We know from the ICMA European Repo survey that European repo market participants have been using more covered bonds for collateral in 2011 than ever before.
The thinking, we imagine, is that in a world where there isn’t enough ‘risk free’ collateral to support outstanding funding needs, the next best thing is collateral which itself happens to be collateralised.
What makes covered bonds so especially special is that they aren’t just collateralised, they are in fact over-collateralised (to varying degrees depending on the issuing country’s conventions).
As it turns out, that could be a problem.
According to Societe Generale’s Covered Bond Weekly, banks which offer covered bond programmes are encountering major redemption pressure, pressure which could soon feed through to the quality of the covered bond programmes they offer.
As SocGen’s Jose Sarafana noted last Friday (our emphasis):
What is striking in the current environment are large redemptions of bank paper (ex covered bonds) in peripheral markets, such as Spain (€72bn) and Italy (€49bn). Spain will see redemptions of €36bn of state guaranteed debt alone. Also the Greek, Irish and Portuguese figures are high for the relatively small size of their respective economies. In Greece €9.2bn matures, €8.5bn in Portugal and €7.2bn in Ireland. This data suggests no relief for peripheral bank debt funding over the coming year.
The question that arises is how peripheral banks will manage with upcoming redemptions while access to capital markets currently being very limited in senior space. Why is this important for covered bond investors? They should monitor banks with large redemptions closely in 2012. If the funding shortfall cannot be matched by deleveraging or deposit growth, and covered bonds are issued instead (either for investors or for direct use for the ECB), existing overcollateralisation of covered bond programmes could fall and therefore reduce the quality of the covered bond programmes.
Add to that the possibility that regulators might be inclined to cap the number of assets banks can dedicate (or encumber) to covered bond pools, and this could hit issuance in the market as well.
Or, as SocGen’s Jean-David Cirotteau summed it up:
Other factors will also be impacting on the covered bond market shortly. One to keep an eye on is the possible maximum ratio of encumbered assets within banks’ balance sheets, thereby imposing a new constraint on banks. Factors such as this may drive the covered bond market to a much greater extent, in our view.
All in all, a situation which could lead to less quality and supply in the covered bond market — just as the funding market needs it more than ever.
Related links:
Draghi: “We are aware of the scarcity of eligible collateral” – FT Alphaville
ECB as Pawnbroker of Last Resort (POLR) – FT Alphaville
The ECB and covered bonds – the next chapter? – FT Alphaville