What Is The ECB To Do?

The European Central Bank meets tomorrow.   The focus is on the details of the asset-backed securities and covered bond plan that was announced last month. 

There are three key issues related to this new initiative:  What instruments will be purchased,  how much will be bought, and how long will the purchase program last?

The ECB will buy the safest tranche of the asset-backed securities.  The initial proposal that it could buy riskier tranches if guaranteed by national governments was quickly rebuffed not only by Germany, which has been critical of the purchase plan, but also France.

Since the crisis erupted several years ago, the ECB has reduced the quality of the assets it will accept as collateral, including ABS.   Greece and Cypriot ABS still does not meet even these relaxed criteria.  There was a report this week that intimated an effort to make an exception of these two countries.  However, this seems unlikely as such exceptions are not fair and would probably not have sufficient support.  

Indeed, it could have very well been an intentional leak to toughen the resolve of German and creditor nation resistance. Recall that the decision to cut interest rates last month and the purchase program was not unanimous.  Draghi referred to it as a “comfortable majority”.  This does not sound as if Germany was the sole dissenter.  

After the low use of the new Targeted Long Term Repo Operation facility,  there was initially some thought that this would increase the pressure on the ECB to “shock and awe” with the “modalities” of it asset purchase program.  A Reuters polls found a consensus expectation that the ECB would buy 200 bln euros of ABS and covered bonds over the next 12 months.  A poll shortly after last month’s ECB meeting, the consensus was for a 300 bln euro program.

We see some risk that the ECB does not announce the size of its purchase program.  This would maximize it operational flexibility.  Once it announces the criteria of its purchases, the market can deduce the potential size.  This is true of covered bonds as well.  The prior two covered bond purchase programs were 40-60 bln euros, which would be the lion’s share of the outstanding supply.