Willem Buiter presents some interesting thoughts regarding the ECB’s one-year liquidity operation last week. What particularly strikes us is the following paragraph (our emphasis):
You may think that this implies that the cost to the banks of borrowing from the Eurosystem for a year – 1.00% – does not imply a subsidy, as the banks’ borrowing from the Eurosystem is secured against collateral. You would be right if the collateral consisted of German government bonds. My guess (I don’t have hard information) is that this was not the case, and that instead the borrowing banks stuffed the Eurosystem with the worst quality collateral they could put their hands on, subject to the constraint that a rating agency had rated it at least BBB-. Given the well-established practice of Eurozone banks that are eligible counterparties of the Eurosystem in repos and at the discount window, to carefully structure collateral packages that just meet the letter of the ECB’s collateral eligibility requirements, I am happy that I am not responsible for vetting and verifying the credit risk present in the portfolio of that increasingly speculative, highly leveraged entity known as the Eurosystem.
In short, Buiter is continuing the theme of the ECB being a good bank with rubbish assets, but creating the illusion that it isn’t. To emphasise the point, he asks us to consider “what if” the liquidity operation – much heralded by the market as an outright and groundbreaking success – was actually just a cloaked bailout or ‘gift’, as Buiter terms it – albeit a not-insubstantial gift, and one that comes without any associated European government approval.
The key determining factor turning a liquidity operation into a bailout, of course, is the quality of assets underpinning the operation. For, as Buiter explains:
If instead the collateral offered by the banks is without value, their secured borrowing is equivalent to unsecured borrowing. The one-year Euribor rate, 1.64%, provides a lower bound on the true unsecured borrowing rate of the banks. I believe it is safe to assume that most of the collateral offered to the ECB in this operation was rubbish. The supply of one-year funds was open-ended (demand-determined) and it is plausible to assume that the banks did not demand more than €442bn because they ran out of collateral and exhausted their capacity to transform pig’s ear securities into silk purse collateralisable assets.
In which case:
The risk-adjusted rate of return to the Eurosystem on its lending to the banks can hardly be more than 0.70%, given the poor quality of the collateral offered and the dreadful state of the balance sheets of many Euro Area banks. In that case there is a subsidy from the ECB to the banks of just over 0.25 percent, say € 1 bn. While this is a small number, on the gargantuan scale on which bank losses and bailouts are measured these days, it is clearly inappropriate for the central bank to engage in quasi-fiscal operations of this nature. Subsidies should be voted by the appropriate parliaments, not distributed by unelected technocrats.
At that 0.25 per cent differential between secured and unsecured rates, and with consideration of a risk-free return over the given period, you could (according to Buiter) actually interpret the operation as being nothing more than an outright ‘gift’ of as much as €10bn from the ECB to participating banks.
However, as Buiter concludes:
If the ECB wants to play Santa Claus, I know of more deserving recipients of their largesse than the banks.
What’s worth remembering too is how the euro-system’s strikingly large covered-bond market fits into this puzzle. You may recall: until the ECB promised to buy up to$60bn worth of covered bonds in sterilised operations, issuance of these securities had all but dried up. The ECB’s decision to purchase covered bonds, however, saw some element of ‘unclogging’ take place with a number of prominent lenders bringing issues to market since then.
Now consider this: covered bonds are eligible as collateral at ECB windows. Other eligible assets, of course, include high quality government debt like German bunds. Currently there is some €610bn worth of outstanding bund paper. To compare, Reuters reports, back in 2006 there was some €950bn worth of German covered bonds outstanding. The total European covered market, meanwhile, was worth some €1,700bn in mid 2007 according to the Bank of International Settlements.
Issuing more German debt to satisfy market demand for high-quality euro-denominated paper that can be used as collateral at ECB windows would, of course, be problematic. Among other things it would involve a high degree of government cooperation. Issuing more covered bonds, however, wouldn’t need any government cooperation whatsoever. The only thing holding back more issuance here is lack of investor demand. But this, as the ECB has clearly shown, can easily be revived when a buyer of last resort enters the market.
What’s more, the unsticking of the covered bond market this way, might then go some way to unsticking issuance of traditional MBS and ABS paper too – also eligible for use at ECB windows.
Now let’s reprise the following comment from Buiter with particular focus on the words emphasised:
The supply of one-year funds was open-ended (demand-determined) and it is plausible to assume that the banks did not demand more than €442bn because they ran out of collateral and exhausted their capacity to transform pig’s ear securities into silk purse collateralisable assets.
If you interpret that as meaning the ECB’s balance sheet is already chock full of all the eligible securities the banks have or are willing to pledge, reviving the covered bond market suddenly makes a whole lot of sense. Above all it provides the banks with yet more eligible (rated BBB- or above) collateral for liquidity exchange at the ECB — and hopefully more if issuance of traditional MBS and ABS markets is ultimately revived too.
The hope no doubt is that banks are reassured into lending once again because they cannot foresee any liquidity squeeze in the short-run.
The trouble is, it doesn’t solve the ultimate problem: that the ECB will still be a good bank with rubbish assets.
Related links:
Why the ECB is a good bank with rubbish assets – FT Alphaville
Forget Latvia, what about Spain? – FT Alphaville
Los covered bonds, por favor – FT Alphaville
RIP Eonia – FT Alphaville
Crushing rates the ECB way – FT Alphaville