[COLOR=#0000ff]European Central BankAll eyes will be focused on Europe tomorrow, when the publishes statistics about a new, 3-year bank funding operation (LTRO) meant to ease liquidity for the banks.[/COLOR]


[COLOR=#0000ff]even [AUTOLINK]ECB[/AUTOLINK] president Mario Draghi are less than optimistic Bulls have been hoping that this funding operation will amount to a back-door bailout vis a vis the banks, as more liquidity could drive down sovereign borrowing. However most analysts and about the true impact of the financing measures.[/COLOR]

The plan
[COLOR=#0000ff]expanded the list of eligible collateralThe new plan expands the list of eligible collateral banks can put up in return for funding from the central ban. Most notably, they've to include credit claims (i.e. loans) and asset-backed securities issued at "A". Banks will—as usual—be forced to pay a penalty for using riskier assets, but they'll be able to use less collateral than previously required after the ECB cut the reserve ratio in half, from 2% to 1%.[/COLOR]


Image: Bloomberg



Bulls' hope is that banks will capitalize on the long term operation and the low price of funding to use in a carry trade—they'll by Italian and Spanish sovereign bonds in big quantities because yields have been so elevated lately, and they'll make a killing off the difference between the sovereign bond yields and the price of ECB financing.


We've seen this idea manifest lately in the popularity of short-term sovereign debt, as evidenced by the demand for 2-year Spanish bonds (at left). Yields have plummeted as banks buy Spanish debt in preparation for the trade. Italian 2-year yields have also fallen sharply, back down to levels not seen since November.

But will it work?

Despite the dramatic decline in yields and market optimism, however, analysts are less than optimistic that the gamble will actually work.
They cite a few different reasons for this cynicism:

• There's absolutely no obligation for banks to use this new funding to purchase more sovereign bonds.
• Increased availability of bank funding doesn't actually alter the inherent sustainability of sovereign debt.
• The European Banking Authority's stress tests make available information about how much sovereign debt banks hold. If market sentiment turns sour again, investors will speculate against the banks that buy peripheral sovereign debt in large quantities.
• Rising borrowing costs have made EU leaders take action to try and fix the crisis. Removing the pressure will only harm momentum towards debt sustainability.