ECB opts for low risk

By Ralph Atkins and David Oakley Published: May 11 2009 20:22 | Last updated: May 11 2009 20:22 Jean-Claude Trichet, the European Central Bank president, took investors by surprise last week when he announced plans to boost one of Europe’s more obscure markets in an effort to jump-start the continent’s flagging financial system. The ECB will buy €60bn ($81.6bn) in covered bonds, a 340-year-old asset class that, before the credit crisis, was widely used by banks to create bonds backed by mortgages or public sector loans. It is hoped the move will revive the €1,100bn market, which has been one of the biggest casualties of the financial crisis and in the process boost the European economy and housing market. The European covered bond market has shrunk by €200bn since August 2007, according to Dealogic. The plan has got off to a good start. Since the ECB’s announcement last Thursday, yield spreads on European covered bonds have tightened by 20 basis points to 4.4 per cent, according to the iBoxx indices. EDITOR’S CHOICE Editorial Comment: World discovers it is still breathing - May-08Figures raise hopes German economy is out of 'freefall' - May-09Global Insight: Chinese tap an inner dynamic to drive growth - May-11Martin Wolf: Tackling Britain’s fiscal debacle - May-07Retail sales rise at fastest for three years - May-12Spain’s Banco Santander also announced on Monday that it would issue a €1.5bn five-year covered bond – one of the first covered bonds issued in Spain since June 2008. Spain’s market has been particularly savaged because of the collapse of its housing sector. The ECB’s €60bn financial injection will help a beleaguered market and restore confidence by encouraging investors to buy covered bonds. Richard Kemmish, head of covered bond origination at Credit Suisse, says: “The strong signal of support from the ECB will go a long way to boost the market. This is a market with a good model that has suffered more than anything from a lack of confidence.” However, the impact of the ECB’s move will depend crucially on how the ECB decides to implement the programme. So far, Mr Trichet has only announced an agreement “in principle” by the 22-strong ECB governing council to buy euro-denominated covered bonds issued in the eurozone. “Detailed modalities” would be announced after its June 4 meeting, he said. Sceptics warn that €60bn is only a small amount – about 5 per cent of the existing covered bond market. It is timid compared with action taken by the Bank of England, which on the same day last week announced it would buy another £50bn in bonds – mostly gilts – taking its quantitative easing programme up to £125bn, or 20 per cent of gilts in the market. However, for the ECB, under pressure to follow the Bank of England and the US Federal Reserve in embracing additional “non-standard” policy instruments, selecting covered bonds as its weapon of choice made sense. Not only are covered bonds low risk – allowing claims on the issuer – they are also covered – which gives the asset class its name – by a pool of high-quality collateral. That is where it differs from securitisation, where investors have no recourse to the issuer’s balance sheet and the collateral is often of a lower quality. The fact that bonds are issued by banks means their purchase could been seen as fitting with the ECB’s strategy of channelling help to the banking sector. Ted Lord, Frankfurt-based managing director and head of covered bonds at Barclays Capital, sees the ECB’s decision to purchase covered bonds as also highlighting the segment’s importance for eurozone financial markets. “Covered bonds support two major areas necessary for economic recovery in Europe – the European mortgage markets and public-sector infrastructure.” The ECB’s immediate aim will be to kick-start the market, rather than aiming directly for broader economic results, Mr Trichet indicated last week. “The idea,” he said, “is to revive the market, which has been very heavily affected, and all that goes with this revival, including the spreads, the depth and the liquidity of the market. We are not at all embarking on quantitative easing.” That assurance probably helped win the support of Germany’s Bundesbank, which has been sceptical about central banks buying assets as part of the efforts to combat the recession. The fact that the European covered bond market is dominated by Germany almost certainly helped as well. But Mr Trichet will be anxious to present the programme as a eurozone-wide initiative. Among the toughest decisionswill be deciding where to focus help to maximise its effectiveness without laying it open to charges of favouritism. The ECB is highly likely to target new issues, as well as existing issues, which could have the effect of encouraging covered bonds in those eurozone countries where the market is under developed. That would also make the €60bn programme look decidedly more ambitious – euro-denominated public issues of covered bonds (new benchmark issues and top-ups of existing issues) have totalled only €13bn this year. Beyond that, the ECB intentions are less obvious. Some governing council members might fret that helping public-sector backed covered bonds would reward fiscal irresponsibility. Focusing on mortgage-backed bonds, in contrast, could be used to provide a much needed boost to property markets, particularly in Spain and Ireland – the eurozone countries which so far are worst hit by falling house prices. Mr Lord argues that the ECB’s hopes of bringing about a general revival of the market suggests “their approach will be broad-based and implemented in different areas”. Armin Peter, head of covered bond business and syndicate at UBS, adds: “It makes sense to target this market, as it has been one of those hit hardest by the credit crisis. It could also help the mortgage markets in the eurozone.”