First ECB head Mario Draghi hinted at discussions of an ABS plan at his press conference. Now we get word from Die Welt that not only is it more than a rumor, it has been discussed by the ECB’s governing council. The German paper also notes that it seems likely that the governing council is far more in favor than against.
The leaked outlines (which are likely accurate since this is no doubt a trial balloon) show a central bank desperate to inject credit into the sagging periphery of southern Europe. Again, we are stuck with the broken monetary transmission mechanism. But this latest plan is actually moving the goalposts again, since last September’s overt OMT was supposed to fix the monetary transmission.
Now that peripheral interest rates have duly obeyed, and nominal yields and spreads have collapsed in an orgy of risk-taking, we are being told that collapsing yields and spreads have not themselves spread to SME’s – small and medium enterprises. So the OMT did not transmit monetary policy (surprise).
Indeed, as I have illustrated previously, banks in southern Europe continue to shrink rather than add to credit assets with new loans. The banking systems in Italy and Spain, in particular, are running off private sector loans despite a marked return of deposits from last summer’s euro concerns. Instead, it has been these very banks buying the sovereign bonds from their own governments that have led the charge in depressing interest rates.
There is a bit of comic irony here – the ECB pushed banks into sovereigns but now complains that the banks are buying only sovereigns.
By most accounts, this ABS idea closely resembles the Federal Reserve’s TALF program from early 2009. In the US version, the Federal Reserve offered non-recourse funding to “any US company that owns eligible collateral”, provided that company or hedge fund had an account at a primary dealer. The terms of the TALF loans were for three years, and eligible collateral was limited to AAA-rated ABS tranches of consumer loans to US residents.
The keys to making TALF “workable” were a US Treasury pledge to absorb the first 10% of any losses incurred by the Fed and, from the perspective of the borrower, the non-recourse nature of the loans. Without the UST guarantee, it is highly unlikely the Fed would have accepted such credit risk, AAA or not. And borrowers were not likely to sign up if the Fed was able to come after them for losses above whatever collateral was pledged. With a non-recourse clause to the arrangement, borrowers could simply walk away from the collateral and leave the losses on the books of the Fed (and UST).
If the ECB is indeed thinking along these lines, we can already sketch the potential hurdles, most of all the credit risk associated with purchasing crappy ABS. The ECB has already borne significant credit risk in the ABS space through the LTRO’s – eligibility requirements for ABS collateral were loosened all the way down to single A ratings. So the question here is, which government is going to offer a credit loss guarantee? There is really only one country that can with any real credibility, the very country that is most likely to resist (or at least publicly appear to) – Germany.
However, there is another angle here in how this might work in the context of European banking. A new ABS program, apart from the LTRO’s and main refinancing programs, would be the equivalent of a collateral-making machine. By standardizing SME loans and standing by with obvious and available funding, the ECB is encouraging the creation of new security collateral that will already be eligible for low cost funding.
Like the reduction in interest rates recently, it is increasingly likely that the ECB has completely given up on restoring interbank funding markets, now accepting liquidity fragmentation as a semi-permanent feature of the current landscape. What is not clear is why and why now. The deepening depression is certainly a factor and that may mean that we are back to insolvency concerns.
Far too often, speaking about liquidity, observers focus on right here and now. That is not what banks do – they are more concerned about liquidity tomorrow and two months from now and next year. The LTRO’s were so oversubscribed because of future concerns (that were proven valid).
The ABS program at the ECB would create a market with sort of “grantor” status for the central bank – they supply the startup funds and enforce a price/rate floor with the intention of kicking a market into gear. By starting this ABS market, they will create future liquidity by allowing banks to turn currently-illiquid SME loans into future securities to be pledged. Right now, if a desperate Italian bank, for example, were to see deposits flow out again, there is little recourse for that bank. It has nothing left to pledge outside of going to the ELA.
After the ABS market is fully running, however, that bank now has a potential reservoir of collateral to package and gain access to collateralized funding (either private or ECB). In my mind, this entire ABS idea is all about future liquidity in the context of a worsening depression and lasting banking fragmentation.
I suppose at least the ECB should be commended for being forward thinking, but if they truly wanted to be and act as such they would actually need to stop monetary policy measures that have contributed to that depression in the first place. The bigger question is if the interbank markets continue to refuse* to coalesce around the common euro currency, then how much effort will be wasted in forcing markets to accept (and the unintended consequences and costs of doing so – like ongoing depression).
* Evidence of durable fragmentation
Swiss Market Rates 1-month -0.10%
Swiss deposit rates still negative out to 3-month
German Bund 2-year 0.00%