Bond Drought Challenges Draghi’s Asset-Backed Stimulus Plan

Photographer: Martin Leissl/Bloomberg

Mario Draghi, president of the European Central Bank (ECB), arrives for a news conference to announce the bank's interest rate decision in Frankfurt, Germany, on Sept. 4, 2014. The European Central Bank unexpectedly cut interest rates to spur economic growth and stave off the threat of deflation. Close

Mario Draghi, president of the European Central Bank (ECB), arrives for a news... Read More

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Photographer: Martin Leissl/Bloomberg

Mario Draghi, president of the European Central Bank (ECB), arrives for a news conference to announce the bank's interest rate decision in Frankfurt, Germany, on Sept. 4, 2014. The European Central Bank unexpectedly cut interest rates to spur economic growth and stave off the threat of deflation.

To appreciate the challenge Mario Draghi faces reviving Europe’s ailing economy by buying asset-backed securities, listen to Frank Erik Meijer.

As head of ABS at Aegon Asset Management, which oversees 240 billion euros ($311 billion), Meijer says it takes him about three months to buy 1 billion euros of securities.

“The number that’s circulating the market is 500 billion euros, but where is he going to get it from?” said Meijer, who is based in The Hague. “Existing bonds are unavailable so he might have to ask banks to create new ones.”

The European Central Bank president’s plans are being greeted with skepticism by investors who have seen the 1.2 trillion-euro market contract more than 40 percent since 2010 as regulators cracked down on the debt blamed for deepening the financial crisis. The securities are also typically bought by pension funds, insurers and banks who hold them until maturity.

Europe's QE Quandary

Draghi said yesterday the ECB will buy a broad portfolio of “simple and transparent securities” that will include ABS and covered bonds as he seeks to free up bank balance sheets and stimulate lending. While declining to disclose the size of the program, he said it would have a “sizable” impact and details would be revealed after policy makers meet in October.

Crowding Out

“The news is clearly positive but the ECB will have to be careful not to alienate the existing investor base in ABS,” said Patrick Janssen, a fund manager at London-based M&G Investments, which oversees 21 billion euros of ABS. “There is a risk of us being crowded out.”

The ECB is aware of the possibility of pushing investors from the market as it buys bonds. In a March paper, the bank’s researchers found that the U.S. Federal Reserve’s so-called quantitative easing program forced investors out of those sectors where the central bank had intervened.

Asset-backed securities are bundles of consumer and property loans that are packaged into notes of varying risk and return. The securities allow banks to share the risk of default with investors, thereby encouraging them to offer more credit.

The market for such securities has shrunk as the Basel Committee on Banking Supervision demands banks increase the capital they hold to absorb losses on the debt.

Sales Slow

European ABS sales fell to about 74 billion euros last year from 325 billion euros in 2007, an almost 80 percent decline, according to JPMorgan Chase & Co. Citigroup Inc. estimated earlier this year that there are only about 13 billion euros of public bonds outstanding that are backed by loans to small-to-medium sized companies, the part of the market that the ECB has sought to revive.

Policy makers are running out of options to stimulate Europe’s economy. With euro-area inflation languishing at 0.3 percent last month, a fraction of the ECB’s 2 percent goal, and Draghi saying the outlook is worsening, interest rates were cut.

The benchmark and deposit rates were lowered by 10 basis points to 0.05 percent and minus 0.2 percent. A basis point is 0.01 percentage point.

The ECB also lowered its economic forecasts for this year and next from its assessment in June, when it last cut rates. Gross domestic product is now predicted to expand 0.9 percent this year and 1.6 percent in 2015, instead of 1 percent and 1.7 percent. Inflation is seen at 0.6 percent this year rather than the 0.7 percent it had forecast.

Bond Rally

The rate cut and the announcement of the bond-buying program triggered a global rally in credit markets. The cost of insuring European corporate debt dropped to the lowest in almost seven years, with the Markit iTraxx Europe Index of credit-default swaps on 125 investment-grade companies falling to 60 basis points. A similar gauge in the U.S. also approached a seven-year low.

European government bonds rose, leaving yields on two-year notes below zero in eight euro-area countries, while the benchmark Stoxx Europe 600 Index climbed more than 1 percent to the highest since July 3.

The ECB initially plans to target the most senior and least-risky segment of the secured bond market. The central bank would only consider buying lower portions, such as the so-called mezzanine part, if governments provide a guarantee, Draghi said.

The ECB needs to buy the junior portions of the securities to have the desired effect, said Robert Wakiyama, who manages the $1.4 billion Credit Suisse Lux Global Securitized Bond Fund (CSSIFAB) from Zurich. That’s because banks and insurance companies that buy the bonds have to hold more capital to insure against losses on the junior portions of the securities.

“Buying senior ABS bonds is not the solution in our view as it doesn’t take the risk from the banks’ balance sheet,” Wakiyama said. “With the current regulation, banks have to retain the most junior part. As long as the ECB isn’t participating in those bonds, I don’t see either a capital relief for banks or the banks giving more credit to the real economy.”

To contact the reporter on this story: Alastair Marsh in London at amarsh25@bloomberg.net

To contact the editors responsible for this story: Shelley Smith at ssmith118@bloomberg.net Michael Shanahan, Shannon D. Harrington

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