Thursday, May 7, 2009

The Debts of the Spenders: The ECB Embarks on "Credit Easing" w/Covered Bond Purchases

Today the ECB's Trichet announced a "credit easing" program of bond offerings known as covered bonds. Covered bonds are bonds that are backed by actual collateral - unlike a govt's implicit trust and safety. The collateral will vary from country to country w/in the Euro zone but can range from mortgages (commercial or residential), public infrastructure debt (railroad, bridge, and tunnel financing), and even shipping. While the market for this debt can be somewhat . . . illiquid (hmm shades of auction rate securities!), Trichet's purchases make the ECB a potential market maker.

Remember, the chief structural flaw of the EU is that the Maastricht Treaty prevents individual member nations from debasing their own currency. This legal restriction was originally aimed at preventing notorious spenders w/large public budgets (the PIGS - Portugal, Italy, Greece, and Spain) from embroiling wealthier members. Until now, these nations had relied on hopes of a bailout by the more fiscally responsible states such as Germany -something that is deeply unpopular among Germans (unsurprisingly). But while currency control remains in Brussels, individual nations are still responsible for obtaining financing on their own through bond sales.

Some pundits theorized that the ECB would be forced to make a single "Eurobond" that would cover all 2 dozen or so EU members. But the ECB has apparently decided that experiment would take too long and pose its own complications. Instead Trichet's foray into covered bond purchases has all the hallmarks of a classical EU ministerial play - an ad hoc, disruptive affair that failed to take into consideration effects on other angles of the capital markets.

LONDON (Dow Jones)--Euro-denominated government bonds came under heavy selling pressure Thursday as demand for safe-haven government debt receded as risk appetite improved, with equity markets advancing as concerns over the results of the U.S. bank stress tests eased.

The European Central Bank's decision to cut its refinancing rate by 25 basis points to a new record low of 1.0% was widely anticipated, and had limited market impact. The ECB left its overnight deposit rate unchanged at 0.25%, also as expected.

However, government bond prices came under further pressure after ECB President Jean-Claude Trichet announced that the central bank would introduce 'nonstandard measures' and embark on an asset purchase program.

Speaking at a press conference following the ECB's interest rate decision, Trichet said the ECB would extend the maturity of its repurchase operations by introducing a new 12-month fixed-rate, full-allotment tender.

"The ECB was clearly unwilling to countenance a shift into U.K./U.S.-style QE," said Richard McGuire, market strategist at RBC Capital Markets. "It appears likely this apparent change in stance is designed to provide the Bank with a further cushion of conventional policy easing before it might be required to further up the credit-easing ante or be dragged down the logistically-challenging QE route."

The European Central Bank blazed a trail into unconventional policy Thursday, saying it will purchase up to EUR60 billion debt securities outright and offer cheap liquidity to commercial banks at longer maturities.


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