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Tuesday, December 27, 2011

The bazooka revisited

This interesting article by Avery Goodman makes the recent ECB-bazooka (LTRO) look like it were the best thing since sliced bread. I had taken quite a different view in my recent posting but I had concluded that posting by saying that one may have to be prepared to accept new wisdoms if the bazooka works.

There are some embarrassing mistakes in Goodman's calculations when he suggests that a bank, after 1 year of participating in bimonthly LTROs, can earn about 30% in spread interest. His (wrong) conclusion is based on the assumption that banks can borrow from the ECB at 1% and buy Italian bonds yielding 6%. Yes, that is a 5% spread but doing that 6 times per year does not increase the spread; in only increases the volume to which the 5% spread applies. And, by the same logic, there certainly is not a 90% return on investment after 3 years!

Sadly, Goodman is perfectly right in saying the following: "If a bank participates to the fullest extent possible in the back door money printing, its executives will have collected fat bonus checks from big profits made on sovereign debt".

The LTROs are a way of providing banks with below-market-rate funding so that banks can increase their spreads leading to higher profits. If such profits were retained, they would strengthen the capital base of the banks which would be one way to justify this kind of subsidy (or slow-motion bail-out). If such profits are paid out as bonuses for executives and/or dividends, the ECB would be subsidizing executives' and/or shareholders' incomes.

What is left out of all these considerations is the issue of risk. So far, auditors have allowed banks to carry their sovereign risk assets at nominal value. Regulators have even called for that (Basel-II). However, even if all the sovereign debt will eventually return to full value again (a highly optimistic assumption), it is quite likely that banks will be required to make some risk provisions for these assets sooner or later. A bank which has to make a 10% risk provision on, say, Italian bonds has just wiped out 2 years' of spread interest through active utilization of the LTRO.

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