ECB Enters CLO Business

It takes a central banker from Goldman Sachs to conceive of the world's largest CLO, and enlist the Eurozone's central banks to do the credit analysis.

Maybe it was inevitable, after the path the ECB has been on for the past three years.  First they re-defined "repo" in 2009 by pushing the maturity out to one full year.  Then they relaxed the credit standards from AAA to single A, and moved the goal posts out to three years.  Now the single A moniker appears to no longer be necessary.  In fact, by the looks of it, the main requirement is only that the "bank credit claims" be "performing."  And subject to the stringent screening of the seven volunteer central banks, of course.

How can a central bank accept collateral that's got one foot in the grave?  Simple, just tranche it.  That's the only way to view a 65% "haircut" as sketched out by Mario Draghi.  He said at the Q&A portion of today's post-meeting press conference that the haircut would "reduce the amount available by almost two-thirds."  The CBs leave the junior tranche to the banks, and keep the senior tranche for themselves.

So the ECB and its seven central bank partners will take on, by Draghi's estimate, "(EUR) 600-700 billion in credit claims" and loan out something more than EUR 200 billion against them.  If the collateral stops paying, and if the borrowing bank goes bankrupt, the ECB would presumably be entitled to the residual value of the posted collateral.  In other words, the senior part of the package.  The bank is stuck with the subordinated part.

Risky?  Sure, that's the way Draghi himself described it.  But setting aside the risk to the ECB and system as a whole, the message we can safely take away is that Europe's financial system is in very serious straits.  The smaller banks, the ones that Draghi says he is most concerned about, must be stuffed to the gills with shaky assets and can't get funding for them any other way.  There's no other reason to lend money against assets so toxic that they require a haircut of 65%.

But the ECB and other central banks will be fine, because they've created a structure that protects them in the event of default, a structure that "increases differentiation of collateral," as Draghi characterized it.  So they're pooling assets, slicing them up, and keeping the senior tranche for themselves.  What could possibly go wrong with that?