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ECB’s CPT discrimination makes no sense

By Bill Thornhill
02 Jan 2018

The European Central Bank’s decision to exclude conditional pass through (CPT) covered bonds issued by non-investment grade issuers from its covered bond purchase programme (CBPP3) will constrain liquidity and credit where they are most needed, and is not necessarily justified by risk considerations.

In a public disclosure issued in late November, the ECB stated that “in view of the potentially higher risks to which they expose the Eurosystem” conditional pass through covered bonds issued by a sub-investment grade entity would be excluded from CBPP3.

The CPT structure enables borrowers to de-link the covered bond rating from the issuer’s, and because of that structural benefit, it has largely been lower-rated banks that have issued using the structure.

If it had been the ECB’s intention to spur consolidation of the European banking sector by constraining liquidity to such banks, its decision would have been understandable. 

However, what it actually said in the same statement was that the purchase programme aimed to “facilitate the provision of credit to the euro area economy [and] ease borrowing conditions for households and firms”.

Despite the good intention, by shutting off the purchase programme to CPT issuers, the central bank has precisely targeted just the sort of credits that would benefit most from a boost to their market access — delivering precisely the opposite of its stated intention.

Without ECB demand, sub-investment grade CPT covered bond banks — like Caixa Económica Montepio Geral, National Bank of Greece, Eurobank and Banca Monte dei Paschi di Siena — will pay a higher cost of funding.

This cost will ultimately be passed on to their customers, cutting down on the provision of credit to the parts of the eurozone which need it most.    

Even though many of these issuers barely relied on the ECB for support in their most recently issued deals, demand from private investors was almost certainly boosted by the conviction that the ECB would have been a buyer of last resort.

The ECB’s reference to risk considerations is also overdone. The CPT structure is sensitive to a postponed payment but, in the event of an issuer’s resolution, the ECB's supervision arm, along with national supervisors, are ultimately the agents that are responsible for ensuring payment continuity.

Intentionally allowing a CPT covered bond to miss a payment would not necessarily augur well for the covered bond market as a whole, and would surely be something that resolution authorities would be keen to avoid.

And if a CPT maturity extension was triggered, the expected recovery on the bonds would be far higher than in a covered bond with a hard or soft bullet maturity, since, without the ability to switch to a pass through, the cover pool administrator of a bullet bond would have to sell cover assets — most likely in a rush, and at a highly discounted price.

Such sales would considerably diminish the cover pool subordinating all investors that hold longer maturing soft or bullet bonds. By contrast, all CPT noteholders would be treated equally if a CPT is extended, and there would be no chance of a forced sale at a discounted price.

Private sector investors might not like the extended payment timeline — but if there's one buyer that can hold on to the final maturity, it's the central bank.

The ECB will no doubt curtail CBPP3 altogether, but its decision to cut out CPT structures from weaker issuers conflicts with its stated mission, and can't be fully justified by risk considerations.

By Bill Thornhill
02 Jan 2018