Draghi prays for a miracle but capital weightings leave his ABS purchase programme fatally hobbled
ABS purchases to include Greece and Cyprus as ECB reveals latest plan for balance-sheet expansion.
|ECB president Mario Draghi|
When the news feed to the ECB’s website for its Thursday press conference failed to work, Euromoney hoped it wasn’t a portent for the performance of the central bank’s latest attempt to expand its balance sheet and stimulate growth.
The ECB’s plans to expand its balance sheet to early 2012 levels (up to €3 trillion) were dealt a blow when its first offer of four-year TLTRO loans attracted a paltry €82.6 billion of interest. This has put additional pressure on ECB president Mario Draghi to make his asset purchase plans in the ABS and covered bond markets succeed.
Announcing the details, Draghi declared that the interaction of all three programmes would have a substantial impact on the ECB’s balance sheet, but he remained strangely elusive on the target size.
“I wouldn’t want to emphasize balance-sheet size per se; [the] only mandate we have is to bring inflation back to close but below 2%,” adding rather testily to the assembled journalists: “I understand your desire to have very precise figures for everything. That makes life perhaps easier.”
The ABS and covered bond purchase programmes will last for at least two years, with covered bond purchases commencing in mid-October and ABS by the fourth quarter.
“They will enhance functioning of the transmission mechanism, facilitate credit provision and create positive spillovers to other markets,” Draghi claims, optimistically.
“Our asset purchases should ease the monetary policy stance more broadly and strengthen our forward guidance. They will reinforce fact of significant and increasing differences in the monetary policy cycle between major advanced economies. With the monetary accommodation already in place, they will underpin a firm anchoring of medium to long-term inflation expectations.”
Assets eligible for purchase under the ABSPP were expected to be a subset of repo-eligible assets, with the ECB only purchasing senior or guaranteed mezzanine tranches in euro-area securitizations of non-financial loans. Deals available for purchase were expected to be those also already eligible as repo collateral.
“We’ve been accepting ABS as collateral for 10 years, so it made sense to have as much similarity as possible,” Draghi commented when the scheme was announced.
Such collateral must be investment grade, simple, transparent and real. “The ABS we are focusing on are simple and transparent, their content ought to be loans that are easy to read, price and interpret,” Draghi says. “We will not orient our purchase programme towards structured ABS as [it] will not be in sync with the aim to boost lending to the real economy.”
Repo-eligible collateral requires two ratings of single A- or higher under the general framework, but BBB- assets are allowed under the temporary framework.
Draghi claims the potential universe that the two purchase programmes will address is up to €1 trillion. According to Barclays, 932 European ABS bonds with an outstanding balance of €660 billion are ECB repo eligible – however, more than half of these bonds are already being used as ECB collateral.
The announcement that the ECB will also buy the senior tranches of ABS backed by loans from sub-investment grade sovereigns – Greece and Cyprus – will surely prove controversial.
“We have decided to include countries with a rating below BBB-, such as Greece and Cyprus, but with extra risk measures,” Draghi says, adding that Greece and Cyprus must remain under a EU-mandated programme of structural adjustment to remain eligible for the scheme. “There must be a programme in place – if no programme, no purchases.” The extra risk measures include that one rating must be the maximum achievable in the jurisdiction and the deal must have at least 25% credit enhancement.
|Without new regulation, the ECB plan to buy ABS risks becoming another funding tool, without capital relief
Early rumours this might happen had sent Greece’s 10-year spread versus Germany 45 basis points narrower early on Wednesday.
Although the volume of ABS from Greece and Cyprus that falls into this category is negligible, it is a step too far for many.
Writing in the FT, Hans-Werner Sinn, president of the Ifo Institute for Economic Research recently stated that: “The ECB’s preference is to purchase the better tranches of these securities and leave the junk for the European Investment Bank.
“But since politicians are not playing along, the ECB will have to hold its nose – and complete its conversion into a bailout agency.”
Of far more significance in terms of volumes of paper available for purchase is the ECB’s treatment of retained assets, which make up more than 75% of the European ABS universe. Indeed, there is €540 billion eligible European ABS placed with investors compared with €1.1trillion in mid-2007.
The €350 billion-worth of eligible ABS deals being used as repo collateral with the ECB are predominantly those that have been retained by the banks for just this purpose. If the ECB buys these bonds, it is simply substituting repo for outright purchase to little net effect.
There are also valid questions over the price transparency of retained assets. The central bank should only purchase such tranches as a co-investor alongside private buyers. The ECB has set a cap of 70% on its purchase of ABS tranches. For Greek and Cypriot deals, this has been lowered to 30%.
The big risk the ECB faces is that the European ABS market is so small that whatever it does will distort it. Demand already exceeds the paltry supply.
ECB vice-president Vitor Constancio has said it “will operate in both primary and secondary market and limit purchases to mitigate effect on prices”. Quite how it does that with only €120 billion publicly placed eurozone senior ABS outstanding is hard to fathom.
Just the announcement of the programme saw spreads on senior bonds of core sectors tighten between 3bp to 15bp and those on peripheral ABS tighten between 25bp and 45bp during September.
The central bank runs the real risk of crowding out the existing investor base in these assets if it attempts anything but modest interventions in the market. Barclays reckons it could buy between €1.5 billion and €2 billion a month.
Draghi has long made it clear that the aim of ABSPP is to stimulate credit to corporates across Europe – particularly in its periphery. He reiterated this during the programme announcement: “The programme is oriented towards boosting lending to SMEs.”
This is where the plan starts to fall apart. According to Barclays, €42 billion of the universe of ECB-eligible ABS does not meet requirements on rating or minimum size for repo. That is not a huge percentage of the total but 80% of it is peripheral ABS – exactly the type of paper that Draghi has pushed to be included in the scheme.
However, the outstanding balance of investor-placed peripheral senior ABS is just €66 billion, and only €6.4 billion of this is SME ABS – the type of issuance that the central bank is so desperate to revive. It is hard to see how the ABSPP will fulfil its aims in peripheral Europe with these kinds of numbers to work with.
The impossible conundrum Draghi still faces is how to incentivize banks to issue ABS while at the same time it offering sufficient spread to be attractive to buyers facing higher capital charges for holding the paper.
Squaring this circle has bedevilled the market for years and boils down to the same thing it always has: more lenient treatment under Basel III and particularly Solvency II, and eligibility for bank liquidity coverage ratios. Final rules on both are due this month and without substantial change the ABSPP could be dead in the water.
“The ABS plan’s success still depends on governments and regulators supporting it,” says Alberto Gallo, head of macro credit research at RBS. “The market is segmented and banks are still unable to issue and transfer risk to investors. Without new regulation, the ECB plan to buy ABS risks becoming another funding tool, without capital relief.”
Analysts at Barclays agree. “The ECB will only be able to promote a healthy European ABS market if it manages to convince bank, and in particular insurance, regulators to lighten current regulatory initiatives’ treatment of ABS, specifically the non-senior part of the capital structure,” they emphasize.
The sense that these programmes are simply a dress-rehearsal for full QE remains strong.
“The governing council is unanimous in its commitment to using additional unconventional instruments within its mandate, if necessary,” says Draghi. “Despite all the measures already taken, the GC still stands ready to take additional measures.”