Can ECB's LTRO help solve the Eurozone crisis?

There had been too much going on in Europe of late. For the past year I have been watching this pact and that pact going into the bin. It has reached a point where I am sick and tired of following the development of any attempt to rescue Europe out of the woods. However as of recent things just change for the worse and the situation in Europe is deteriorating by the day. 

Does Greece exit matters?


Again Greece is at the center of attention not for the better but for the worse of things to come. Well, total private and public debts in Greece amounts to about $540 billion. There has been rumors circulating among EU countries that Greece is about to leave Eurozone. In fact more than 80% of Greeks vote to remain in Eurozone. Repercussions of Greece exit.

1) Revert back to Drachma - expect devaluation of 30-50% of its value. People have withdrawing massive amount of funds from the banks and on Monday alone they withdraw a record $898 million. In other words a bank run has already begun.

2) ECB,IMF and foreign banks will have to take hugh losses.

3) It will create a 'bank run' in lesser stable economies like Spain, Portugal, Italy and many other Eurozone countries. In fact last week Spain's 4th largest bank Bankia already getting bailout from the Spanish Government. It share price had dropped 65% since July last year. So we expect more European bank bailouts will be on the way. On Monday, Moody's downgrade 26 Italian banks and reviewing credit ratings of 114 more European banks.

4) Governments all over Europe are rapidly making preparations for a Greek exit from the euro. The following is from a recent article in the Guardian....

"The British government is making urgent preparations to cope with the fallout of a possible Greek exit from the single currency, after the governor of the Bank of England, Sir Mervyn King, warned that Europe was "tearing itself apart".

5) Euro and EU will risk collapsing. This is dangerous and will have wide repercussions around the globe.

Will Greece set off the Derivative Time Bomb?

Europe is only the catalyst of bigger things to come. The Global derivatives market is worth more than 1 quadrillion and Europe might just start off the chain reaction. The $5 billion loss in JPMorgan is only small pocket change. JPMorgan is exposed to more than $85 trillion in derivatives with less than $1 trillion in collateral. It is like getting a funding of $85000 in a margin account with only $1000 as collateral. In other words it is leveraged 85 times !
If Greece exits, it might be another Argentina. After more than 20 years since their last crisis, Argentina had yet managed to solve its economic woes. So, Greece exit is also not an ideal solution because Greece has little to fall back to. Its economy is depending on tourism rather than manufacturing as an income earner. Without a manufacturing base, Greece will have a tough time to stand on its own. There will be tremendous unemployment and people might be resort to crime as a means to survive and hence more chaos will be expected.

Greek Records Filing ?




Just to check out on how Greece’s progress to firewalled  its financial problems, the above picture taken in the Greek Finance Ministry (courtesy of ZH) which is screen grabbed in a documentary by German TV station ZDF says it all. The above picture shows how the Greek Ministry of Finance keeps its financial records in garbage bags and shopping carts. Just wonder how those foreign creditors, bankers and bondholders are going to get their money back !! So what other solutions are available to ring fence the Eurozone crisis?


LTRO solution to the problem


Since the ECB are prohibited to print money like its counter part in the US Federal Reserve, the ECB had been using LTRO (Long Term Refinancing Operations) for quite some time as a means for injecting liquidity into the Eurozone countries. LTRO is a bit similar to a POMO (Permanent Open Market Operations) in the bond market.


If the authorities want to increase the money supply in an economy, it can do it through bonds where it will buy up bonds issued by the banks. By buying up bonds the authorities will directly inject funds into the banks which in turn will lend it out to borrowers in the private sector. This is what we call the ‘Loose Money’ policy by the authorities. By ‘Tight Money’ policy it will be the reverse where the authorities sell bonds in the open market to clean up ‘excess liquidity’ from the market. That is why LTRO is also known as 'Cash for Trash' operation.


LTRO is another form of controlling the money supply through is ‘loose Money’ policy. By buying Sovereign Bonds from banks in countries like Greece and Spain, the ECB will inject funds with very low interest rate which can be considered as ‘free money’ to help boost liquidity in the system. Banks can then use the funds either to lend it out to borrowers or buy higher yielding assets for a profit or buying into lesser profitable operations or bailouts.


By putting up those sovereign bonds as collateral to ECB, it also helped to keep their yields (interest rate) low. If not when their yields rise it will be very difficult for them to pay back their loans later.
Usually, LTRO is a short term operation and normally their lifespan only last between 1 month to a year.  However since the Sovereign bonds in Spain, Italy, Portugal and etc are long term in nature 3, 5 or 10 years maturity, naturally the recent LTRO  issued will have a maturity matching date which is up to 10 years. This is to facilitate the rollover of the debts should there are still problems in paying down the loans.


So what is the problem with issuing long term LTROs? There are three problems going to arise from this.

1. ECB cannot just back off from this operation as it serve as a guarantor to the sovereign bonds. Hence the yields will only remain low with the backing of ECB. Once they back off then yields on the sovereign bonds will shoot up and hence any chances for them to pay back will be close to nil.
2. By backing off from the LTRO, confidence level in the banking system in Europe will diminish and hence further downgrades in the European Banks will be on the cards.
3. By injecting cheap funds into the banking sector the authority hopes to reduce interest rates and stimulate economic activity. However such program will usually fail and hence will lead to what we economists call ‘liquidity trap’. Liquidity trap is a situation where constant injection of funds failed to stimulate economic growth because people instead of spending more money will hoard it because they believe deflation will always be a trap.

They will always be waiting for things to get cheaper and hence spend less and less. A good example for a country affected by deflation is Japan where almost zero interest rate failed to stimulate consumer spending and its economic growth come to a standstill. This has resulted in Japan’s ‘Lost Decade’.

As a result the ECB will have to continue supporting the Eurozone countries for years to come because such program can only be lifted when economies in countries like Greece, Spain, Italy and the rest stabilized. The ECB will have to continue supplying cheap credit to the affected countries to nurture their economies back to investment grade and minimal credit risk. It is like the ECB is being sentence to 20 years in prison.