The ECB Changes Its Mind Which Bonds It Will Monetize, Then It Changes It Again

To get a sense of just how chaotic, unprepared, confused and in a word, clueless the ECB is about just its "private QE", aka purchases of ABS, which should begin in the "next few days" (but certainly don't hold your breath) - let alone the monetization of public sovereign debt - here is Exhibit A. Because if you were confused about what is about to happen, don't worry: it appears the ECB hardly has any idea either, because it was just on October 7 when 40 ABS bonds were dropped from the ECB's "eligible for purchasing" list. And then, just a week later, the ECB changed its mind about changing it mind, and reinstated 19 of the ineligible bonds right back!

Citi's Himanshu Shrimali explains the stunning flip flop that only the ECB could have pulled off without losing all its credibility (perhaps because it no longer really has any):

As straight forward as the details of the ECB’s ABS purchase programme (ABSPP) released on 2 Oct 2014 seemed, many market participants were taken by surprise on 7 October when about 40 bonds became ineligible under the central bank’s collateral framework and 19 of them were again reinstated on 15 October. We understand that the bonds were initially removed from the list of eligible securities because of inadequate servicer continuity provisions — a requirement which came into force on 1 October 2013 but had a 1-year transitional period until 1 October 2014. We believe the reinstatements occurred because the ECB had earlier misinterpreted the adequacy of servicer continuity provisions in these bonds.

 

Some of these expelled bonds, which include Spanish and Portuguese RMBS, have lost 2–3 points in cash prices, according to our trading desk. A similar tiering is evident in the broader ABS market with ineligible bonds demanding 40–50bp spread pickup over eligible bonds.

Don't worry though, and just repeat: "the bonds fell and rose not because of ECB frontrunning, or lack thereof, but because of fundamentals." Keep repeating until it becomes the truth.

But back to the "official" narrative:

One of the pre-requisites for an ABS to be eligible for the ECB’s buying programme is eligibility under the collateral framework. The collateral criteria have been amended several times over the years, and although the central bank provides a link to check the eligibility of a bond, the experience with the recently removed bonds shows the difficulties investors face in identifying the bonds that can potentially become ineligible. We provide a simple summary of the collateral eligibility criteria in this note and identify bonds that are at relatively higher risk of becoming ineligible under the ECB’s collateral criteria.

 

Eurosystem Collateral Criteria

 

The collateral eligibility criteria consist of a general framework and a temporary framework. The temporary framework was introduced after the GFC to decrease the constraints in ECB collateral eligibility in an attempt to support bank lending and liquidity in the euro area. Under the general framework, the ECB accepts senior ABS securities having the second-best rating of single–A1 or above while the rating threshold under the temporary framework is relaxed to triple–B2 provided the  bonds meet certain other conditions. We provide a summary of the collateral eligibility criteria in Figure 1.

 

 

As can be seen, the bonds that are rated single–A or above are eligible if they comply with the loan-level data reporting requirement and are not subordinated to any other tranches in the structure. Triple–B rated bonds, however, need to satisfy a few more conditions such as the servicer continuity requirement3 and also some additional collateral conditions listed in the above table. As such, many bonds that are currently eligible under the general framework may become ineligible following a ratings downgrade to triple–B if they do not meet the additional requirements of the temporary framework. Conversely, many bonds that are currently rated triple–B and are not eligible under the temporary framework may become ECB eligible once they are upgraded.

Remember when bond investment decisions were made based on such trivial, Old Normal things as leverage or interest coverage ratios, or heaven forbid, a covenant analysis?  That's all long gone: it has now been replaced, at least in Europe, with the "servicing continuity provisions" - so if you want to front run Mario Draghi, better get to know there:

Servicing Continuity Provisions

The servicing continuity requirement is the most ambiguous condition in the eligibility criteria because of its subjective nature and also because of a range of wordings in deal documents for servicer substitution. The conditions on collateral, on the other hand, are more objective and we believe that most eligible bonds satisfy them so we do not go into further details on them.

The ECB requires certain provisions in deal documentation to ensure timely servicing of the loans backing an ABS:

  • Provisions for a back-up servicer, or
  • Provisions for a back-up servicer facilitator to find a back-up servicer within 60 days of a trigger event, and
  • Triggers for the appointment of back-up servicer

The bonds that were removed from the eligibility list recently had some servicing continuity provisions in place but they did not meet the requirements prescribed by the ECB. Issuers of retained deals can amend the servicing continuity provisions in the documentation to make them ECB–eligible or can even appoint a back-up servicer if they intend to sell their retained bonds to the ECB. Permanent TSB, for instance, appointed a back-up servicer for its retained Fastnet 6 RMBS transaction in March 2011. Amending the documentation for placed deals, however, will be more challenging because it would require note holder approval.  Moreover, the associated costs of amending the documentation or appointing a back-up servicer or facilitator may dissuade many investors from pursuing such amendments. As such, we think placed bonds with inadequate servicing continuity provisions are more likely to become ineligible than retained bonds.

And the section everyone has been waiting for: the "Bonds at Risk of Becoming ECB–Ineligible", in other words, if you have been loading up on these in hopes the ECB will take them off yours hands, now is the time to dump, before everyone else figures out just how confused the ECB is:

The bonds that are currently eligible but have inadequate servicer continuity provisions can become ineligible if their second-best rating falls to triple–B. While core country ABS are unlikely to get downgraded to triple–B in the near future because of their current high triple–A rating, some peripheral assets that are currently rated single–A may be downgraded if collateral performance worsens or even due to the recent changes in S&P sovereign ceiling methodology (see European Securitized Products Weekly). We identify such bonds that are on the fringe of ratings threshold of the general framework and assess whether their servicer continuity provisions comply with the ECB’s requirements.

 

We shortlist 39 placed eligible bonds having the second-best rating of single–A–minus and examine the servicer continuity provisions present in their offering circulars. There are also 60 retained bonds that are currently eligible and rated single–A–minus but we do not analyse their servicing continuity provisions because the issuer may amend them if required. Our study of the servicing provisions of the currently eligible triple–B rated bonds and some other bonds which recently became ineligible helps us in judging the adequacy of the provisions of the shortlisted bonds.

 

We provide a list of our shortlisted bonds in the below table along with our view on the adequacy of their servicing continuity provisions. We also provide a justification for our view and a relevant comparable bond (if available) that has similar servicing arrangements in Figure 2. As the table shows, most Portuguese deals do not have any servicing continuity provisions. In Spain, on the other hand, the fund manager or the gestora is generally responsible for appointing a new servicer if the existing servicer fails to fulfil its obligations. As such, the fund manager acts as the back-up servicer facilitator. In some deals, the fund manager also takes over the servicing responsibilities until it appoints a new servicer ensuring that there are no servicing disruptions but a few deals do not have such provisions. In the latter case, there is no guarantee that the fund manager will appoint the new servicer within 60 days of the occurrence of the trigger event and we think such deals do not satisfy ECB’s servicing continuity requirements.

The table:

Finally, the inverse question: if the ECB could eliminate some 40 bonds on a whim, without warning, and simply because it did not read the fine print only to re-read it later, will it take another call from Goldman or BlackRock to make sure that anything that isn't nailed down (and is owned by Goldman and BlackRock) is eligible for purchase by the ECB? Here is Citi's take:

More Bonds to be Reinstated?

 

Following the ECB’s reinstatement of recently removed 19 bonds on the eligibility list, one wonders if there are more bonds that are can potentially become eligible. We analyse the servicing continuity provisions of the 21 remaining bonds that were removed on 7 October and find that most of them contain a backup-servicer facilitator but their deal documentation do not contain any provision to ensure the appointment of a new servicer within 60 days of the trigger event. Hence, these bonds are very likely to remain ineligible unless a back-up servicer is appointed or the deal documentation is amended.

 

We, however, find one exception — RHIPO 9 deal. A2 and A3 tranches of RHIPO 9 RMBS are ineligible even though the deal contains a pre-appointed back-up servicer (Banco Cooperativo). A closer look at the offering circular reveals that Banco Cooperativo will act as the back-up servicer only in certain circumstances. Although we could did not find the exact circumstances when the bank will act as the back-up servicer, we think the most probable reason why RHIPO 9 bonds  were removed is because the back-up servicer arrangement in the deal is not unconditional.

The bottom line: "the ambiguous wordings of the servicer continuity provisions in many deals and the recent flip-flop actions of the ECB show that the decision to assess ABS eligibility is not straightforward. The already visible tiering between eligible and non-eligible bonds will develop further once the ECB commences its ABS purchase programme so a clear understanding of the eligibility criteria is critical in identifying mispricing."

Said otherwise, in the new normal, the only advantage comes to those who know, ahead of time, if central bank X will buy what they have to sell. Everything else is noise.

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