LTRO: What It Meant, What It Means, Part 2

by: Macro and Cheese

In response to yesterday's post, "LTRO: What It Meant, What It Means," two readers chastised me - and rightly so - for omitting a major consequence of the ECB's bank lending program, LTRO. Specifically, in doling out over EUR 1 trillion to Eurozone banks in exchange for collateral of relatively low quality, the ECB is increasing its risk through more leverage and credit exposure.

The readers are certainly correct that the ECB is taking a risk with LTRO, and ECB President Draghi has admitted as much. There are prices to pay for LTRO. One of the potential costs is very long-term, but one is immediate, and is unfolding even now.

The purpose of yesterday's post was to highlight how well the LTRO program worked in the immediate term. Euro bank stocks have rallied along with global equity markets, and the funding cost of the Eurozone countries most at risk, particularly Spain and Italy, has come way down. The economic landscape has changed, at least for the time being. This change has been dramatic and has "cost" the ECB only EUR 504 billion in new loans. But yesterday's discussion should have included mention of the possible pitfalls of LTRO.

The real menace comes in the event of a further weakening of the Eurozone economy. If the economy were to contract, the collateral that the banks have pledged to the ECB may cease to be "performing" (seemingly the only hard criterion for collateral for the second round of LTRO). The ECB would be at risk--and ultimately so would the banks that pledged the defaulting securities.

Any defaults, be they of collateral or the banks themselves, would be a serious issue for the ECB. The ECB is supporting its EUR 3 trillion balance sheet with EUR 10.76 billion in capital--leverage of nearly 300 to one. With the fiscal situation of European sovereigns already strained to the breaking point, it's hard to see where the money to cover the defaults could come from. This issue of a ballooning balance sheet, coupled with shaky collateral and the 3-year tenor of the ECB loans, is precisely why Trichet and Weber would not go the Draghi route. They bristled at the risk.

The odds of a calamity of the sort that would endanger the ECB are not great, but nor are they impossibly long. Europe is facing a recession and has already contracted in the final quarter of last year. Every bailout adds to the risk of recession down the road by imposing austerity or higher taxes in exchange for cash today. By writing bail-out checks now, Europe swaps a short-term safety net for long-term growth.

Which leads us to the immediate risk, one that complicates the possibility of recession that could lead to an LTRO-related default. The reaction of markets to LTRO has been remarkably similar to that of QE I and QE II, the Fed's version of the European loan program. In the four months following the announcement of QE II, for example, crude oil rose about 20%. Similarly, after the initial LTRO operation on December 21, brent crude has risen in euro terms by about 16%, over a much shorter period of time. This has pushed euro-denominated brent to an all-time high, as we can see below.

Brent in EUR
(Source: Bloomberg)

Gasoline on the continent last week was $8 per gallon. (This figure has been making the rounds, and being the skeptic that I am, I got on the phone with a French friend to confirm it.) It can only be higher now, after this week's big runup in brent. Unlike the United States, there has been no big decline in the cost of natural gas to offset the pain at the pump. As an unintended consequence of LTRO, a bigger piece of European disposable income with go into gas tanks. This will weigh on the economy, and increase the odds of an LTRO mishap.

That all being said, the doomsday scenario of a total bank collapse in Europe is very unlikely, in no small part because of LTRO. The program went a long way towards restoring stability to the banks that were over their skis. Far more likely is another round or two of down-road can-kicking until time and growth heal the wounds and put some ground below the risk of systemic failure. Along with the endless bail-outs will come a gradual chipping away of living standards as people work more, pay more in taxes, and take home less disposable income.

Compared to TARP, TALP, the QEs, and the bailout of 3 out of 5 PIIGS, LTRO was a huge success. Not only was it effective, it was also amazingly efficient. The program provided a needed jolt to the banking system in Europe and changed the game. Stocks on the continent and in the US alone are $4 trillion higher--not bad for EUR 500 billion in margin money. Draghi took a risk, no doubt, but he got a lot of bang for his euro.

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

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