How European banks are using ECB´s 1 yr LTRO tender...

We find this funny — but then, we write about finance all day, and are easily amused.

The analysts at Deutsche Bank have a theory that the amount of money rolled from the European Central Bank’s 12-month Long-Term Refinancing Operation (LTRO) into its three-month one — an indication of banks’ demand for ECB liquidity — might not be too high. And that’s because . . .

Gauging the extent of the rollover is tricky. The EUR 442bn of the original 1Y tender was bid partly by stronger banks for carry trades and in part from weaker banks for funding needs. The Bundesbank noted in its financial stability review that the demand at the 12M was due more to carry trades being implemented, rather than funding risk aspects. A year ago, accessing funds via the Long Term Refinancing Operation (LTRO) for carry trades was attractive for stronger banks given the fact that they could lock in long term financing at rates not very dissimilar to the 1Y Eonia at that time and the economy appeared to have started its march onto the recovery route.

Given current market conditions, we think rollover of carry trade demand appears less likely– spread volatility is higher, there is funding uncertainty with regard to the ECBs willingness to continue with the fixed rate regime and 3M Eonia is significantly lower than the ECB financing rate.

Yes, demand for carry trade is less likely.

Also because this particular carry trade has gone spectacularly bust, as we noted yesterday.

There’s been a tendency for banks to use ECB funds to buy longer-dated government bonds — especially those of peripheral eurozone sovereigns like Greece and Spain. It’s an easy carry trade, and, until about seven or eight months ago, was considered a rather riskless one. Not any more!

Anyway, if LTRO carry trade demand might be less, that’s not to say demand due to funding needs will be too. Indeed, Deutsche Bank reckon about half of the one-year LTRO was used for funding purposes, which might indicate about half of it could be rolled-over into the ECB’s three-month operation.

Oh — and for those curious about that Bundesbank note, here it is :

The high demand for liquidity in the 12-month tenders is less the result of risk aspects; rather it is mainly based on banks’ ability to conduct arbitrage business by financing higher-yielding bonds with similar maturities using the money obtained in the 12-month tenders. In addition, banks can borrow money for a year at favourable conditions, thereby eliminating uncertainty related to potential increases in key interest rates over the course of the year.

Liquidity’s unintended consequences, have at thee.

http://ftalphaville.ft.com/blog/2010/06/29/273386/ltroops/

Financing carry trades instead of dealing with real economic issues...