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How not to open a beer bottle

06 October 2014
Richard Kemmish


One of the many surprising things that Mario Draghi said yesterday about the ‘current measures’ (the covered bond and ABS purchase programme and TLTRO) was that the ultimate yardstick by which he would measure their success was Eurozone inflationary expectations. Which for me is a little bit like using your teeth to open a beer bottle; it might work, it might not work but the potential damage to the tool used is enormous.

If that is his strategic objective of buying covered bonds, what should the tactical considerations be?

I was asked recently what the difference between covered bonds and US subprime securitisations were from a systemic point of view assuming that the first law of thermodynamics applies to credit losses. That is, credit losses are constant, all that the capital markets can do is move them around.

Firstly, credit losses have a far greater potential damage if concentrated in a security than if spread across an entire balance sheet, or across an entire financial system. And then even more potential loss if that exposure is leveraged. And then again if all of the leveraged investors have highly correlated triggers according to which they need to reduce their leverage (and thus realise a mark-to-market loss).

The capacity of a system to absorb vast amounts of credit losses if they are sufficiently dissipated has been demonstrated beautifully in Spain. Lots of mortgages that should never have been written, but a robust banking system (yes, I’m prepared to defend that statement) and wider society capable of absorbing the blow. 

Secondly, unlike energy, you can create new credit risks. It happens whenever anyone is incentivised to originate an asset at a level that does not reflect its credit risk. Most obviously this is when you can transfer all of the risk to a third party (skin in the game is the preferred cure for the securitisation market. But surely it has to be all of the skin in the game. BTW, anyone know the origin of that idiom?).

But also it can happen when the difference between secured and unsecured funding levels for a bank exceeds the unexpected credit losses of the asset (that is, those over and above the credit charge factored in when the asset was originated). Which is why the Spanish banking system wrote all of those mortgages in the first place.

So I would suggest that the ‘modalities’ (central bankers love that word) of the purchase programme should be judged by the extent to which it increases the potential damage caused by any given quantum of credit losses and by the extent that it incentivises the origination of loans at levels that do not reflect their potential credit losses.

The rather vague rules published recently do not give us enough clues. Only the ECB’s actual behaviour will tell us that.  

Given the potential dentist’s bill, probably better to find the bottle opener. Given the potential damage to the covered bond market, probably better to do proper QE by buying government securities.

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