- 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.
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).
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