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Thursday, May 14, 2009

The ECB "Buys Into" Spanish Property

“The 60 billion euros they announced is peanuts for an economy the size of the euro zone,” economics professor and former Bank of England policy maker Willem Buiter said at a conference in Dublin yesterday. “I expect they will announce more or that the recession in the euro zone will be longer and deeper than would otherwise be necessary. They have a record of being somewhat behind the curve.”
European car sales dropped 12 percent in April.... Bayerische Motoren Werke AG’s registrations dropped by almost one-third to 55,633 even as the German market expanded 19 percent, helped by the government’s 2,500 euro ($3,400) sales bonus .........Spain extended its auto-sales slump with a 46 percent plunge in registrations, the largest among the continent’s main markets, while U.K. sales dropped 24 percent. Eastern European registrations dropped 21 percent, almost twice the rate of decline in the west, as Romanian demand fell by more than half.

The title to this post, and the accompanying photo are obviously a joke. But behind every joke there lies a grain of truth, and my present one is no different from all the rest in that sense, since the ECB is now indirectly buying into a piece of the Spanish property action, and they are about to do so by the acquisition of an instrument known generically as "covered bonds", the purchase of 60 billion euros worth of which was announced by the ECB last week, much to the surprise of the assembled press conference journalists, many of whom either couldn't believe or couldn't understand what they were hearing (see transcript extract below). These instruments may be generically known as covered bonds, but in Spain we call them cédulas hipotecarias.

The only covered bond most of the journalists who attended the press conference seem to have been aware of, however, was the German one - known as Pfandbrief - and hence the move was seen as some sort of "sweetner" for a fairly reluctant Bundesbank. In fact things are rather different, since, although the Pfandbrief do form part of the picture, via in particular the Hypo Pfandbrief Bank of troubled German Hypo Real Estate, in both Spain and Ireland some form or other of covered bond is to be found at the heart of the wholesale money financing strategy invented by the banks (in the early years of this century) when they realised that bank deposits alone were not going to prove sufficient if they wanted to make good on all the mortgage provision opportunities the low interest rate policy (2%) being pursued by the ECB was creating. As it happens, I have long taken an amateur's interest in the subject of covered bonds (and cédulas hipotecarias), in fact I got interested in them just as soon as I realised what an important part of the Spanish picture they were. You can find a convenient summary of what they are, how they work, and why understanding them is important if you want to get to grips with the current Spanish crisis here.

Really, and to cut a long story short, refinancing the cédulas has become important since they were originally issued on a short term (5 or 7 year duration) basis (presumeably to keep debt servicing costs down), but since they were matched against mortgages which were issued with a 20 to 30 year maturity, they were always going to need rolling over (and over, and over), and again, since the quantity of money involved is large (anywhere between 250 and 300 billion euros between now and 2014 at a guess), and since virtually nobody has wanted to know about buying them since the US sub prime crisis broke out in August 2007, they had become a big potential headache for the Spanish authorities, with something like 50 billion euros in the current Spanish bank bailout programme being earmarked for easing the renewal process.

Indeed so important have the cédulas been that you could virtually say that the current Spanish crisis was inaugurated in September 2007 when the wholesale money markets were closed to the Spanish banks who wanted to sell them, even if after hours and hours of talk-show debate (and miles and miles of column print) devoted to the crisis, hardly any Spanish voter knows what they actually are.

Well, to cut a very long story short, the good news is that the refinancing issue is now probably (and bar the shouting, and the details) as good as resolved, so if you haven't the time, interest or inclination to get involved in more of all the detail on this I suggest you now jump to the conclusions section, were I muse a little bit on what some of the political counterparty consequences of this new level of risk assumption by the ECB are likely to be.

Quantitative Easing, Financing Spanish and Irish Mortgages, Or What?

Basically, most observers have now spent the best part of a week looking into the tea leaves and trying to discern just what it was which lay behind last Thursday's announcement. So peculiar was the announcement (or at least the manner in which it was made) that Bloomberg even have an article headlined "Covered Bond Market Seizes On Plan For ECB Purchases", which explains how the complete confusion now reigning in the secondary market for these instruments (due to the incredible uncertainty over what securities policy makers will actually buy, how they will pay for them, and how great the final quantity purchased will be) has meant that trading in the bonds has all but ground to a halt (again). And this as a consequence of a move which was intended to support the market is a strange result, to say the least.

The initial confusion has only been added to by recent public disagreements between governing board members, and the statement from European Central Bank council member Marko Krnajec (governor of Slovenia's central bank) to the effect that the bank is likely to increase its asset- purchase program from the initial 60 billion euro plan provoked immediate reaction, in particular from Germany’s Axel Weber, who opposes outright asset purchases and has been pushing for the ECB to set an interest-rate floor beyond which they will not reduce further. Indeed Weber was very explicit in reaction to Krnajec yesterday, saying that he sees “no need” for the ECB to buy further private assets to support lending. “I currently don’t see the need for outright purchases of further private debt obligations,” he is quoted as saying. (Joellen Perry at the WSJ Blog has a piece covering similar gound, as she says, maybe ECB predictability has now become the main victim of the crisis, while Claus Vistesen makes basically the same point in his ECB Communication - All at Sea? and his Quantitative Easing à l`ECB? posts.)

The dispute goes even further, and extends not only to what to buy, and how much, but even to how to pay. Kranjec on being asked how the ECB planned to fund its debt purchases, said: “This has yet to be agreed. As a central bank we are creating money. We have no limits with funds to finance projects.” While Weber told journalists tersely: “Note well: It’s not our goal simply to print money.”

The new uncertainty about the ECB’s actions may be undermining market
confidence at a crucial moment. An ECB report Wednesday suggested reviving
investor confidence is key to kick-starting bank funding markets that have dried
up amid the crisis. Lacking steady access to traditional funding sources such as
bond and inter-bank lending markets, the report said, European banks could
curtail lending to households and firms, dampening economic growth.
Joellen Perry, Wall Street Journal Blog

So what is the goal? This is really the key issue, and trying to follow the ECB's ruminations in this sense is more akin to watching a mystery play unfold (in every sense of that expression). Well, where do we look for clues? I can think of no better way than by examining the question and answer to-and-fro Trichet himself had with the journalists in the press conference. So here we go, lets see if you can make sense of all this. The issues are, remember:

a) Does the decision to buy covered bonds constitute quantitative easing?
b) If it is quantitative easing, is it to ease credit, or fend off deflation?
c) Why was the decision taken now?
d) Will the ECB "print money" to finance the purchases, or will the acquisitions be "sterlised"
e) Why covered bonds as opposed to, say, commercial paper?


"The Governing Council has decided in principle that the Eurosystem will purchase euro-denominated covered bonds issued in the euro area. The detailed modalities will be announced after the Governing Council meeting of 4 June 2009."
Jean Claude Trichet, Speaking at the Press Conference Following the Rate Setting Meeting, 7 May 2009.

Question - My second question comes back to the covered bond issue. I wondered if you could explain your general rationale behind this specific asset class? And in that vein, if I can recall correctly, covered bonds are mainly used by the banks in which a lot of German is spoken for refinancing, and not so much in the rest of the euro zone. So are you not implicitly delivering an advantage here to banks that use this particular asset to refinance?

Trichet - On the covered bonds, I remind you that we are in the euro area of 329 million people, this is a single market with a single currency, and what we are doing is what we judge appropriate for the single market with a single currency. All of us in the Governing Council are striving to take the right decisions expected by the 329 million fellow citizens. Covered bonds were considered by the Governing Council as a segment of the private securities markets that in general has been particularly affected, more so than others, in terms of the impact of the financial turbulences.

Question - Firstly a question on the covered bonds. Can you tell us how you came to the figure of around €60 billion? Is that some estimate of the amount of stimulus you feel you ought to be injecting into the economy? Is that what your thinking was? And secondly how are you going to pay for this? Will the purchase be sterilised or can we write that you are going to be printing money?

Trichet - On your first question, I give you a rendezvous for the next meeting when we will discuss all the technicalities for this operation, which is new for us and which calls for appropriate handling. Around €60 billion is only an order of magnitude, appropriate for attaining our goal, to help to revive this particular segment of the market.

With regard to sterilisation, it is included in the question of the exit strategy. I mentioned in the introductory remarks that we consider this issue as absolutely decisive. We have to be up to the present exceptional circumstances. And I don’t want to repeat all the areas where we were the first central bank to act and to take bold decisions. Whether it was the longer-term refinancing of commercial banks, or at the beginning of the turmoil being the most forthcoming central bank as regards its collateral framework, or when we had to take bold action in particular at the very beginning of the turbulence on 9 August 2007. As regards today’s decision taking into account all elements we considered that we could and we should go beyond what had been until now our main channel for enhanced credit support mainly by the refinancing of commercial banks which has, by the way, produced important results. I would like to mention en passant the figures which show that thanks to the decisions we have taken so far - they don’t incorporate of course the new decision taken today - our one-year money market has lower interest rates than in the sister central banks’ money markets. This is also the case at least with one sister central bank for the six- and the three-month money market interest rates. One has to take into account everything, and in particular our handling of our own money market with our full allotment, fixed interest rates procedure, the very forthcoming attitude we have as regards longer-term refinancing, which has even been enlarged today and the collateral that we accept. That being said the Governing Council considers sterilisation and the exit strategy absolutely essential to maintain the maximum amount of credibility in the medium and long term. The public debate emerging on whether or not some central banks are paving the way at the global level for future inflation is extraordinarily counterproductive. We, central banks – and I’m sure that we are all in agreement on this – are determined to solidly anchor longer-term expectations and eliminate these fears about future inflation.

Question - Just again on covered bonds. I understand that you are not ready to answer the question of how these purchases will be financed, but perhaps you could give us an idea of the reasoning behind that decision. Are you doing this to lower any credit spread between covered bonds and the risk-free interest rate, or is the main motivation behind it to inject more liquidity into the system?

Trichet: No, the idea 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.

Question - One question for clarification because I obviously mistook something for what it isn’t. When I heard about this covered bond programme, I mistook it for quantitative easing. Can you explain to me why it isn’t?

Trichet: If I might use our own vocabulary, it is part of our “enhanced credit support” operations. We have used this expression for quite a long period of time because we consider all the non-conventional measures we have taken in connection with the refinancing of banks as enhanced credit support. If you wish, you could call that credit easing, because it is a way of improving the functioning of the market that had been affected particularly markedly by the financial turbulences.


As can be seen above, initially observers were completely bemused by the decision. Some saw the move to buy covered bonds as an attempt to boost a market which was now facing competition from state-guaranteed bond issues, while others, like Bodo Winkler, capital market expert at the VDP covered bond association, which represents banks that issue German covered bonds (or Pfandbriefs) argued the very presence of the ECB in the market would bring indirect benefits.

"Interest from an institution as renowned as the ECB could be a significant support to the market. It would mean the ECB would have these quality assets - covered bonds- on its books,"he said. Winkler also argued that the meer presence of ECB activity would help lower spreads for the bonds, which in the German Pfandbrief case are securities created from either mortgage loans or public sector loans. The German market is in fact one of the oldest and largest (dating from the mid 1990s), while the Spanish market is more recent, but has now become the second largest.

Others have also suggested that, depending on how the purchases are conducted - in the primary or secondary market - acquisitions might indirectly free up banks to acquire new bonds themselves, thus also bolstering the market. While the Spanish cedual market has remained virtually a dead duck (Santander did issue a cedula following the ECB decision, for the first time in many months, and at 122 base points above what they were earlier paying) the German one has remained active and German banks issued 7.33 billion euros of Pfandbrief in January (down 42 percent year on year and by nearly half from September's 13.8 billion euros). Data from Thomson Reuters show that Germany is still the largest originator of covered bonds, closely followed by Spain. The two countries account for around a third of the euro zone market each. France is next at just under 20 percent, while Italy has a mere 2 percent.

The exact size of the wider European covered bond market is the source of some confusion, with estimates raning between 700 billion and 1.5 trillion euros. Some analysts estimate that if the ECB sticks with the BB rating currently applied in deciding whether bonds are acceptable as collateral for their lending operations, then around 450 billions worth of covered bonds would be eligable for purchase. (NB - this is the big change, at the present time Spanish banks can take cedulas and deposit them with the ECB as collateral for borrowing, now they will be able to sell them to the ECB direct).

According to the data supplier Dealogic the covered bond market has contracted by €136billionn since May 2007, and currently stands at €1,118 billion.

In general it is possible to say that the analyst response is that the ECB's decision to buy bonds for the first time in its history raises almost more questions than it answers. Reponses from Annegret Hasler and Frank Will (see below) are typical.

"Nobody knows what exactly this means for covered bonds. No one knows whether this will be purchases on the primary market or on the secondary market, and this makes a big difference," said Annegret Hasler, a covered bonds analyst at Commerzbank. "Market participants are likely to go on hold until they know further details."

"What we don't know is if the ECB will focus primarily on covered bonds in trouble, maybe Irish covered bonds, or if they are focused on certain Spanish cedulas?" RBS covered bond strategist Frank Will said on a call for clients. "It is also not clear how they will divide the 60 billion over the various countries."

How to spread the spend is a contentious issue in the euro zone because the covered bond and mortgage markets are more developed in some countries than others, opening the ECB to political heat. The premium that investors demand to hold covered bonds from Spain and Ireland fell on Friday, suggesting they are seen as the most likely beneficiaries.
"There are only two housing markets in Euroland which are currently experiencing
significant distress: Spain and Ireland," said UniCredit credit strategist
Markus Ernst. "Any partial support of specific regions or covered bond
issues would surely raise political criticism."

Italy's La Stampa unsurprisingly (since Italy has only 2 percent of the covered bond market) suggested last Friday that the decision was largely designed to help German banks - they obviously don't know about the cédulas! Germany's Boersen-Zeitung billed the move as the "ECB steps up the fight against recession", while the more "in the know" Spainish daily El Pais ran with "ECB activates money printing machine to combat crisis". Of course, as I mention above, the decision will help the German banking system too, since Hypo Real Estate and its Dublin-based unit Depfa Bank have around a 12 percent market share between them (or about 90 billion euros) of Germany’s pfandbrief bond market, according to data from the VDP Association of German Pfandbrief Banks. So any collapse of Hypo Real Estate Holding (which the German government describe as "systemically important") may indeed threaten the stability of the whole pfandbrief market.

UniCredit economist (and my RGE monitor co-blogger). Aurelio Maccario noted wryly: "Somebody somewhere is probably saying they should also think of something else to help other markets like the Italian market," he said. He also made clear that another key question was whether the ECB would effectively inject another 60 billion euros into markets, or neutralise the purchases' impact on money supply. "To sterilise you have to do exactly the opposite measure with exactly the same amount. If you buy 60 billion euros of covered bonds then you sell 60 billion of some other assets, corporate bonds, government bonds for example ....If you want to sterilise it by selling other assets, you risk rising other spreads, you risk rising long term interest rates. And then if you don't sterilise it then it is a pure easing, which you can label as quantitative easing."

As I have been pointing out, Maccario gets right to the heart of the matter here, since some Council members, and most notably the German contingent (Axel Weber and Juergen Stark) have been busy expressing reservations with the whole idea of purchasing debt in the first place, while other policymakers like the Greek and Cypriot contingents (Athanasios Orphanides and Lucas Papademos) have been pushing for broader purchases of private securities as a way of keeping deflation from the door.

But as Deutsche Bank economist Mark Wall points out, sterilised purchases would obviously help the covered bond market but it would have little impact on either companies or households, so it would be hard to see the point, and it would be even harder to see why Trichet would consider sterilised purchases to constitute the use of new monetary tools. "In terms of the aggregate effect on the economy, if they are sterilising it they are neutralising it," Wall said.

Spreads on covered bonds from Spain and Ireland have tightened since the decision, pulling government bond spreads with them, suggesting that markets are expecting the volume of purchases to increase, and Spain and Ireland to be the principal beneficiaries. Spreads in Spain and Ireland had been way up, with Spanish covered bonds maturing in 10 years typically trading at about 200 basis points over mid-swaps, compared to about 300 basis points over mid-swaps for an Irish covered bond and just 60 basis points for a German issue.

According to Royal Bank of Scotland analyst Harvinder Sian "The impact on periphery spreads we think is very profound ... This is a credit-easing after all, so we should expect the positive momentum, and that's exactly what we've got." In support of his view Harvinder pointed to the fact that the premium that investors are demanding to hold debt issued by euro zone countries other than Germany fell have fallen, with 10-year Italian, Greek and Spanish spreads among those hitting their tightest levels since late last year. In the government bond market, the 10-year Greek/German yield spread narrowed to as low as 160.3 basis points on Friday, the tightest since early December 2008, while the equivalent Irish/German spread also closed in to 163.8 basis points - the narrowest since early January. "The idea that the ECB is buying assets now does spread risks across the euro area in terms of the economy and the momentum going forward," according to Sian.

So What Are The Consequences (Political or Otherwise) Of All This For Spain?

Well first of all this is obviously very good news from a Spanish point of view. The Spanish economy is evidently in the throes of a major correction (most of which has yet to get underway) which will involve moving from a construction and consumer debt driven economy to an export driven growth model.

But in the path of this correction lie three very strong impediments.

1) The need to refinance the cédulas (estimated cost 250 to 300 billion euros)
2) The need to resolve the issue of the growing volume of builder and developer non-performing loans (or the million plus empty houses) - estimated bank expoure 470 billion euros (Bank of Spain data).
3) The complete lack of competitiveness of Spanish wages and prices.

Basically, we can see a solution in three parts here. The ECB will refinance the cedulas as we move forward (done). This will not only help the banks, it will take some pressure off government finances, and it will effectively give support to the last-man-standing in the Spanish real world economic arena, Bank of Spain Governor Miguel Angel Fernandez Ordoñez. I don't expect to see more interview in El Pais with deputy prime minister Maria Teresa Fernández de la Vega, accusing him of being alarmist about the reserves of the Spanish pension system. He who pays the piper, we should remember, effectively calls the tune.

Which brings us to the second point, the housing overhang, and the bad loans that go with it. Now while the details remain far from clear, I fully expect Spain to follow in some shape or form the "Irish solution" of either buying the houses direct, or buying the loans which go with them (with or without the creation of a bad bank). But neither Spain nor Ireland will be able to sustain the volume of public borrowing necessary to finance this move unaided. I therefore fully expect the issue of EU Bonds to raise its head again. (I have spelt out what this is all about in this post here). As it happens, a journalist friend of mine interviewed EU Economy Commissioner Joaquín Almunia recently, and asked him explicitly about Commission intentions here. I am adding the exchange as an appendix, and as you will see, he neither says yes, nor does he say no, what he says is that they are a logical development, and that they will come gradually, which is EU speak for "they are in the pipeline" (so, this item is effectively done too).

So we are left with the third point, the correction in wages and prices, also known as "the budget from hell". It is most obvious that with the Spanish economy likely to contract between 5 and 7 percent this year (it contracted at a 7.2% annualised rate between Q4 2008 and Q1 2009), and to continue to do so next year, and the government fiscal deficit likely to run at over 9% (the present EU Commission forecast is for just under, but there will be overshoot since the contraction will be more rapid than they are anticipating) then Spanish public finances are headed for an acute crisis. And given the (by then) growing dependence of the Spanish economy on direct EU support then, as I said above "he who pays the piper will call the tune", and the "budget from hell" will be imposed, whatever José Luis Zapatero think he wants.

Evidently ten years of bad craftsmanship cannot be put straight in a day, but Europe is going to have a good try at doing so. The EU is now "in media res" of that much needed restore and restoration work to remedy its institutional deficiencies and address its "crisis overload" problem. Remedies are available and being developed, even if getting Europe's leaders to talk about them explicitly is something akin to leading a reluctant father-to-be up to the altar.

EU (rather than exclusively national) bonds can and will be created. These will effectively give Europe a fiscal capacity that is, for all intents and purposes, equivalent to that of the U.S. Treasury. Second, given the deflation problem, the European Central Bank can now follow the Bank of England and the Swiss National Bank by entering the next tier of quantitative easing, expanding its balance sheet and starting to buy those crisp new EU bonds in the primary market.

Quantitative easing, which is simply a generic way of referring to all the recent attempts to boost money supply when interest rates fall close to zero, becomes in this particular case a euphemism for "printing money," with the unusual characteristic that this time, inflation is exactly what we are looking for. And if we don't get it, well, as Paul Krugman wrote in a recent New York Times op-ed on Spain, we run the risk of ending up with a European economy that is depressed and tending toward deflation for years to come.

The most important thing to realize is that the arrival of deflation is not only a threat; it is also an opportunity. Having the power (nay the necessity) to print money should give Europe's central administration one hell of clout should it need to use it, and it will. As Joaquín Almunia said not so long ago, "You would have to be crazy to want to leave the eurozone right now," given the economic climate. It's precisely this fear that will serve as the persuasive stick to accompany that ever so attractive financial carrot which is now being dangled forth. (Assuming, that is, that Europe's leaders understand: in this case at least, sparing the rod would only amount to spoiling not only the child, but all the brothers and sisters and aunts and uncles, too.)

So though the first argument in favor of buying cédulas hiptecarias and issuing EU bonds (etc) might be an entirely pragmatic one - namely that it doesn't make sense for subsidiary components of EU, Inc., to pay more to borrow money when the credit guarantee of the parent entity can get it for them far cheaper - the longer-term argument is that the ability to make such purchases and issue such bonds might well enable the EC and ECB to become something they have long dreamed of becoming: an internal credit rating agency for EU national debt. Caveat Vendor!

Appendix: Extract From Interview With Joaquín Almunia

Question - The Euro has proved to be an effective shield protecting eurozone economies from the shocks of the crisis. But some argue that the crisis has highlighted the fact that European financial markets are fragmented and that there is a need for a single market for government bonds. George Soros argues that “a eurozone bond market would bring immediate benefits in addition to correcting a structural deficiency”. It would lend credence to the rescue of the banking system and allow additional support for the more vulnerable EU members. Do you agree?

Joaquín Almunia - As the Commission itself pointed out in the report on 10 years of Economic and Monetary Union published in May 2008, the euro-denominated bond market indeed remains very fragmented on the supply side. The issue of European bond issuance has been discussed on and off for several years now and even more frequently since the financial crisis started. I think this is something we should consider in future to promote greater financial market integration and more efficient European government bond markets. But I also think this is likely to be a gradual process. Better coordination of national government bond issuance, for example, could be a first and necessary step.

I would like to stress also, that for all governments, both inside and outside the euro area, the best way to gain credibility in investors' eyes and avoid problems with financing is to carry out responsible fiscal policies.

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