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New ECB repo rules increase covered bond extension risk

By Bill Thornhill
01 Aug 2017

The European Central Bank’s decision to curtail wind down entities' access to repo liquidity materially increases the risk of a covered bond maturity extension or default, and is not consistent with its mission as lender of last resort or its previously benign approach to the asset class.

From January 2022 restructuring entities that had been ECB repo-eligible counterparties up until March 22 this year will no longer be repo-eligible.

Restructuring entities set up after March 22, 2017, won't be eligible, and if a third party were to provide liquidity to these wind down entities by accessing central bank liquidity, they would also be disadvantaged.

The new rules show that the lender of last resort has abandoned one of its prime tenets. It is no longer willing to support entities that are not explicitly bank lenders and are not crucial for the real economy. 

By restricting liquidity, the ECB probably expects to hasten the speed that they are wound down.

The unintended consequence of this is that, without such access to emergency liquidity, the probability of a missed payment increases.

This has several implications for covered bonds, which the central bank has favoured so far with low repo haircuts and three separate purchase programmes.

Extension by default

In the event an issuer becomes insolvent and the cover pool is segregated from a bank, the segregated pool may could well fall foul of the new rules. 

The cover pool administrator would in fact be denied access to repo funding, an option that investors had until now assumed was available.

German Pfandbrief law, for example, grants the administrator of a segregated cover pool a banking licence which would in theory enable it to access emergency central bank liquidity. 

While there has been no official wording on the subject, there have been plenty of behind-the-scenes discussions leading some bankers to believe that the Bundesbank would be ready to support the Pfandbrief market.

But this could all now change, not just for Pfandbrief but for all covered bonds covered by the Eurosystem. The central bank regulator is now more likely to allow a maturity extension of a segregated soft bullet or conditional pass-through cover pool to be triggered. 

Since a hard bullet covered bond cannot extend following an issuer event of default, the end of repo eligibility could make a covered bond event of default more likely.

Investors may “wonder whether a maturity extension will be more likely for a covered bond after an issuer’s default when other liquidity options are being restricted,” said Commerzbank’s covered bond research analyst, Michael Weigerding, in a report last week.

However, it is possible that a segregated cover pool is not considered to be the same as a wind-down entity as it is not forced to sell assets as quickly as possible but instead must wait until all covered bonds are repaid on schedule. 

If that’s the case, the ECB needs to make it clear, otherwise investors and rating agencies will draw their own conclusions.  

By Bill Thornhill
01 Aug 2017