ECB buys covered bonds

An ECB spokesman told DW Monday the ECB had begun buying securities known as "covered bonds" to help boost the eurozone's economy.

The purchases are the bank's latest effort to stimulate the economy of the 18-member bloc and prevent it from slipping back into recession.

Covered bonds are issued by commercial banks, backed or "covered" by revenues from pools of bank assets such as mortgages - money owed by home-buyers to banks.

By selling covered bonds to the ECB, commercial banks will essentially be borrowing money from the ECB. The ECB, in turn, will create the money it needs in order to buy those bonds by making entries on the ECB's spreadsheet.

"The ECB will announce on its website every Monday at 3:30 p.m. Central European Time, starting next week, how many covered bonds purchases were made and settled by the bank in the previous week," the ECB's spokesman said. He declined to say how large a weekly volume of covered bond purchases the ECB planned to make.

Luca Bertalot, secretary general of the European Covered Bond Council (ECBC), told DW that the Council had consulted closely with the ECB on the structure of the central bank's covered bond asset purchase program.

"We see it as a very positive step that Mr. Draghi, the ECB's chief executive, has recognized the importance of covered bonds as a mechanism of transmission of monetary policy to the real economy," Bertalot said.

According to the ECBC, the total value of covered bonds outstanding in the European Union at the end of 2012 was 2.8 trillion euros ($3.57 trillion). The covered bond market is thus large enough to allow the ECB considerable scope for asset purchases.

In effect, the ECB intends to pump cheap money into financial markets by buying billions of euros' worth of covered bonds each week, in the hope that doing so might stimulate the real economy.

But the question is whether covered bonds will in fact stimulate the real economy, or merely further inflate the FIRE economy - the "finance, insurance and real estate" economy.

Covered bonds reduce default risk

Covered bonds are called "Pfandbriefe" in Germany, where an early form of the bonds were introduced by Frederick the Great of Prussia in 1769 to make it easier for owners or large agricultural estates to get cheap credit. Groups of land-owners guaranteed individual members' loans against the risk of individual default.

Today, covered bonds are a special form of senior debt contract in which the issuer - usually a commercial bank - promises bond buyers that the issuer's debt repayments will be backed up not only by the creditworthiness of the issuing bank, but also by a "cover pool" composed - in most cases - of a large number of mortgage contracts.

The issuer of a covered bond has a legal obligation to maintain sufficient assets in the cover pool to satisfy the claims of covered bondholders at all times.

This means that if a bank that has issued a covered bond gets into financial trouble and has difficulty making its bond payments, the bond-holders have a direct claim on the stream of monthly payments made to the bank by a pool of mortgage borrowers whose mortgage obligations to the bank are included in the cover pool.

This claim on the bank's stream of incoming mortgage payments is senior to the claims of other creditors on the bank's assets. That means holders of covered bonds are in line to be repaid first, before other creditors, if a bank gets into trouble.

The risk of default on covered bonds is therefore significantly lower than the risk of default on ordinary bonds issued by the same credit institution. For that reason, the interest rates banks pay to buyers of their covered bonds are lower.

Covered bonds a way for banks to refinance their loan books cheaply, and for bond buyers to reduce their risk exposure.

What is the "transmission channel" to the real economy?

Ideally, this gives banks the ability to raise cheap money by leveraging their mortgage pools, and pass on the savings to real estate borrowers - or indeed any borrowers, whether they are real estate buyers, business investors or consumers. That is the "transmission mechanism" by which the ECB hopes to stimulate the economy using covered bond purchases.

In Europe, since the majority of covered bonds are issued by banks and covered by the banks' mortgage pools, they are ultimately backed by the value of mortgaged real estate properties.

The question is whether this means that the ECB's covered bonds purchase programme will stimulate banks mostly to make more mortgage loans, rather than business loans - not necessarily a desirable outcome on a continent where Spain, Ireland, and arguably several other countries have already suffered mortgage bubbles.

Not all covered bonds are mortgage-pool-backed. Roughly a third of European covered bonds are covered by banks' portfolios of public-sector debt instruments.

For example, a bank issuing a covered bond may own a portfolio of sovereign bonds. If the bank has difficulty meeting its own payment obligations to the holders of the bank's covered bonds, the bond-holders have recourse to the stream of payments the bank takes in each month from the governments who issued the sovereign bonds and sold them to the banks.

In that case, debt repayments made to the bank by the government would be diverted to the owners of covered bonds issued by that bank.

Information on the specific types and quantities of covered bonds purchased by the ECB will become available as the program gears up in coming weeks and months. As for the program's impact on the real economy, on house prices or on the overall level of borrowing in the eurozone economy - the vagueness of the ECB's press releases suggests that at this point, not even the ECB really knows what the impact will be.