non- economic demand (NCB nagging) is to rise before it and then sell to it. Looks like holders of Italian bonds, except banks, sold significantly more than Italy net sold; not counting shorting Possibly pushed banks into bonds positions Moved bonds to diabolical loop holders Second LTRO net uptake, adjusted for Greece ELA, appears to be 1.75x first LTRO, despite stress reduction.

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13 Month LTRO and 2012 Fire Sales and Failures 200bn of bank debt coming due in Q1 2012 Fire sales and bank failures in early 2012 foreseen. Since it was in place Oct 6, even the 13-month LTRO can't be the solution to whatever ailed the market in November, or October, Another benefit available under the 13-month LTRO: Italian banks issued 40bn