Let's take a step back and consider the following question. Given that we know that European banks are already too highly levered, does it make sense for them to borrow more money and then invest the borrowed money in risky sovereign debt?
From an economic point of view, the answer is no. However, from the banks' point of view, the answer is an obvious yes. There is no downside for them. They will be bailed out if the situation in Europe deteriorates.
Where does the money go?
It is well understood that the most effective remedy to Europe's malaise is economic growth. However, little of the LTRO is going in that direction. Data released on Monday by the ECB details positive loan growth, but you need to look beyond the top-line numbers. There was negative consumer loan growth. There was negative non-financial corporation loan growth. The growth was being driven by financial companies.
Dependence on the ECB
LTRO is a sweet poison. Why should a bank go to the open market and borrow money when you can go to the trough and borrow at 1%? The LTRO creates a dependency on the ECB. The European banks have been effectively knocked out of non-European markets for funding because foreigners realize that these banks are largely insolvent. However, how long can the ECB provide backup? How long can the ECB ignore that many of the banks are zombie? Might the next page in the playbook be the Bank of Japan's strategy of the 1990s?
Avoiding tough decisions
I continue to believe that Europe is not dealing with its problem head on. The bailout of Greece is a fool's errand. The 130 billion euros and the "selectively defaulted" Greek debt does not solve the problem. Indeed, it is unbelievably naive to think that the Greek debt-to-GDP ratio will be 120.5% in 2012. It is a classic case of throwing good money at bad.
What Greece needs is a massive devaluation, and that is impossible given that the country is shackled to the euro. Even a 100% repudiation of its sovereign debt would not solve the problem. It is still running massive fiscal and trade deficits, and the debt would just be racked up again.