ECB: "Litterbin of the Last Resort"

We’ve read from time to time that European banks have been launching deals, and not particularly good ones at that, solely for the purpose of using those securities as collateral for loans from the ECB. However, we hadn’t seen a longer-form treatment of that phenomenon. The Economist has decided to step into the breach. The subhead says it all: “The assets being dumped on the ECB do not look very recyclable.”

From the Economist:

The European Central Bank (ECB), widely praised for providing banks with ample liquidity during the credit crunch, now has a problem: how to encourage banks to place freshly created asset-backed securities (ABS) with investors, rather than dumping them, like so much radioactive waste, in its vaults.

The ECB accepts a wide range of assets, including those such as ABS for which there is temporarily very little trading, as collateral in its refinancing operations. Provided the tranche of securities is the most senior, and rated A- or above, the ECB will take it. No surprise then that since August a large number of banks have designed ABS tranches, backed mostly by mortgages, purely for ECB consumption. Of €208 billion ($320 billion) of eligible securities created, only about €5.8 billion have been placed with investors, according to calculations by JPMorgan….

On the face of it there is no immediate problem. Only around 16% of the ECB’s collateral so far is ABS. Banks are drinking from the liquidity fountain and keeping the cost of high-street mortgages contained at the same time, which they might not be able to do otherwise.

But it is not helping the revival of a publicly traded ABS market, and may be fostering the creation of even murkier securities. Many of today’s ABS are even less transparent than those sold before the crisis—the ECB requires a rating by only one agency, not the usual two, and pre-sale reports are often sloppily prepared. That, at least, is the concern of some rival central bankers, although the ECB itself is not panicking, yet…

All the main central banks have learnt a lot from this crisis. America’s Federal Reserve and the Bank of England found that they had too few tools to cope with the liquidity drought. The Fed threw open its emergency lending facilities to investment banks, as well as accepting a much broader range of collateral in its open-market operations. The Bank of England, several months too late, widened the range of collateral it accepts as well. Only the ECB, rather smugly, can say that it has stuck to its pre-crisis rules. But there are still gaping differences that can be “gamed”, or arbitraged, between the three systems.

The Fed accepts complex credit derivatives in its liquidity operations, which the others do not; the Bank of England, with its Special Liquidity Scheme dating from April, accepts AAA securities of all types, but only those held on a bank’s balance sheet before the end of last year. The British bank also applies more stringent “haircuts”—ie, it is tougher on valuations—than the ECB, according to market participants. The result, unless the ECB changes its tune, is that it could well end up as the repository of last resort. If banks start to default, the ECB—and ultimately the euro-zone taxpayer—could be left holding a lot of toxic assets. Almost as bad—for those with a mind for justice—is the thought that the same supposed rocket scientists, using the same benighted techniques that caused the mess, may be taking everyone for a ride again.

Central bank liquidity policy needs refining and harmonising, as the Financial Stability Forum, a group of banking-industry regulators, made clear in a report in April. This week Mervyn King, the Bank of England’s governor, hinted at plans for an integrated framework “making clear the terms on which liquidity will be provided in times of stress”.

Market participants say the trouble is that spelling out those terms beforehand can create moral hazard and encourage recklessness. One argument doing the rounds is that the ECB’s broad acceptance of collateral before the crisis may actually have added fuel to the fire.

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  1. Richard Kline

    If the central banks can’t/won’t nationalize distressed firms, the firms will game them; it’s that simple. For concerns functionally insolvent, they don’t even have anything to lose, and something to gain by doing so. Nationalization isn’t a panacea: if zombie banks are ‘put down,’ the central banks are stuck with _all_ their losses, not just the ones sloshed around in these ‘liquidity puts.’ Presently, the central banks are hoping that a financial system recovery will grow the Big Busters back above the red ink line, so the CBs are obviously reluctant to lock in maximum losses now, conceding any flexibility in consequence. . . . Japan to an elephant’s age to grow back above the redline; doesn’t look a real good bet.

    At the very least, CBs in US, UK, and EU need to harmonise their policy _interventions_ to keep the big financials from sloshing losses from shop to shop. Regrettably, those three CBs don’t see the problem the same way, so they aren’t yet on song. The vapid announcement of this weeked from the Group of 8 finance ministers before they repaired to their dachas for some R & R indicated a continuing inability of sovereign financial authorities to meaningfully coordinate their actions—which means that the Big Financials are still the engineers on this train. Reassuring conceit, that, what?

  2. fuguez

    I completely agree with Richard.

    It seems silly that the CBs appear to be allowing ‘freshly-designed’ structures onto their books, but it’s not their money. Of course the rational thing to do is to seperate your rubbish and re-cycle the most toxic to the CBs or anyone else who wants it. The financial system – banks and CBs – has a problem to solve. People accept that the best way to build profitability back into the system is to allow the banks to continue to operate;the question is how does the system deal with the obvious damage.

    It is becoming obvious that one side will get to hold the baby while the other gets to ‘hold the nappies’.

  3. Anonymous

    At the risk of stating the blooming obvious this type of mehchanism (with appropriate variations and dodges) is one way Lehman could offload USD120Bn of nasty assets in the middle of a credit crunch without realising a chunky loss.

    49 1/2

  4. Anonymous

    These ‘litterbin’ provisions are a new take on the ‘good bank/bad bank’ approach used during the U.S. S&L crisis of the 1980s. But this time, instead of being a private-sector creation, the ‘bad bank’ is the central bank.

    The great mertit of the scheme, at least for the schemers, is that the private-sector management and their companies get to soldier on. Central bankers have at least limited tenure, and imagine that they can ride out the rough patch until conditions improve. Good luck with that, pals!

  5. etc

    The central banks aren’t as secure as they think. If there’s a big public screw up this year before the election, maybe the next Congress and administration will fill the 4 Fed openings with people that vote against Bernanke, and we’ll see a revolt like Volcker saw.

  6. Bitter Renter

    A commenter on a different blog summarized this article in six words: “Privatize the profits, socialize the losses.” Heads, I win. Tails, you lose. The banks continue to engage in this behavior. Bonuses go to the management. Losses go to the taxpayer.

    I, with my limited knowledge of economics, can see only way to combat this: “Socialize the profits, privatize the losses.”

    In other words, (1) raising taxes on the wealthy, (2) allowing banks to fail.

  7. Anonymous

    But what happens if the central bank fails, because its balance sheet has been looted of its high-quality Treasurys and stuffed with junk?

    Obviously, the central bank is ‘too big to fail,’ because it issues the fiat currency. But what if, after defaults on a big tranche of its CDO holdings, the Federal Reserve’s assets were less than its liabilities?

    Well, some common stocks have traded, and do trade, with negative net worth. As long as they’ve got cash flow and service their obligations, the accounting fact of having negative net worth doesn’t automatically or necessarily shut them down.

    And it would be the same for the Fed, I reckon. Paper dollars aren’t redeemable for the Fed’s assets, so a traditional run is impossible. The Fed would muddle through even with a hole in its balance sheet.

    No, the real risk to the Fed is that gigantic, off-balance sheet, $2.3 billion slush fund called the ‘custody account.’ Foreigners most certainly could execute a run on the custody account, which is 2-1/2 times the size of the Fed’s own balance sheet.

    The Fed should never have let the custody account grow so large that it could threaten destabilization. But they did. So the markets, as usual, will probe for weakness. ‘Quake lakes’ are nothing, compared to the custody dam giving way. Run, Ben, run!

  8. Anonymous

    “The European Central Bank (ECB), widely praised for providing banks with ample liquidity during the credit crunch, now has a problem: how to encourage banks to place freshly created asset-backed securities (ABS) with investors, rather than dumping them, like so much radioactive waste, in its vaults.”

    To keep it simple, as an investor with not an insignificant amount of capital at my disposal, why would I want them if the ECB considers them radioactive? I find that premise insulting in the extreme, particularly given that I have not been overly impressed by the ability of central banks to properly understand the unfolding credit market dynamics themselves.

  9. Ginger Yellow

    “To keep it simple, as an investor with not an insignificant amount of capital at my disposal, why would I want them if the ECB considers them radioactive? “

    There’s a difference between not being on a central bank’s list of eligible collateral and being radioactive. The point is that there are a lot of potential (ABS) deals at the moment where the risk/reward would be right for certain investors, and in some cases for the sponsors too, but the ECB is providing much cheaper funding with little sign of turning off the taps. It’s these deals in the middle, and the market for them, that the ECB’s policy is hurting. It’s at either end of the spectrum where there wouldn’t be a market anyway – the truly “toxic” paper and the safest stuff – where no amount of central bank action will have much of an effect either way. The point the Economist and others are making is that the ECB’s rules and the easy availability of liquidity thereunder are resulting in structures and asset pools that would never have been brought to market in the first place – pools of conventional mortgages mixed with development loans, for instance, or deals where the assets wouldn’t support a market spread on the liabilities. At some point the EB is going to have to decide whether it’s willing to accept that for the sake of propping up the banking sector in places like Spain, or if the risks to its balance sheet and the long term health of the market are too great.

    The ECB is in a weird position relative to the other major central banks. They were in the most sensible position at the start of the crisis, and the broad eligibility criteria probably ensured that there was no European Northern Rock (IKB etc notwithstanding). But as events unfolded they didn’t act to tighten up or refine their criteria, so they are now in arguably the worst position. The Bank of England was very late to act, but its response, when it came, was highly targeted – it dealt with the overhang of 2007 assets without subsidising new issuance. The ECB has no explicit mechanism to deal with that problem, and it’s going to have to develop one.

    FYI, if you want a truly long form treatment of the issue, may I suggest you look at the feature in EuroWeek issue 1056 (full disclosure – that’s my publication).

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