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Comment

ECB covered bond buying must be needs-based

To be useful, the ECB should direct its covered bond purchase firepower where it is most needed — away from core Europe. But although logical, it's not without its risks. And the Greek referendum plan has added a few more.

If the European Central Bank wants to get the most out of its second covered bond purchase programme, then it must adopt a needs-based approach and buy those bonds that have been among the more affected by the sovereign crisis. And, given that the forthcoming €40bn purchase programme is 50% smaller than the first exercise, it’s all the more important that its limited firepower is more effectively targeted.

By fine tuning its purchases, the ECB would be more likely to meet its main objectives, which are not likely to have changed since the first programme. These were to reduce interest rates, ease funding conditions, develop bank lending and improve market liquidity.

Buying the bonds of issuers that are capable of funding themselves competitively at almost any time will not meet these objectives. But by buying the bonds of issuers who face exorbitant funding costs and who have sometimes been locked out of the market, the ECB could make an immense difference.

Purchases in the ECB’s last purchase programme were in proportion to the capital share of the national central banks that own the ECB. Based on Germany's stake of around 20%, German Pfandbriefe saw the most buying — even though German issuers can easily fund themselves at their own choosing and at very competitive levels of around mid swaps plus 50bp or even tighter.

At the other end of the spectrum are countries like Portugal, Ireland and Greece, which have an ECB capital share of just 2% or less. But since their banks’ access to the covered bond market has been shut off for almost a year, it’s questionable whether ECB buying would make much of a difference as private investor credit lines are also likely to be shut off — meaning that the deals that the ECB could invest in simply won't exist.

In the middle ground are countries like Spain and Italy, which have ECB capital shares of 8% and 12% respectively. Strong national champions in those countries, like UniCredit and Santander, have been able to attract a good deal of private investor demand this year for their covered bonds, but they cannot fund much tighter than mid swaps plus 260bp. It is with this type of issuer that the ECB could make a difference — and this is where it should therefore direct its efforts.

But there's a catch, and it comes in the form of the Greek bailout referendum. If it fails, the sovereign bond markets of Spain and Italy will surely weaken, dragging their covered bond deals down with them. If it does choose to help those who need it most, the ECB will need nerves of steel.

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