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What is in the core?

14 July 2014
Richard Kemmish

A nuclear core is where the meltdowns happen. The core of an apple is the inedible bit. But in the financial markets core has taken on exactly the opposite meaning. It’s the bit that is safe when the periphery is melting down. The covered bond market didn’t invent the terminology of course but we did superimpose our own prejudices to make it an even more ridiculous concept.
When covered bond traders were debating whether they could continue to honour market making agreements they had a (now infamous) conference call where they decided that they could for core countries but not for the periphery. They then went on, like Diocletian, to divide their empire into two. Ireland was the sticking point, was it core or periphery? They eventually decided that mortgages were periphery whilst the public sector bonds, such as Depfa, were core (“Time makes fools of us all. Our only comfort is that greater fools shall come after us”).

The call was also the final nail in the coffin of trust between traders and DCM, but that’s another story.

Obviously the dividing line between core/periphery had to be moved as the crisis worsened. And there were refinements, such as inner core and outer core (which quickly replaced soft and hard core as emails containing the words ‘hard core’ tended to get trapped by IT firewalls too often) but the approach remained essentially manichean and nationally based.

It was this approach to credit risk, therefore to relative value and by extension to moral judgement (if you think The Sun is bad, see what Das Bild has to say about the Greeks) that strong banks in peripheral countries objected to so much. 

When Bloomberg pricing analytics suggest a peer group for an illiquid covered bond they come up with similarly rated covered bonds with the same underlying asset class. The suggested benchmarks for a poorly rated German mortgage bank for example, might include an Italian national champion.  To the average covered bond investor that might seem absurd, to a strong Spanish bank, more defensible. When I put this point to Bloomberg recently, it was obvious that they would side with the strong Spaniard’s viewpoint because that is closer to what prevails in other markets.

My working definition of periphery at one stage was those countries in which covered bonds traded inside the government curve, a definition which briefly included France and Belgium, but only from the seven year part of the curve onwards.  It’s always fun to define other dividing lines and see how well they predict covered bond spreads, (the alps, wine producing/beer producing, Catholic/ Protestant, garlic/herring).

But now that credit spreads have compressed again alternative definitions of core have emerged. One of my favourite (on the basis of its practical usefulness) is the definition of core covered bond markets on the basis of the product’s systemic importance, therefore of the probability of governmental support. Spain is clearly a core country, the UK peripheral.

Why do I think this is a useful definition? Because there is a strong argument that a covered bond is most likely to default in a ‘strong’ country where covered bonds are not systemically important. Hypo Alpe Adria, SNS, Depfa, Northern Rock, were all meltdowns in the core.

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