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Do you like my new haircut?

07 August 2017
Richard Kemmish

It has been heavily rumoured that the ECB will this autumn announce that conditional pass through covered bonds will have a new uniform hair-cut when presented for repo instead of the existing size, maturity and basis dependent hair-cut grid.

There are practical problems with the proposal – for example defining ‘conditional pass through’. Is the difference between a soft-bullet and a conditional pass through purely a matter of the length of the extension – 1 year good; 30 year bad? Or is it a function of the mechanics of the extension? If the latter, can you justify a uniform haircut for the vast structural diversity in the conditional pass-through community? That diversity is a function of the terms and conditions of the pass-through itself (SARA clauses, acceleration, cross-pass through triggers, etc). But it is also a function of the trigger definitions – conditional pass throughs like soft bullets differ according to whether an issuer event of default must have occurred first.

If the proposal is implemented it will hit the Polish issuers hardest – they have no choice but to use conditional pass through due to the way that the law is structured there.

But more important than the practical problems: is it justified?

Changes to collateral rules can be about risk mitigation – the central bank protecting it’s balance sheet – or about public policy objectives. Sometimes these objectives might conflict (as discussed in my previous post about wind down entities).

Let’s assume the former. The ECB is only exposed to the credit quality of the bond when the issuer has defaulted (not strictly true, the bonds could be used as repo collateral by a third party but as in that case the bond and the repo counterparty have a low credit correlation this is presumably not a concern for the ECB).

Assuming that the issuer has defaulted already, does a conditional pass through covered bond represent more or less credit risk than a conventional covered bond? Impossible to say.

But the ECB is unlikely to wait for the resolution process to work itself out to find out. Instead they will sell the bond. Their hope is that the value that they realise will be more than the money they have advanced against the collateral. Crucially the money that they advance is based on the haircut and the market value – not par. What determines whether they get their money back or not is not the ECB’s opinion on the efficacy of the conditional pass through, it is the market’s opinion of its value. The evidence here is clear – there is no meaningful pricing differential between the products.

Furthermore, I would argue that the pricing of a conditional pass through after the issuer’s default is likely to be better rather than worse than the pricing of a conventional bond. Their rating is more delinked from that of the issuer – hence they are unlikely to step-off any rating cliffs – and the crystallisation of the pool will make the likely pay down profile far easier to model.

Which all suggests that the possible new haircut will be about public policy objectives rather than risk mitigation. That concerns me.

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