This morning at 5:00 AM the European Central Bank released the results of their second LTRO program. This program allows any European bank to show up at the door of the ECB and request an unlimited amount of money. The banks must pay 1% interest annually on the money borrowed and promise to return it in full in 3 years.
The European Central Bank under its mandate is not allowed to print money and purchase assets, which is known in the United States as Quantitative Easing (QE). Under the LTRO program the ECB prints money and allows banks to "borrow" it. This allows them to bypass the Quantitative Easing ruling.
The first of these programs was conducted back in December where 523 banks borrowed 489 billion euros. The second program this morning had 800 banks show up to the window and borrow 529 billion euros.
That is 1,018 billion euros total or 1.34 trillion dollars in printed currency to help you imagine to the size.
Now the banks can take this free money and re-invest it into an asset that yields greater than 1%, allowing them to keep the spread. What has a greater than 1% return? Let's take a look.
Exxon Mobile currently pays investors 2.16% annually for purchasing their stock. This is called a dividend payment. A European bank can take their fresh cash, buy Exxon stock, and keep a 1.16% annual spread in free money. (2.16% Exxon payment - 1% they owe ECB = 1.16%)
A 30 year government bond in the United States currently pays 3% annually. A European bank can purchase US government bonds and keep the 2% annual spread.
This is called a "carry trade." This funding is what has sent all "risk assets" soaring as banks around the world continue to take their free money and re-invest it back into the assets with higher yields.
Is there a problem with this? Yes. There is a reason why Exxon Mobile and a 30 Year government bond have the yield they do. While they are not as risky as some municipal bonds, corporate bonds, or a commercial real estate building (which provide yields above 4%) they still have some risk.
For example, what if a European bank purchases stock in Exxon Mobile and the stock is 10% lower in 3 years when their bill comes due? What if the 30 year US treasury bond has fallen in value by 10% (bonds fall in value if interest rates rise)?
How about interest rate risk? What if the value of the asset has stayed the same but the US dollar has fallen by 10% over the next 3 years? When they exchange their currency back into euros to pay back the ECB they must pay out this loss.
This is the danger in a carry trade. So the question is, in 3 years from now what will the ECB do if banks cannot pay back the money? It is the ECB's responsibility to make sure the banking system stays solvent and runs smoothly. By demanding the banks take losses it would create massive damage to the system.
The truth is at this point it does not matter. The central banks, private banks, and governments are all working together to keep the broken system moving forward for as long as possible. They have pushed almost all their chips into the pot at the poker table and have no choice but to push everything they have left and then bluff, hoping that the financial system believes the lie.
You will see another round of Quantitative Easing in America. You will see another LTRO program in Europe. You will see another response from Japan and China who both want their currencies to trade lower and boost exports in the currency wars.
The problem is so large and so far beyond repair that the only solution is to continue to move forward and hope that the system holds together. The truth is that the central banks have lost control of the financial system, which has only been masked but a market that has behaved orderly so far.
Back in 2008 the financial system foundation which can be thought of as the foundation on a home began to be eaten away by termites. The solution to this problem over the past four years has been to remodel the exterior of the home and add a new landscaping package. Those driving by have no understanding of what is taking place to the home under the surface, a rotting foundation only waiting for a trigger to collapse.
Please do not get complacent because the stock market is rising, real estate professionals tell you the housing market has bottomed, and interest rates are at all time record lows. The financial system is more vulnerable today than it was in August of 2008.
