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29 June 2015
Richard Kemmish

You aren’t going to look to me for the latest on the Greek drama but whilst we are in a state of stasis awaiting the result of the referendum (or Greferendum as it is now being called. Note to all financial journalists: please stop doing that), I thought it would be interesting to speculate about the ECB’s holdings of Greek covered bonds.

Keynes said that a central bank should provide unlimited liquidity to solvent banks against high quality collateral. Central bank orthodoxy suggests that they should not be making political decisions (as Mr Draghi says at every opportunity, they are a rules based institution). So how should we understand the decision last weekend to cap the size of the Emergency Liquidity Assistance (ELA)? Presumably the ECB now thinks that either the banks aren’t solvent or the collateral is no longer high quality.

Lets think a bit more about that collateral.

I have no idea what proportion of the ELA is currently backed by covered bonds issued by the bank pledging them but I suspect that it is a fairly large proportion. The total size of the Greek mortgage market is about €70bn, even assuming a 20% haircut, a few mortgages pledged elsewhere and a few mortgages originated by non-Greek banks that still suggests that around half of Greek bank’s ELA could be backed by residential mortgage covered bonds. 

Covered bonds are of course exempt from the rule against pledging ‘own issued’ securities – which suggests a degree of confidence in the quality of the collateral, at least by whoever put that rule in place several years ago.

So I think it is safe to assume that the ECB is currently fairly long Greek covered bond risk and, presumably, quite worried about that. Also fairly safe to assume that if they were to either ask for their money back or increase the haircut on the covered bond collateral that the entire Greek banking system would become insolvent.

Hopefully, by way of risk mitigation the ECB is currently trying to work out the value of that collateral and how it stacks up against the existing haircuts. 

How should they think about that value? Effectively the ELA is a special type of repo. If it were a private sector contract the value would be quite clearly defined in the terms of the Global Master Repo Agreement (section 10.3 if memory serves correctly), which seems as good a starting point as any from which to approach the ECB’s problem.

Under this, in the event of an insolvency event by the Greek banks the ECB would be the non-defaulting counterparty and as such be able to choose the valuation methodology for close out purposes. They have a choice between actual sale proceeds – not going to happen – firm market quote – almost as unlikely and, if the above are deemed either impossible or ‘not commercially reasonable’ then the ‘Fair Market Value’.

What is the Fair Market Value for Greek covered bonds?  See the next post.

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