ECB Unveils Asset Buying Program in Balancing Act to Energize EU Economy (10/9)     Print Email
Thursday, 09 October 2014

By James David Spellman, Principal, Strategic Communications LLC

Leaving interest rates unchanged, the European Central Bank said last week that it would buy government bonds and other assets for at least two years in hopes of increasing bank lending to businesses and thereby stimulate growth.  Left unanswered were questions about the size of these initiatives and whether additional measures, “quantitative easing,” would be launched soon, as inflation in Eurozone countries remains stubbornly low and a new phase of recession takes hold.


"This program is orientated to boost lending to SMEs (small and medium-sized enterprises)" and get inflation closer to the 2-percent target, ECB President Mario Draghi said, adding that the asset-buying program is designed to be "simple and transparent."  Outdoors, during the press conference in Naples, hundreds encountered riot police in protesting against austerity measures, a rare scene now but a common one throughout Europe between 2011 and 2012.

By buying up existing debt, the ECB would free up banks to offer new loans at record low rates.  ECB purchases will be in two areas:  asset-backed securities  (“ASB “) bundles of financial products such as mortgages), slated for the fourth quarter, and covered bonds (bonds that give investors “recourse” to assets that secure or “cover” the bond as collateral if the debtor fails to repay), which will start in the second half of October.   

"We want to be as inclusive as possible, but with prudence,” Draghi said, referring to the quality and breadth of ECB asset purchases.  Debt with ratings below BBB-, sub-investment grade (notably banks in Greece and Cyprus), will be included provided the risks of those purchases are mitigated by other ECB purchases and those countries have “an ongoing program with the EU” (remain in EU and IMF bailout programs).  

ABS:  “Senior” (the first investors holding debt that would be repaid if default occurs) ABS and the more risky “guaranteed mezzanine” (used to provide money as a company transitions from one type of funding to another; such instruments would only be bought by the ECB if “guaranteed” by government debt) ABS would be purchased in primary (when first offered to investors) and secondary (when resold by investors) markets.  Critics fear this gives banks an opportunity to dump toxic loans.

Covered bonds: The Euro-denominated bonds would have underlying assets that include exposure to private and/or public entities.  The bonds must have a minimum first-best credit assessment of credit quality step 3 (CQS3, currently equivalent to an ECAI rating of BBB- or equivalent).   

Draghi left open the size of these efforts. "I understand your desire to have very precise figures for everything. That makes life perhaps easier. But I have to say that I wouldn't want to emphasize the balance sheet size per se. That's very important, but it's only an instrument." 

Analysts conjectured that the ECB purchases would be perhaps one-fifth of the example €1 trillion pool Draghi earlier signaled the bank could draw upon.  One reason:  The supply of ABS that meets ECB’s quality standards is small.  Given this, some expect the bank to eventually resort to purchases of government bonds, “QE” in disguise.

As a Financial Times report observed, Draghi has to strike a balance in each of three areas:  size, scope, and risk-taking.  The ECB’s purchases must be large enough to generate enough bank lending that sparks and sustains economic growth.  The extent to which the central bank will buy “sub-investment” debt means balancing the purchase of debt from Greece and Cyprus, for example, to help those economies, against potential risks to the ECB.

Many investors expected Draghi to do more, showing their disappointment with a 2-percent drop in Germany’s main market index, a 2.8-percent fall in France’s, and a 3.9-percent decline in Italy’s.  The FTSE 100 slid 1.7 percent to its lowest close since December last year.  Meanwhile the Euro closed flat, trading near two-year lows, but rates fell for government bonds, most notably those for Greece, Cyprus, and Spain.

 

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[1] “ECB announces operational details of asset-backed securities and covered bond purchase programmes,”
ECB Press Release, October 2, 2014.  Available at:  http://www.ecb.europa.eu/press/pr/date/2014/html/pr141002_1.en.html .