Posted in the Wall Street Journal by Richard Barley:
The European Central Bank's decision to buy €60 billion ($81.5 billion) of covered bonds is a smart move that is already yielding results -- before it has spent a single euro. The giant €2 trillion market is a vital source of funding for European banks but since the crisis started, spreads have remained stubbornly wide reflecting liquidity fears. Thanks to the ECB's intervention, spreads have not only tightened, but issuance is picking up too, reducing funding pressures on many banks.
Banco Santander this week issued the first Spanish covered bond in nearly a year to strong demand. The deal was planned before the ECB decision, but was helped by increased investor confidence; the bank may have saved around 30 basis points on interest costs as a result. Several others have followed. Benchmark "jumbo" covered-bond issuance nearly halved last year; 2009 sales by May 13 had fallen 68% against the same period of 2008, according to Dealogic. But analysts are now raising their issuance targets for 2009.
In large part, the problems in the covered-bond market haven't been about credit risk. Unlike asset-backed securities, investors have a claim on the issuing bank as well as an underlying pool of mortgages. Banks have to maintain the credit quality of the pool, which remains on their balance sheet, giving them an incentive to originate good-quality loans as they retain the credit risk. These features allow the bonds to achieve very high ratings -- often triple-A. And although some have been downgraded, there has never been a default on a covered bond, even though the market traces its roots back to the 18th century.
But liquidity fears have dogged the market since late 2007, when market-making in the bonds was briefly suspended. Jumbo bonds, which account for half of the debt outstanding, were marketed as highly liquid and included an inter-bank market-making agreement that aimed to assure investors they would be able to sell with minimal price disruptions. The suspension of dealing shattered confidence.
That has given the ECB a juicy illiquidity premium to aim at. Covered bonds are a better candidate for unconventional policy than the Bank of England's focus on buying corporate bonds, which have never been particularly liquid and where much of the spread widening is arguably due to credit risks. More importantly, a revival in the covered bond market will allow banks to raise longer-term funding than that available under government guarantees, many of which are limited to three years. That's another important step in the credit healing process.