Monday, 8 September 2014

Draghinomics ABS is big. Very BIG!

ECB's asset-backed securities purchase programme (ABS PP), with underlying assets consisting of loans to the Euro-area non-financial private sector (i.e. corporates), announced by Mario Draghi on Thursday was received with subdued enthusiasm by commentators and financial markets alike.

The widespread perception is that it is a step in the right direction in order to unblock credit flows to Eurozone's private corporate sector, especially small and mid-sized enterprises (SME) in EU's periphery that have no direct access to credit markets and rely entirely on bank financing. However, the programme is too small to have any meaningful economic impact: the total stock of SME ABS outstanding is approx. EUR 90bn, i.e. 0.9% of Eurozone's GDP. If we only take into account SME ABS not retained by banks for repo purposes we end up with a total stock of just EUR 10bn, i.e., 0.1% of Eurozone's GDP.

The numbers are absolutely accurate. And irrelevant. Who said that the ECB will only buy existing SME ABS?

Here is Thursday's ECB statement announcing the launch of the ABS programme:

"The Eurosystem will purchase a broad portfolio of simple and transparent asset-backed securities (ABSs) with underlying assets consisting of claims against the euro area non-financial private sector under an ABS purchase programme (ABSPP). This reflects the role of the ABS market in facilitating new credit flows to the economy and follows the intensification of preparatory work on this matter, as decided by the Governing Council in June."

There is no reference to "only existing" ABS. And during the Q&A session of ECB's press conference, Mario Draghi had this to say (note: underscoring is my own):

"Question: I have two questions. The first is on the purchase programmes that you announced. Do you have more details of what kind of ABS you are planning to buy? Mortgage, residential mortgage, just to SMEs?
Draghi: The purchase of ABS will involve both newly created and existing ABS and would also include the real estate, the RMBS, real estate ABS. It would also include a fairly wide range of ABS containing loans to the real economy."

The fact that ECB's purchase programme includes "newly created" ABS changes everything. It means that banks:
(i) Can structure ABS having existing loans to corporates as underlying and sell them to the ECB
(ii) Can make new loans to corporates (using ECB's cheap financing provided via TLTRO - targeted longer-term refinancing operations), repackage them as ABS and then sell these to the ECB (with the proceeds used to repay the TLTROs)

This is a sea-changing event. For at least 3 reasons:

1. The ECB will be the facto lending money almost directly to Eurozone's private corporate sector,  including SMEs. The banks will be simply unavoidable intermediaries in the process with corporate credit risk being fully transferred to the ECB (the ECB cannot by law lend directly to coporates having to use the banks as a conduit)

2. Banks can deleverage by transferring existing corporate loans to the ECB by repackaging them into ABS (without any negative impact on their P&L as a way will surely be found to transfer the loans to the ECB at the value they are accounted for in banks' balance sheets)

3. Banks can make some extra profits with no additional consumption of capital by conceding new loans to corporates and then repackage and transfer them as ABS to the ECB (first the banks make money via the interest rate differential between corporate loans and TLTROs; once the loans are repackaged into ABS and sold to the ECB, banks get rid of the credit risk and make money via the small differential between interests paid on individual corporate loans and slightly lower interests paid on corporate ABS due to the lower risk of a portfolio of individual corporate loans vs. the average individual loan contained in that portfolio). Thus improving their P&L, increasing retained earnings and capital buffers

How big will ABS PP's impact be? Mario Draghi mentioned that as a result of the programmes announced on Thursday, ECB's balance sheet should increase by EUR 1 trillion, 10% of Eurozone's GDP. Given that ABS and TLTRO are the facto linked (ECB's balance sheet increases with the concession of the later, which are then substituted by the former), the only question is how the EUR 1 trn will be split among ABS and covered bonds, for which a purchase programme was also announced on Thursday.

Assuming that
- 75% of the EUR 1 trn will be linked to ABS
- Eurozone's private sector corporate debt held by the banking sector is around EUR 7 trn (aprox. 80% of the total private sector corporate debt)
- SMEs account for approx. 50% of total Eurozone corporate bank loans
- the Eurozone peripheral countries (Italy, Spain, Portugal, Greece, Ireland) account for roughly 30% of this total and the main focus will be to unblock credit flows to these countries' SMEs

it follows that ECB's ABS programme could have an impact equivalent to
- approx. 11% of total existing bank loans to Eurozone corporates
- approx. 35% of total existing bank loans to Eurozone periphery corporates
- approx. 70% of total existing bank loans to Eurozone periphery SMEs

We can obviously discuss the assumptions just made and come up with different numbers, but the conclusion will stay the same: ECB's ABS purchase programme is hardly going to be just a bit of noise.

If we take into account that a public Eur 300bn investment programme (3% of Eurozone's GDP) is likely to be implemented by the European Union at the initiative of the new Juncker Commission, there is more than a fairly good chance that EU's economic growth will start to surprise on the upside in 2015. And if the investment programme is well targeted, i.e. investments in areas with a positive impact on the economy's supply side, rising its growth potential (needed infrastructure improvements, education & training, R&D), the effects will actually be more than just short-term GDP growth cosmetics in the best spirit of "Hollywood economics".

Having said this, will Draghinomics (and a bit Junckernomics) will be sufficient to definitely overcome Eurozone's financial and economic malaise? No.

Taken as a whole the Eurozone is in pretty decent shape. The problem is the asymmetry in competitiveness between centre and periphery. This can however only be solved by doing structural reforms in the periphery with the aim to attract massive amounts of foreign direct investment (FDI) to broaden the peripheral countries' production and export basis and thus solve their chronic and unsustainable current account deficits (especially true for Portugal, Spain, Greece).

Will political leaders take advantage of the 2-3 years time that Mario Draghi is buying them? No idea. The only think that is clear is that tracking their "structural reforms performance" will be easy as it just requires to monitor three variables: FDI investment to build new production capacity in the periphery (portfolio flows to buy existing assets don't count), exports, current account balance.

In the meantime, enjoy Super Mario's party. It will be a spectacular one.

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