ECB may have to change tack on bond buys

Activists of the Occupy Frankfurt movement have set up a fireplace near the Euro sculpture in front of the European Central Bank in Frankfurt, Germany Nov.3, 2011. The ECB announced to lower their key interest rate to 1.25 percent. AP Photo/Michael Probst

(AP) FRANKFURT - When European Central Bank head Mario Draghi said that he was ready to "do whatever it takes" to save the euro, he fueled investor hopes the bank would again start buying government bonds to lower borrowing costs for struggling countries.

Just one problem: The ECB has tried bond-buying before. And it didn't work very well - the action was seen as too hesitant and fell short of decisively lowering borrowing costs for stricken Spain and Italy.

Draghi is certain to face questions Thursday at his news conference after the bank's government council meets about possible bond purchases and the financial turmoil in Europe.

Last week, Draghi noted that excessive government bond interest rates "come within our mandate" if they are hindering the ECB's efforts to spread its single interest rate policy throughout the 17 countries that use the euro. That was seized on as a hint the bank might restart its Securities Market Program that bought bonds in the open market, but which has been left dormant since March.

Bond purchases drive their prices up and their interest rates, or yields, down - price and yield move in opposite directions. The ECB's earlier purchases were able to temporarily drive down the yields - and therefore the borrowing costs incurred by Spain and Italy when they floated new bonds.

Analysts say that Draghi has raised expectations for action so high that markets could be sorely disappointed if no new bold measures are announced Thursday. An interest rate cut from the current record low of 0.75 percent remains a possibility, though many analysts think the bank will wait at least until September. Market attention is most intensely focused on what Draghi will say about the bank's willingness to influence the market for government bonds.

Slavena Nazarova, an economist at Credit Agricole expects Draghi to emphasize the bank's willingess to use all its weapons to support the eurozone - but take no new actions: "We are skeptical that such intervention will come as soon as this week, so there is quite a big risk of disappointment for the markets."

The U.S. Federal Reserve may also leave investors a bit crestfallen, as it considers Wednesday and Thursday whether to do more to stimulate the uncertain economic recovery in the United States. Analysts say it likely will not move to buy more government bonds and stimulate the economy by expanding the supply of money in the economy.

For the ECB, simply re-starting the SMP remains problematic. The bank first used the program in May, 2010 as Greece headed for a bailout, then paused it. It was re-started in August, 2011 as the crisis spread from small countries such as Greece, Ireland and Portugal to countries whose governments are too big to easily bail out - such as Spain and Italy.

But after an initial dip in yields, Spain and Italy soon saw them rise again. The problem was that the ECB said the program had to be limited - a statement that kept it from overly impressing the bond market.

On top of this, there was opposition from the Bundesbank, Germany's central bank and a high-profile member of the ECB's board. The Bundesbank remains skeptical of bond purchases, saying they come too close to breaking the ECB's founding treaty, which forbids it from financing governments.

Because of the treaty restrictions, the ECB must claim the bond purchases are meant to ensure its ultra-low interest rates are being passed on to all borrowers throughout the eurozone.

It's a restriction not faced by the U.S. Federal Reserve and the Bank of England, both of which have engaged in large-scale bond purchases to expand the supply of money in their economies and try to boost growth.

Here are some other possibilities the bank might look at, all with drawbacks:

— Team up to buy bonds with the eurozone's bailout fund, the European Financial Stability Fund — or by its replacement, the European Stability Mechanism. The problem is that the EFSF and ESM have limited funding left after bailing out Greece, Ireland and Portugal

- Offer another round of cheap, three-year loans to banks, as the ECB did in December and February. Some of the 1 trillion euro taken by banks was used to buy government debt, lowering borrowing costs for several weeks. But banks buying bonds raises the threat that if a country defaults on its bonds, the banking system would be hit. That would hurt credit availability, choking the economy.

- Leave any bond purchases to the EFSF/ESM. The ECB could express willingness to buy the bailout funds' bonds in the open market. That means the ECB could support the effort indirectly.

- Drop the ECB's insistence on being paid in full on any of the bonds it owns in case a country defaults. Such ECB "seniority" could make investors afraid they would be behind the bank in the line to get paid back - and lead them to demand higher yields on a country's bonds. That's the opposite of what the ECB would be trying to achieve. But if the ECB makes a loss on their bonds, that's passed back to the governments that finance it.

"A reactivation of the SMP only makes sense if other measures are decided on," such as dropping the bank's preferred creditor status, said Christoph Balz, analyst at Commerzbank. He warned that dropping that "seniority" status could create new problems. Any ECB losses would be passed back to national governments as part of the bank's profit or loss for the year. That means losses on Spain could hit troubled Italy, for instance.

Such a change "is not so easy to do," Balz said. "This argues for Draghi likely not making any announcement this week of any big program to buy bonds," said Balz.

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