LTRO: What It Meant, What It Means

by: Macro and Cheese

The biggest financial event of the year is now behind us. The ECB announced the results of its second Long Term Refinancing Operation (LTRO) at about 5:25 am EST Wednesday morning, coming in larger than expected at EUR 529.5 billion. Of that total, EUR 311 billion was "new money" being loaned to banks, as opposed to old ECB loans being rolled over. The operation was much more widely dispersed than the first LTRO of December 21 was, reaching 800 institutions vs. 523 banks the first time out.

A few observations:

  • This was the most effective government intervention by any government since the crisis began in 2007. By lending a total of EUR 504 billion in net new funds ($672 billion) during the course of the two LTRO operations, the ECB gave a boost to markets globally. European stocks rallied as much as 20%, European sovereign yields plunged dramatically (from 6.25% to 3.75% in the case of Italy), and even the Nasdaq rose 20%.
  • Jean-Claude Trichet, the predecessor to ECB President Mario Draghi, would never have done LTRO, nor would his heir apparent, Bundesbank President Axel Weber. Both would have found LTRO too far afield of the ECB's mandate to implement such a measure. This was bold, and it was all Mario Draghi.
  • Draghi succeeded in getting funds down to the smallest of regional banks, the ones he was most worried about. He shrewdly designed the operation to take place in two parts, to make sure all institutions had a chance to see how it went, and then to participate. Because Draghi is particularly concerned with Eurozone unemployment, he has done his utmost to ameliorate that particular problem.
  • Given the depth of participation, Draghi also succeeded in getting banks to participate despite the risk of being stigmatized as weak or in trouble for doing so.
  • Not only did LTRO work in the same fashion as the quantitative easing of the United States, Japan, and Britain, it also targeted the banks directly, providing them funding when there was none, especially longer-term funding, which had become all but unavailable.

LTRO was indeed impressive. I say this as a skeptic of government intervention in general, and of ECB measures in particular. Anything coming from the 17-country Eurozone is bound to be slow and subject to a consensus, and Draghi was able to cobble together support within weeks of assuming office, and swiftly carry it out.

But that's all behind us, and the question now is, was the global equity rally of 15-20% justified, and will the market hold its gains and move higher?

It's hard to quantify the intangible value of supporting the European financial system, which LTRO has clearly done. The kind of support that banks have received could lead to a virtuous cycle by which banks will begin to lend amongst themselves and to their corporate constituents. This effect certainly occurred in the US to a greater or lesser extent during QE I and QE II.

This positive financial impact can't be quantified, but the other aspect of LTRO - the amount of cash available to stimulate the economy through lending or asset purchases - certainly can be. We know that although the combined "headline" number of the two LTRO operations was just over EUR 1 trillion, less than half that amount (EUR 504 billion) consisted of "new loans," as mentioned. At $672 billion, this is slightly larger than QE II.

To dig deeper and to see if the LTRO-QE II comparison is an apt one, we need to compare the nature of the two. With QE, the Fed prints money to buy government bonds, which it purchases on the open market. Investors from all ranks sell their bonds and presumably use much of the proceeds to buy other assets such as stocks, bonds, or commodities.

With LTRO, use of proceeds is more complicated. Only banks participated in LTRO, and banks are not big buyers of equities, particularly in this environment. They can (and did) buy sovereign bonds, which certainly helps, but that doesn't boost equity markets very much, certainly not directly.

There is anecdotal evidence that many banks were primarily interested in taking advantage of the tenor of the loans (up to three years) rather than out of interest in borrowing the money per se. Without longer-term funding, banks are particularly vulnerable to liquidity problems, issues that can lead to default in the worst case. If this is the case, then banks can borrow for the full three-year term, and then deposit the proceeds short-term until a need arises.

ECB deposits

This chart shows overnight funds deposited at the ECB by banking institutions, in billions of euro. At around the time of the first LTRO operation on December 21, the balances rose dramatically, exceeding EUR 500 billion early this year. This figure exceeds the entire size of the initial LTRO operation. Although balances began rising prior to the December 21 date, the net amount of LTRO (e.g. new loan proceeds) was only EUR 193 billion. In aggregate, all of the "new" LTRO money was re-deposited back at the ECB. This liquidity has effectively been sterilized, just as much as if the ECB had issues short-term bills.

Unlike the QE operations--which had their own limitations - LTRO was a banking operation, designed as much to assist their "gap" (maturity) risk as it was to provide banks with funds. It is therefore an open question as to how much of that liquidity will make its way into equity and other markets.

Perception is key. You'll recall that about half of the rise in equity markets attributed to QE II occurred before any funds changed hands. Markets started rising, and then rose relentlessly, following Bernanke's famous speech in August 2010, even though QE II did not take place until the following November. There is a strong possibility that LTRO is acting in the same way. If so, markets may deflate as the expected liquidity from LTRO doesn't materialize.

Towards the end of the day markets exhibited some strange behavior, with gold tumbling nearly $100, and S&P 500 futures plunging into the close. The rumor making the rounds is that a large hedge fund was liquidating positions in a post-LTRO operation. That may or may not be the case, but there is a certain logic to the idea. As good as LTRO has been for Eurozone banks, it may end up being much less so for markets.

See also "LTRO: What It Meant, What It Means, Part 2"

Disclosure: I am short S&P 500 index futures.