If you have little idea of what LTRO stands for, trying to comprehend the European debt crisis might be like trying to finish a puzzle with several pieces missing. LTRO, or long-term refinancing operation, acts as the injection to banks to eases credit, state borrowing costs, and improve the overall economic outlook. With a second LTRO in Europe on the way, let's look at how the LTRO operates, what effects it had, and what the future LTRO holds for markets.
LTRO: The basics
Like during America's financial crisis in 2008, in which the government approved the Troubled Asset Relief Program allowing the use of $700 billion to buy or insure troubled assets from banks, LTRO allows the European Central Bank to lend money to banks at low rates over a long term backed by riskier collateral. In the first round in December, the LTRO lent 489 billion euros over three years at the average ECB's benchmark interest rate over the period, currently at 1%. Over 500 different banks took the funds, including BBVA
What did the banks do with all this cash? It's tough to tell. But, aside from having enough liquidity to survive, the ECB also had hopes that the banks would buy government debt to lower costly interest rates on government bonds, and lend more to businesses and consumers.
Was it effective? Bond yields did fall for several countries, including Italy, where two-year bonds yielded over 7.5% in November and fell to around 3% currently. However, that could also be attributed to Prime Minister Mario Monti's spending cuts and tax increases to help balance Italy's budget. As for more lending, the latest ECB survey of banks actually reported an expected tightening of credit standards. But to the LTRO's credit, the eurozone has yet to fall apart.
LTRO: The market effects
Some, like Societe General, argue the LTRO is similar to the Federal Reserve's quantitative easing, and the same stock rallies that occurred after the Fed's QEs apply to the ECB's moves. Since the first LTRO, European stocks -- measured by EURO STOXX 50 (INDEX: ^STOXX50E) here -- rallied 11%, beating even the S&P 500's
As Financial Times reported from a note from Citi Bank:
The ECB's LTROs have succeeded in breaking the negative spiral of rising risk aversion, poor asset performance and forced selling. Money is cheap, and every day, confidence is building little by little, prompting buying. The resulting asset performance in turn raises confidence further.
However, others see LTRO as merely propping up banks with enough cash to stay solvent, but not providing any boost to economic growth. As the same Citi Bank note said, "the fundamental story remains bleak." With forecasts of zero growth for the eurozone in 2012, the recent rally may have been correcting stock prices from a worst-case scenario of a complete Euro breakup to a less severe outcome.
The next LTRO
The second planned LTRO will take place on Feb. 29, with the size estimates ranging from a few hundred billion euros to over 1 trillion euros. If lending comes out on the higher end of estimates, markets could see it as an infusion into banks that will eventually loosen credit and improve growth -- like quantitative easing. If lending lands lower, the market may be less enthused about the potential upside from the extra cash.
As many graphs show, during the Fed's QEs stocks rallied, but after the QEs ended stocks tumbled. While this second round of nearly free money to banks could continue to spur confidence and keep the European rally going, the question is if the rally can sustain itself without further intervention from the ECB -- or if the ECB is prepared to take further action.
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Fool contributor Dan Newman recommends filtering out Lord of the Rings when researching LTRO. He also holds no shares of the companies mentioned above. Follow him @TMFHelloNewman. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.