ECB Confirms Acceptance Of Junk Debt As Collateral Ahead Of Imminent Italy Downgrade

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by Tyler Durden
Wednesday, Apr 22, 2020 - 02:56 PM

Update (1450ET): Just as we suspected and detailed below, The ECB has followed The Fed's path by accepting junk debt as collateral for its lending facilities.

In an effort to mitigate impact of possible ratings downgrades on collateral availability, the European Central Bank says it will “grandfather until September 2021 eligibility of marketable assets used as collateral in Eurosystem credit operations falling below current minimum credit quality requirements.”

As we noted below, this is all being done to avoid (among other things) a potential catastrophe when Italy is downgraded to junk (expected Friday).

Full ECB Statement below:

  • ECB to grandfather until September 2021 eligibility of marketable assets used as collateral in Eurosystem credit operations falling below current minimum credit quality requirements

  • Appropriate haircuts will apply for assets that fall below the Eurosystem minimum credit quality requirements

  • Decision reinforces broader package of collateral easing measures adopted by the Governing Council on 7 April 2020, which will also remain in place until September 2021

  • ECB may decide further measures, if needed, to continue ensuring the smooth transmission of its monetary policy in all jurisdictions of the euro area

The Governing Council of the European Central Bank (ECB) today adopted temporary measures to mitigate the effect on collateral availability of possible rating downgrades resulting from the economic fallout from the coronavirus (COVID-19) pandemic. The decision complements the broader collateral easing package that was announced on 7 April 2020. Together these measures aim to ensure that banks have sufficient assets that they can mobilise as collateral with the Eurosystem to participate in the liquidity-providing operations and to continue providing funding to the euro area economy.

Specifically, the Governing Council decided to grandfather the eligibility of marketable assets and the issuers of such assets that fulfilled minimum credit quality requirements on 7 April 2020 in the event of a deterioration in credit ratings decided by the credit rating agencies accepted in the Eurosystem as long as the ratings remain above a certain credit quality level. By doing so, the Governing Council aims to avoid potential procyclical dynamics. This would ensure continued collateral availability, which is crucial for banks to provide funding to firms and households during the current challenging times.

The following decisions have been taken:

  • Marketable assets and issuers of these assets that met the minimum credit quality requirements for collateral eligibility on 7 April 2020 (BBB- for all assets, except asset-backed securities (ABSs)) will continue to be eligible in case of rating downgrades, as long as their rating remains at or above credit quality step 5 (CQS5, equivalent to a rating of BB) on the Eurosystem harmonised rating scale. This ensures that assets and issuers that were investment grade at the time the Governing Council adopted the package of collateral easing measures remain eligible even if their rating falls two notches below the current minimum credit quality requirement of the Eurosystem.

  • To be grandfathered, the assets need to continue to fulfil all other existing collateral eligibility criteria.

  • Future issuances from grandfathered issuers will also be eligible provided they fulfil all other collateral eligibility criteria.

  • Currently eligible covered bond programmes will also be grandfathered, under the same conditions.

  • Currently eligible ABSs to which a rating threshold in the general framework of CQS2 applies (equivalent to a rating of A-) will be grandfathered as long as their rating remains at or above CQS4 (equivalent to a rating of BB+).

  • Assets that fall below the minimum credit quality requirements will be subject to haircuts based on their actual ratings.

Non-marketable assets are not part of the scope of the temporary grandfathering. All measures will enter into effect as soon as the relevant legal acts enter into force. The measures will apply until September 2021 when the first early repayment of the third series of targeted longer-term refinancing operations (TLTRO-III) takes place. The same end date will also apply to the collateral easing measures announced on 7 April 2020.

The ECB may decide, if and when necessary, to take additional measures to further mitigate the impact of rating downgrades, particularly with a view to ensuring the smooth transmission of its monetary policy in all jurisdictions of the euro area.

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In English, the excuse for allowing junk-rated debt is that any downgrades to junk (or current junk ratings) may be 'transitory' due to the virus.. and thus The ECB will look through the cycle (hoping that the ratings will magically recover)... all of which is farcical since ratings by their nature look through the cycle anyway. But that's not really the point is it - just enable the credit to flow.


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Now that the Fed has opened the pandora's box of moral hazard by purchasing select junk bonds, every other central bank would like a piece of the action. And sure enough, as Bloomberg reports, on Wednesday evening the ECB will hold a call where they may discuss whether to accept junk-rated debt as collateral from lenders.

Translation: the ECB is about to announce it will accept junk bonds as eligible collateral, and why not: the Fed is doing so, so it makes sense for everyone else to pile on.

According to Bloomberg, in a step similar to the Fed's backstopping of fallen angel high yield paper, the ECB's conference could be "intended to head off concerns that some sovereign and corporate bonds will soon be downgraded to non-investment grade because of the cost of fighting the coronavirus pandemic."

Already a storm is brewing: on Friday S&P is set to review credit rating, which it currently ranks two notches above investment grade with a negative outlook. A downgrade would be a step toward potentially excluding the euro zone’s third-largest economy from the ECB’s refinancing and asset-purchase programs, precipitating a crisis.

Yields on Italian debt have risen in recent days. The premium investors demand to hold 10-year Italian debt over Germany’s soared 25 basis points on Tuesday to 263 basis points, despite the country managing a successful bond sale. In raising more than 110 billion euros ($119 billion), it reminded investors just how much it needs the cash. Barclays Plc sees outflows of as much as 200 billion euros if the nation’s rating is cut below investment grade.

As we discussed over the weekend, ratings have become a pressing concern in markets as lockdowns spark the biggest recession in decades. Moody’s Investors Service, which will review Italy in May, rates the nation at its lowest investment grade. While the ECB’s current rules mean Italy would have to be cut to junk by each of S&P, Moody’s Investors Service, Fitch Ratings and DBRS to be excluded from its operations, the prospect of downgrades is unnerving investors. A cut in the sovereign would flow through to the corporate bonds and commercial paper that the ECB also buys and takes as collateral.

Last week, Moodys reported that its "B3 Negative and lower list" soared to its highest tally ever — 311 companies. That tops a former peak of 291 companies, reached during the credit crisis of 2009 and the commodity-related downturn in April 2016. At 20.7% of the total rated spec-grade population, the list also shot up above its long-term average of 14.8%, and closing in on its all-time high of 26.1%. This spike is the result of the confluence of a coronavirus outbreak, plunging oil prices, and mounting recessionary conditions, which created severe and extensive credit shocks across many sectors, regions and markets, the effects of which are unprecedented.