LTRO: Draghi Makes His Case

by: Macro and Cheese

Following the global swoon of equities on Tuesday, today's ECB meeting was a big one. From the time of the announcement of the ECB's first LTRO operation on December 21, the Eurostoxx 50 Index had rocketed up 14.3%, only to give back nearly 40% of that gain over the past few days. The Fed did its part to calm things down yesterday with talk of a "sterilized QE," but the market was looking for reassurances from the LTRO architect, ECB President Mario Draghi. Following the regular monthly ECB meeting, Draghi had his opportunity.

The market's initial verdict was swift and negative, with Eurostoxx coming off 1% from the day's high. As time went on, stocks gained their composure and went out at the highs of the day. Since the market is always looking for its next fix of government intervention, the view of the meeting was that Draghi was holding out the possibility of more LTRO. But is that really what Draghi did?

The highlight of the monthly ECB meetings is the Q&A session following the terse statement read by the ECB president. Today's meeting was no different, but the questions were particularly interesting. The policy statement was tedious and utterly expected. But the press corps can't be scripted, and as usual they were happy to get into the president's face.

If there was one word to describe Draghi's performance, it was "defensive." Draghi took the first question on whether there would be more LTRO and ran with it, congratulating himself that LTRO had been an "unquestionable success," and that "great progress has been achieved." He claimed LTRO "removed tail risk" and was responsible for a "return of confidence."

At the end of his laudatory assessment, Draghi said "the ball is in the governments' court" to repair balance sheets and keep the economy going, and it was downhill from there. Brian Blackstone, the ECB reporter for the Wall Street Journal, asked about the sources of future eurozone growth, and about Draghi's relationship with the Bundesbank. Blackstone got an earful - but not regarding his questions. Draghi told Blackstone that he read his articles about LTRO "very carefully" and disagreed with the reporter's assumptions about the ECB's balance sheet relative to eurozone GDP. He went on to offer up ratios of his own, saying that after adding in assets such as gold, the ECB's leverage is lower than the U.S. and U.K.

Draghi sidestepped Blackstone's question on the Bundesbank, but the next reporter asked Draghi what he thought of Juergen Stark's comment that the quality of collateral used for LTRO is "shocking." Stark is not just anyone. He's the former executive board member of the ECB who resigned in December, almost 2 1/2 years before his term was slated to end. Draghi responded that Stark had also voted for LTRO before he resigned, though he admitted Stark left before a collateral determination was made.

Draghi also launched into a defense of the ECB's consensus when the press raised the issue of a leaked letter from the head of the Bundesbank, Jens Weidmann, to Draghi immediately following the second round of LTRO. The letter was very critical of LTRO, a uniquely Draghi initiative. Draghi stated that yes, there were bound to be differences of opinion, but that the two men have an excellent relationship. He said he was sure Weidmann himself didn't leak the letter, but who else could it have been? Draghi is walking a tightrope. Both men are in their first year of eight-year terms, and his German counterpart is clearly unhappy.

When asked about banks buying sovereign debt to meet LTRO collateral requirements (and pocketing 200-400bp in positive carry), Draghi said that about EUR 53 billion of sovereign bonds had been purchased, EUR 40 billion of that by French banks. Draghi went on to claim the banks already had sufficient collateral, and that these purchases were intended to over-collateralize their loans. Although no reporter called him on it, Draghi's assertion is almost certainly false. No cash-strapped bank - the kind that would borrow through LTRO - would post collateral beyond what is required of them, especially EUR 40 billion of it.

That wasn't Draghi's only dubious claim. With very little prodding, Draghi also criticized the notion that the rise in overnight ECB deposits by financial institutions has negated the effects of LTRO. Critics have pointed out that of the EUR 504 billion in net LTRO lending, about EUR 443 billion - nearly the entire amount - has ended up back at the ECB. Draghi said the ECB knows who is doing the LTRO borrowing and ECB overnight depositing, and that the institutions are not always the same. This, he said, is proof that the money is being put to work.

It's a stretch to think that the total amounts of LTRO loans and ECB deposits being within 10% of each other is a coincidence. Even if it were, the effect is the same: On a net basis the ECB has loaned EUR 504 billion, and EUR 443 billion has come back. Whether those deposits come from BNP or Deutsche Bank doesn't matter. The cash is not in the system.

Draghi tested his credibility one more time when asked about LTRO and its effect on commodities, and crude oil in particular. Like Bernanke before him, Draghi resolutely denied any connection, saying any rise in the price of petroleum is a coincidence. If so, it's an extraordinary one. Brent crude is up 15% since the first LTRO operation was announced, almost exactly the same as the rise in WTI crude during the first few months following the announcement of QE II.

We learned a lot from the ECB meeting today, probably more than Draghi would have liked. We already knew that LTRO was an ostensible success. Bank and sovereign spreads have declined, stocks are up, and banks are much more able to manage their liquidity.

But we also confirmed that LTRO is highly controversial, and probably a source of regret for Draghi's most important partner of seven more years, the head of the Bundesbank. We learned Draghi is defensive to the point of singling out a journalist for his critique of Draghi's expansion of the ECB balance sheet. We learned that French banks, already leveraged to the hilt, have added EUR 40 billion to their balance sheets - much of that, it seems, in Italian government bonds.

The money quote is that an Italian is in charge of the ECB, and the Germans aren't happy about it. Draghi may have the bank, but the Germans have the money. Though you can never say never, given the chasm and palpable opposition, another LTRO operation any time soon is highly unlikely. More probable is the end of Draghi's honeymoon, and a decline in his ability to effect the aggressive measures that have characterized his first three months in office.

Please note: I am short equity index futures.