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Sovereign QE has arrived (don’t tell the Germans)

09 December 2014
Richard Kemmish

Some securitisation friends have been getting very excited recently about their big idea: that Eurozone government bonds should be repackaged into a giant Collateralised Bond Obligation which would be eligible for the ECB’s buying programme. The ECB gets to hit it’s balance sheet target, the securities meet the definition of assets eligible for the programme, and Europe gets the sovereign QE that it needs. Maybe some securitisation people can charge a fee or find a way to arbitrage the prices of the securities involved? Everyone is a winner. 
I think that tells you everything you need to know about the political naivety of the securitisation market. Seemingly they think that German objections to QE can be overcome by structural legerdemain. A crude stereotype about Germans only caring about the letter, not the substance of the law? Patronising, at best.

But before we get too cynical perhaps we should look at the ways in which the covered bond purchase programme could become backdoor sovereign QE. There are two main areas.

Firstly, public sector covered bonds. So far this is more of an idea than an actuality. No one is currently writing new public sector loans so that they can add them to the cover pool and sell them to the ECB. But over time the obvious economic catch – that sovereign bonds usually trade at tighter spreads than public sector covered bonds – will diminish.

Public sector covered bonds make economic sense due to either distinctions within the country (the municipality of Marseilles pays more to borrow than the French republic) or between countries (Spanish governments pay more spread than French covered bonds). The latter smells of arbitrage (“so what?” say our securitising friends) and has been in almost terminal decline since the crisis – compare foreign exposure in pfandbrief pools now to pre-crisis levels.

But it is the former case – where regional borrower’s access to national government funding is squeezed – where public sector covered bonds might be economically equivalent to funding sovereigns at the ECB.

Secondly, there is the substitution effect within bank liquidity books. Remember when Commission announced that covered bonds were eligible for liquidity cover ratio purposes as tier 1 assets? Remember the sight of Luca Bertalot being carried shoulder high through the streets of Frankfurt by a cheering mob?*

Covered bonds yield more than govvies so the negative carry of bank liquidity books will be ameliorated. Except it wasn’t quite that simple. The greater value haircuts of covered bonds mean that for any given bank treasury there was a break even covered bond/government curve spread. If spreads were tighter than break even, they are economically incentivised to sell their covereds and buy governments.

So, the ECB doesn’t need to push the spread of covered bonds through the spread of govvies to incentivise bank treasuries to buy more government bonds. Just narrow the spread.

No it isn’t the blatant arbitrage envisaged by sovereign CBO’s, but it is a very real effect.
*I exaggerate, slightly.

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