Did the Three-Year LTROs Really Cause Bond Yields to Decline? Jacob Goldfield, Will Levine, Spencer Salovaara
LTRO Collateralized, daily variation margin, floating rate, non-fixed haircut loan from the ECB.  http://www.ft.com/intl/cms/s/0/87157274-4676-11e1-89a8-00144feabdc0.html#axzz1raGTF6XO  http://www.reuters.com/article/2012/01/27/europe-banks-funding-idUSL5E8CR1UV20120127  http://www.concertedaction.com/2012/01/19/bidding-behaviour-in-the-eurosystems-december-3-year-ltro/
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.”  “…the consensus is that the ECB’s 489bn three-year loan liquidity shot last month has averted a credit crunch for the region’s 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.”  “…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.” 
Stress Rises in Italy “It’s a very serious situation. There’s one scandalous episode after another, there’s the economic crisis, we’re 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 Italy’s leading pollsters.
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.
December 4: Monti details specific reform package (including pension reforms) “The Berlusconi government was all about jokes and personalities,” Mr. Bagnoli said, “and they didn’t 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
High rates create a crisis atmosphere which leads to change ECB: magnificent inaction
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
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. Can’t get out for a yr if do LTRO.
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
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.
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 <1 yr bonds Dec 2011 and used LTRO. (Even Monti bonds were 1-yr LTRO eligible).
Evidence from 1-yr Bond? LTRO coverage started Oct 6 Goes to higher levels, despite enormous “arbitrage” and declines more than any other maturity Possible intepretation: prob(near-term default)
Private Repo Market Exists Private repo in Dec declines as much as LTRO net add: ~ € 200bn. Mar repo unavailable.
Other Suggested LTRO Benefits / Dollar Funding Dollar Funding Nov 30: 50bps – First of monthly 3-month auctions was c. €50bn, so c. €65mn Regulatory Benefit – 2018 – Change the regs Accounting benefit – Goes the wrong way Coordination Signal
Cost of Misunderstanding the Effect LTRO Undermines reform – Misattributing the cause of the rate decline saps governments of energy and political capital Raises probability of repetition during future stress Causes unnecessary intra-Eurosystem discord – Conservation of happiness principle Credibility
Risks of Too Much ECB Financing Intensifies diabolical loop if used to buy government bonds Systemic subordination spiral Systemic margin spiral Tends to raise Target2 (yet another spiral) Reduced or Enhanced Tail Risk?
Why Initial Interest? Central bank observations of liquidity as a problem or solution are sometimes incorrect (see Bernanke speech, April 13, 2012) Central banks subject to Maslow’s Law of the Instrument: liquidity
Glossary Maslow’s Law of the Instrument (Maslow, A. The Psychology of Science, 1966) – If all you have is a hammer then everything tends to look like a nail. Market/Shmarket; n. the doctrine that pessimistic market prices are never related to fundamentals because of the bad equilibrium liquidity self-fulfilling-prophesy spiral. – Practitioners are called spirologists – see Fundamental/Shmundamental
Glossary Post Hoc Ergo Propter Hoc; the logical fallacy of succession implies causation
Glossary Ante Hoc Ergo Propter Hoc: new logical fallacy: preceding implies causation
Significant Government Change in Italy – September 7, 2011: “It’s a very serious situation,” said Renato Mannheimer, one of Italy’s leading pollsters, whose regular survey in the Corriere della Sera newspaper this weekend showed 8 out of 10 Italians opposed to the government and a similar number critical of the center left opposition. There’s one scandalous episode after another, there’s the economic crisis, we’re being observed very critically by the world at large and there’s generalized distrust of the political class… [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.” – October 23, 2011 Berlusconi mocked by French and German leaders: “[w]hen asked at a press conference if [Berlusconi] had reassured them about his action to reduce his country’s debt level, Ms. Merkel and Mr. Sarkozy looked at each other with wry smiles, casting their eyes to the ceiling.” 10.23.11 http://www.ft.com/intl/cms/s/0/30bc980a-fd95-11e0- b6d9-00144feabdc0.html#axzz1bkjvzBc8http://www.ft.com/intl/cms/s/0/30bc980a-fd95-11e0- b6d9-00144feabdc0.html#axzz1bkjvzBc8 – October 26, 2011 “Italian MPs in fist-fight over pensions” The Telegraph 10.26.2011 http://www.telegraph.co.uk/finance/financialcrisis/8851408/Italian-MPs-in- fist-fight-over-pensions.html http://www.telegraph.co.uk/finance/financialcrisis/8851408/Italian-MPs-in- fist-fight-over-pensions.html – November 9, 2011 “[We] have long argued that Mr Berlusconi was unfit to govern, but even we have been shocked by how, as the euro crisis drew closer to Italy, he partied and politicked, brushing off the need for reform.” http://www.economist.com/node/21538161 http://www.economist.com/node/21538161
November 8—12: Berlusconi loses parliamentary majority, pledges to leave office, resigns November 13 – 17: Monti sworn in, announces generic reforms, wins confidence vote, but Berlusconi waiting for Monti to trip up November 25: Italian yields hit highs. “Having placed their faith in the former economics professor and his unelected team of technocrats…. Italians are getting a little nervous… there is still no clarity on Mr. Monti’s planned emergency measures.” http://www.ft.com/intl/cms/s/0/4558dd5e-177c-11e1-b20e-00144feabdc0.html#axzz1sFYOM4js http://www.ft.com/intl/cms/s/0/4558dd5e-177c-11e1-b20e-00144feabdc0.html#axzz1sFYOM4js Italy Peak Crisis
Glossary Maslow’s Law of the Instrument (Maslow, A. The Psychology of Science, 1966) – If all you have is a hammer then everything tends to look like a nail. Post Hoc Ergo Propter Hoc; the logical fallacy of succession implies causation Ante Hoc Ergo Propter Hoc: new logical fallacy: preceding implies causation – Actual LTRO graph Market/Shmarket; n. the doctrine that pessimistic market prices are never related to fundamentals because of the bad equilibrium liquidity self-fulfilling-prophesy spiral. – Practitioners are called spirologists – see Fundamental/Shmundamental