Article / 02 September 2014 at 14:15 GMT

The Eurozone needs action, and ABS won't cut it

Managing Partner / Spotlight Group
United Kingdom
  • Dismal Eurozone data requires urgent ECB action
  • Asset-backed securities cannot revitalise EU markets alone
  • Sovereign debt use might prompt debate, but it will also provide results

By Stephen Pope

All eyes and ears will be on the European Central Bank press conference this coming Thursday, September 4. I think we can dismiss any notion that ECB president Mario Draghi will tinker with the interest rate structure again. On June 5, when the refinancing and deposit rates were cut to 0.15% and -0.10%, respectively, Draghi effectively ruled out further rate reductions.

What the watching world will be looking for are not repeated platitudes about projections for the medium-term inflation forecast or targeted long-term refinancing operations. Instead, it will demand a little more urgency regarding alternative or quantitative measures that can be deployed in the Eurozone.

Eurozone at risk
As the data grows more and more dismal, the Eurozone needs concrete 
measures and not vague intentions. Photo: iStock Editorial

Urgent action is required as the Consumer Price Index level is just 0.30%, unemployment is stuck in double digits at 11.5%, youth joblessness is a staggering 23.1%, and the ZEW Economic Sentiment Index in the Eurozone decreased to 23.70 in August (from 48.10 in July).
Source: ZEW
Source: Eurostat

Quantitative easing, but in what form?

The accepted belief is that the ECB is preparing to initiate an asset purchase mechanism to acquire asset-backed securities that are (to use Draghi´s words) "simple, transparent and real." The central bank's objective is to resuscitate the market and in turn the economy, but the ECB remains dependent upon how and when Europe´s many regulators will define exactly what "simple", "transparent" and "real" actually mean.

The European market for ABS has effectively been closed since the start of the economic and financial crisis. Indeed, ABS can be seen as the first financial asset class to be hit as the crisis reared its head in 2008. The US subprime mortgage meltdown led to a rapid deterioration in collateral quality in the US ABS market, and this led to a lack of overall liquidity as ABS AAA notes were widely used as collateral for inter-bank lending. This, in turn, had a negative impact on the European ABS market.

In August, President Draghi said that ECB purchases of European ABS would reactivate the market, and that’s why the bank intends to concentrate its efforts on instruments that are easy to price.

This, I think, is an interesting point. As far as I am concerned, in an economic region that is characterised by low confidence, growth and employment, any collateral that is even one notch less than plain vanilla should not qualify as "simple, transparent and real."

The scale of things

Compare the Eurozone…

  • The Gross Domestic Product of the Eurozone area was worth EUR 9.724 trillion in 2013 (based on data from the World Bank Group).
  • The European ABS market has a size of EUR 1.4 trillion, i.e. 14.39 % of GDP.
  • Eurozone sovereign debt-to-GDP ratio stands at 92.6%.

with the United States…

  • The US GDP was worth EUR 16.8 trillion in 2013 (based on data from the World Bank Group).
  • The US ABS market has a size of USD 10.3 trillion, or 61.3 of GDP.
  • The US sovereign debt-to-GDP stands at 101.53%

The Eurozone ABS market, we must conclude, is too small as a whole. This means that, when the regulators define exactly what instruments can be classified as “simple, transparent and real”, their size (relative to GDP) will be much diminished and the scope for an ECB QE programme to be effective will appear minimal.

The European ABS market does not enjoy the scale of its American counterpart, 
diminishing the utility of this asset class. Photo: Thinkstock

The reality is that if the ECB is determined to use only approved European ABS, then their size and scope will be insufficient to catalyse activity inside the Eurozone. It appears as if the ECB will be wading into an asset class that will fail to deliver any genuine revitalisation to the market. Consequently, plotting an exit strategy will become extremely difficult.

The investment community has proven itself to be yield-hungry. It is only because the market perceives the ECB as being a backstop bid that sovereign yields in the periphery have fallen as far as they have. Any investor that seeks the lure of the ABS market will do so because of enhanced returns, but they will not get that from instruments that are “simple, transparent and real”. 

Of course, if the ECB buys this type of asset that will pull in speculative money as well, but the real lure of ABS comes from deconstructing the collateral structure to make an “in house” assessment of the ingredients' value. One has to be sure that the instrument has financial synergy, and that does not happen with ABS that are plain vanilla. Real yield flows from a variety of flavours.

A tight ship or a leaky vessel?

It would have been so much more satisfactory if the ECB had either kept the entirety of its ABS market assessment in-house (or at least coordinated solely with other semi-state or supranational entities). Instead, the central bank has indicated that it does not have sufficient knowledge and so has looked to BlackRock Inc. — the world’s biggest money manager — to provide advice on developing the programme. This has the risk of allowing allegations to arise if an external party is seen to make a super-normal profit by trading (or even front-running the ECB) in ABS that can be seen as “simple, transparent and real”.

I am not for one moment suggesting that BlackRock Inc. would act in anything other than a proper manner — let me be absolutely clear on that. However, other asset managers may start to figure out what sort of advice is being given and seek to position themselves ahead of the ECB.

I can make a stab at assuming what kind of ABS may be considered: They will most likely be residential mortgages, small- and medium-sized enterprise loans and car loans. They are not likely to be swaps, structured products with knockout clauses or synthetic securities. It's not so hard to start a slow accumulation in a portfolio (there's no need to be greedy), but the potential for taking a turn is open for all to see.

Delay will be Draghi’s order of the day

The word on the wire is that the committee set to coordinate the thoughts of the Basel Committee on Banking Supervision, the International Organization of Securities Commissions and BlackRock Inc. will report its findings on high-quality ABS in November, followed by a final report in March.

I grow sick and tired of saying it, but this is once again an example of Eurozone delay and dither. For starters, the total ABS market in Europe is already too small, let alone the restricted subset that the ECB will potentially work with. It is also unlikely that any QE via ABS will occur this year. The programme needs to be based on sovereign bonds (an asset class that does have the necessary size and scope). These can give the programme a kick start, leaving it free to incorporate ABS at a later date.

As I have said before, the use of sovereign debt will bring many hotly debated issues to the forefront but at least action could taken immediately. Sovereign bonds have the immediate benefit of being simple and transparent, even if their yield structure is far from reflecting reality.

--Edited by Michael McKenna

Stephen Pope is a 30-year plus veteran of the markets

Jim Earls Jim Earls
When are people going to grow up and let the system clear so it can move forward on real price discovery?
fxtime fxtime
Definitely agree Jim.
Stephen Pope Stephen Pope
The problem within the Eurozone is that the Euro is effectively a derivative of the Deutsche Mark & the Euro only suits Germany & the states that also show strong fiscal discipline, Austria, Finland & Netherlands.

Given that the decision was taken in 2009/10 that Greece & in turn other ailing nations would not be cast adrift from Project Euro it is a given that the ECB will be sucked into ever more entanglement.

I thought Greece should have left the Euro in 2010/11...however, it was clear that it could have been the small unravelled stitch that then gathered pace undoing the southern seam. Spain and Portugal would have followed and the pressure would have been on Italy.

Draghi through his commitment to do whatever it takes, then via OMT has given those distressed nations a backstop bid. Sadly, one can argue that whilst the ECB has played its part to calm the storm the national politicians have failed to do their part. What annoys me is seeing France calling ever more spending.
Crossover521 Crossover521
"What annoys me is seeing France calling ever more spending. "
Because when you have double digit unemployment and you're nowhere near your inflation target, what the economy needs is a cut on spending right?
Stephen Pope Stephen Pope
Hello there,

I understand that my view will not be matched by everyone. Still, this is a platform for ideas to be aired and debated.

Yes, I do take issue with the way France is governed. The administration has been in power for the past two years and has shown a disregard for the private sector. Lasting wealth does not stem from the central state, it comes from free enterprise. Of the wealthy OECD nations France ranks just 38th as a place in which to business.

The President calls for more spending despite the fact that the level of debt to GDP stands at 91.80%. Compared to Germany at 78.40% France already has too much borrowing. Unemployment at a national and youth level remains high because business is hemmed in by red tape and an attitude that the state knows best and can pick winners.

Time after time President Hollande said the budget deficit target would be met...time after time France has requested more time. The tight spread to German debt does not reflect reality.
Crossover521 Crossover521
I'm not focusing on France specifically.
I'd rather debate the idea that somehow cutting spending in the middle of a recession/deleveraging is going to boost the economy.
This idea defies basic marcoeconomic identities that stand true by definition e.g. surplus of the gvt equals the combined deficit of the domestic prvate sector and the external sector to the penny and vice versa.
Contrary to your opinion, corporate profits were high in economies that didn't rush to slash net spending like the US and UK.
Contrary to your opinion, the slash on gvt spending deepened the recession in the Eurozone.
Austerity can only work when you're the only one imposing it.
Germans did it when everybody else was expanding and they somehow believe that it's feasible now for the Eurozone as a whole.
That's pure ideology.
Stephen Pope Stephen Pope
The ideology has a basis in calling for a curtailment of state spending "G" that is matched by significant deregulation and roll back of bureaucracy. The pace of reform in all affected nations has not been quick enough so whilst the cut in "G" i.e. via austerity has been implemented insufficient progress was made in creating the conditions for the private sector to step up and fill the gap.

It was the lack of rapid reform that deepened the recession.

The long term multiplier of C and I is greater than that of G were capital is frequently spent on pet projects or distorted by political motives.

Of course there are time lags so reduced G in t=1 is probably not going to be replaced by C or I until t = 2 or maybe 3. One aspect I argued for at the time was for the national central banks to act as conduits of capital for national SME's. The cheap liquidity from the ECB was mostly funnelled back to the ECB and not lent.
Crossover521 Crossover521
You're still missing the point.
G - T (fiscal deficit) = (S - I) (net saving of domestic private sector) + (M - X) (external deficit)
In other words when an external deficit exists, there must exist an even larger public deficit if the private sector is to have a surplus (S - I > 0).Otherwise private debt will by definition rise.The private sector will always cut down its expenses (C, I) if it wants to deleverage so the economy has to rely on either the gvt or the external sector (external surplus) to fill the spending gap.
Now by definition you can't have all economies run external surpluses thus by definition not all economies can be like Germany.
Even more so when it comes to the Eurozone, 2nd largest economy in the world.It should run humongous external surpluses if the public sector does not want to fill the spending gap.How feasible is that? Do you know anyone able to absorb such a huge amount of exports?
Stephen Pope Stephen Pope
I apreciate the alphabet soup of Keynesian national income identities. We can argue within this framework or try and apply MV = PT or indeed any other arrangement.

My concern is that when the cry is to spend more on stimulus I ask where is the money coming from? The loudest voices for stimulus come from the least willing to reform. As debt levels tend toward 100% + of GDP the only way in which investors keep taking the new issues is if everything is given a backstop bid bid. Is that via the ECB and an enhanced OMT? Or do we we mutualise all future sovereign debt. The Euro project either has to be all in for total federalism or it has to break up and let nations use currency flexibility to set their own appropriate pace of adjustment. The half backed approach has a finite shelf life.
Crossover521 Crossover521
I don't think there's anything to argue about when it comes to identities.That's the way it is. That's why they are identities and not formulas..A sector's deficit is another sector's surplus to the penny.A sector's net saving is equal to another sector's net lending.

Regarding where the money is coming from.ANY sovereign free floating fiat currency issuer cannot involuntarily run out of said currency.Which leads to the conclusion that had countries retained their currencies, they could still have all sorts of problems but insolvency (at least when it comes to debt denominated in their currency) would not have been one.This should be ringing some bells that it's the architecture of the EMU the root of Europe's current problems above anything else.I need only mention that during the 90's Greece had a similar debt to gdp ratio to the one it had when it asked for the Troika intervention.And yields were double digit during the 1st half of the 90s.
Crossover521 Crossover521
And when is the best time to reform anyway?If you had an option would you reform a country in the early 00's, Germany style, where everybody else is growing and you can persue export led growth or would you rather do it when your private sector along with your main trade partners are all trying to deleverage ?
I find it ridiculous that everybody is screaming reform on anything but the currency.
Hence I fully agree with you.We either disolve the EMU or bind the central monetary authority with a central fiscal authority that will enjoy monetary sovereignty.The current scheme cannot go on forever.
Stephen Pope Stephen Pope
I am with you on that. .. still let's see what MD says in a few minutes. I puzzle to see how 10bps is anything other than a gesture. Makes the statement of June 6th loom rediculous. Credibility is short supply.


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