What is LTRO?

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LTRO stands for Long Term Refinancing Offer and a program used by the ECB to inject liquidity into the European banking system. Contrary to popular belief LTRO is not a new program and has been in use by ECB for years. However starting at the end of last year, the ECB made dramatic changes to the program by first expanding the duration of its loans which used to be only 3 or 6 months to a full 3 year term and secondly by providing an unlimited amount of capital for the banks to borrow. As result of these actions the European banks borrowed more than 1 Trillion euro from the ECB in two LTRO rounds.

How does the LTRO work?

Member banks provide ECB collateral (typically the sovereign bonds of their respective nations) and in turn the ECB offers them ultra low cost loans (currently 1%). The banks then take those low cost funds and invest the money in the sovereign debt of their nations which currently yields between 3%-6% at three year maturity levels. This provides a very profitable margin for the banks and creates a natural set of buyers for sovereign bonds allowing the weaker European economies to finance their government spending.

One of the key reasons why the ECB must follow such an indirect path to liquidity injections is because it is prevented by law from buying new sovereign debt issuance for its own account. (Although it may buy sovereign debt in the secondary markets, which it also does in order to stabilize the weaker credits in the region)

Has the LTRO been successful?

The results so far have been mixed. The program did have an initial positive impact on both yields and the EUR/USD but the rally did not last and certain EZ bonds, most notably those of Spain have since set fresh record highs rising towards the 7% level which most market participants believe is unsustainable.

Although so far the ECB has refused to consider the prospect of LTRO III, most market participants believe that it will be forced to act if rates remain at current level or inch higher. As the only pan-European institution able to act quickly the ECB and its LTRO programs are the primary policy tools to combat the credit crisis in the region.

Boris Schlossberg
Managing Director

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