Mario Draghi got off to a bold start when he took over last November. Not only did he reverse the two rate hikes of his predecessor promptly after assuming his post, he also initiated LTRO, the 3-year refinancing program offered to all 17 Eurozone member banks. He broke ECB tradition by lowering the credit quality standard from AAA to just A, and pushed the definition of "repo" out to three years, a duration unheard of on Wall Street repo desks.
At this month's ECB meeting he did it again, taking the ECB into an area unimaginable just three months ago. Draghi took LTRO in a different direction. He explained that for the next LTRO due to take place on February 29, credit standards for collateral would be significantly relaxed. There would still be guidelines, but the single A rating criterion seems to have been dropped. Instead, the eligibility of collateral will be determined by the central banks of seven of the 17 Eurozone countries.
Those seven countries (Ireland, Spain, France, Italy, Cyprus, Austria, and Portugal) would ultimately be responsible for their own credit decisions. The approved collateral would reside with them, though the ECB would have the final say as to whether or not the collateral would be accepted. However, as Draghi emphasized, the central bank operating in the jurisdiction of the collateral issuer would be the best judge of credit quality. It is not likely that the credit evaluations of the various central banks would be second-guessed.
The only threshold mentioned in Thursday's press release is that the "credit claims" be "performing," so we are left to ponder what kind of collateral would be satisfactory. Draghi did give us a hint at the answer, however: the kind of collateral that would require a "haircut" of about 65%. Responding to a question from the press following the ECB meeting, the President said that the loan amount secured by this collateral would be reduced by "almost two-thirds," which would provide an "acceptable" credit buffer.
This redefinition of the means by which the ECB provides liquidity to its member banks is the latest forceful transformation of the institution Draghi began overseeing just months ago. It also belies Draghi's deep concern for Europe's financial system and the impact it is having on Europe's real economy. Draghi signaled that this revamped LTRO program istargeting the smaller regional banks that can't easily adjust their balance sheets, let alone lend to their area's businesses.
Draghi's interest in the Eurozone business community tipped his hand. As he expressly mentioned in today's question and answer session, the private sector "counts for almost 80% of employment in the Euro sector" and is in need of ECB support. With his clear concern for employment, Draghi has pushed the ECB far in the direction of a dual mandate shared by the Fed, namely inflation and employment.
This was a stunning ECB meeting. We can draw two conclusions, both of which will impact stock markets over the long term. First, we can add Eurozone employment to the list of indicators that we can use to forecast the actions of Draghi and the ECB. Because of his fear of unemployment, Draghi will likely err on the side of loose monetary policy even as and when inflation begins to rise. At the same time, if unemployment heads higher--and it might well do so--we can expect more "non-standard measures" along the lines of LTRO.
Second, if we consider the lengths to which the ECB has gone in order to provide liquidity to all of the Eurozone banks, we can assume the stress within the financial system must be acute. This stress goes far beyond the large banks' exposure to the peripheral sovereigns since the smaller regional banks seem to have little exposure or they would have pledged sovereign bonds as collateral. Draghi seems to be more concerned with loans, even unsecured loans, and these banks seem unable to fund them, at least at present.
There are a lot of cross-currents pushing and pulling the markets these days, nowhere more than in Europe. The additional liquidity that the ECB is providing through LTRO is a bullish factor, all things being equal, and it probably will end up to be. But beyond the immediate, today's measures are hardly an endorsement of health. With the Eurostoxx 50 index up more than 16% since mid-December, markets are looking awfully stretched.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
