There is no doubt that without the bank’s swift intervention, the implications of the liquidity squeeze on the wider economy would have been far, far worse.
But at what point does the market’s reliance on ECB repo funding develop into moral hazard? Are banks, as has been suggested, using the facility to fund new origination? Are they taking advantage of the single rating requirement to offer up weaker collateral to the ECB? What is the unwind scenario of the €200 billion of ABS that has been engineered and retained to tap the ECB window? And, most important, how can a functioning market ever reappear while the ECB (and the Bank of England SLS scheme) are prepared to offer cheaper funding?
Accusations of ECB funds backing new origination stem from the sheer volumes of collateral that have been posted with the ECB. But this can be misleading, as banks may often post collateral with the central bank but not draw the repo line: the collateral is simply posted as a backstop if needed. Indeed, in its April 2008 financial stability report, the Bank of Spain pointed out that ECB borrowing still only represents 1.3% of Spanish bank balance sheets. They have, however, collectively increased their use of ECB liquidity from €19.1 billion in April 2007 to €47.6 billion in April 2008 and are seen by many as the root cause of worries about the repo scheme.
Fitch recently cited evidence that the ECB is accepting collateral pools from Spanish banks that are based on higher LTVs, higher levels of borrower concentration and exposure to higher-risk sectors than previously seen. By only requiring one rating (as the ECB does) it is easier for lower-quality assets to be included in asset pools than for deals that would require scrutiny from more than one agency.
Yves Mersch, a member of the ECB’s governing council, has admitted that collateral quality has become "a matter of high concern" for the central bank. A tightening of the rules moved one step closer in July with comments by ECB president Jean-Claude Trichet that "we are permanently examining and applying our rules (on acceptable collateral) with great care. If it is necessary to refine elements of our scheme as we did in the past... then we will see what we have to do." News that the bank had accepted as repo collateral €455 million-worth of bonds backed by Australian car loans from Macquarie shows how far things have gone. In 2004, structured finance accounted for just 4% of ECB collateral – today it is 18%.
A massive unwind of ECB paper in response to either tighter rules or collateral quality deterioration is something that many in the securitization market are becoming increasingly worried about – with good cause. If the market is faced with trying to reabsorb a glut of these bonds on top of the overhang it is already trying to deal with following the restructuring of the SIVs, the already remote prospect of any market recovery will be further away than ever.