MORNING'S EUROPEAN LEAD, PART II

Help by ECB Long Term Refinancing Operations

Channels through which the European countries and IMF lent their support remain very unclear. However, it does appear that the G-20 last weekend drew a line in the sand. They said before we give Europe anymore money, make the money tied up in your financial facilities and mechanisms work.

The real relief to the European experience has been through the European Central Bank. Sovereign bonding is one issue, while the functioning of European banks is another. In the end, both are tied together, but for band-aid purposes seen today.

Sovereigns must function to keep the tax revenue stream rolling, at least. Banks, on the other hand, must keep their liquidity rolling, at least. Where sovereigns get international support, banks aren't as directly supported, but have large financial implications in the event of failure.

For banks, the risk paradigm is surrounded by their past of borrowing their loan funds lower than the rates of their loans. These funds came from short term interbank markets. Add to this the collateral deterioration of what European banks previously pledged to obtain their loan funds (being in large part sovereign debt), and the ECB had to shore up the European banking community. Just as with the LIBOR 3 month rate chart in the article below, U.S. equities also enjoyed the relief from banking liquidity support.

In Europe, with sovereigns experiencing whispers of default, interest rates rose beyond the rates at which European banks originally borrowed. These original borrowing rates composed the base of European banking lending.

The LIBOR 3 chart shows how high, and how the rates corrected. The S&P 500 index chart to the right shows financial stress, until the ECB took its steps.

Steps taken by the ECB started on December 21^st, 2011 with their first Long Term Refinancing Operation. Which is to say, they accepted collateral from Euro banks in exchange for guaranteed money at a rate of 1% for three years This rate of lending lets Euro banks barrow at 1% and buy Euro sovereign bonds at a much higher yield--a carry trade--which should have a symbiotic effect.

The secret to the success represented by the charts amount to the ECB first buying sovereign bonds to assist in sustaining prices and reducing yields on the bonds. Secondly, on December 28, 2011 the Federal Reserve, Bank of England, Bank of Japan, Bank of Canada and Swiss National Bank all agreed to lend dollars at reduced rates in the bank liquidity system. This made U.S. dollars, or Eurodollars, available to meet European banks' demand for U.S. dollars. Eurodollars, as a unique form of currency deferential, funds so much of European commerce. With the ECB's LTRO, the eurodollar recovered, while interest on money went down, and U.S. equities went up.

Tomorrow, we will learn of the response to the ECB's next round of LTRO's. Should the uptake by banks be in the range netting 320B to 340B euros, all should maintain and stability in markets prevail. A deviation from these amounts could open a can of worms.

So far, this dynamic looks almost like a form of quantitative easing by the Federal Reserve, but only maintains banking liquidity. At the same time, the real issue of how sovereigns pay their bonds still searches for cash and international support