2011 Crisis

Commentary on ECB Bond Buying Program and Policy Recommendations: Why the new bond purchase program is not enough.

9 August 2011

by Jacob H Schmidt

In order to avoid further distress in the credit markets the ECB decided to reopen the bond purchase program of Italian, Spanish and potentially other periphery bonds. While this step is considered key to avoid further spread widening and a total freeze of the credit markets, we believe that there are other and potentially better ways to bolster the markets.

Status quo

Over the last 6 months spreads of European periphery bonds have widened significantly indicating the increasing credit risk of these countries’ debt versus German bunds.  While Greek spreads reached record levels of more than 20% (2000 basis points, bp), Portuguese and Irish spreads came close to 1000 bp over Bunds. Over the last 2 months credit spreads of the large European economies (Italy, Spain, France) have also widened, reaching levels where the sustainability of the countries’ financing need is questioned. Last week Italy’s 5 year spreads (CDS) reached 370 bp, Spain 410 bp and France 140 bp.

The Greek bailout in July was designed to isolate the contagion problem from the bigger countries Italy and Spain. As the bailout cum re-profiling of Greek debt is to happen by the end of August, the markets have refocused on Italy and Spain leading to a sharp sell-off in their bonds / widening of spreads. The reopening of the bond purchase program by the ECB which was announced over the weekend, should help stabilising the credit markets.

Opinion

While we agree that a stabilisation of the credit markets is extremely important in order to prevent another 2008 scenario, the renewed bond purchase program of Euro 320 b poses several problems: size of the underlying bond markets versus bond purchase program, moral hazard, front running by hedge funds and other markets participants (PIMCO) of announced programs et al.

Recommendations

We believe that alternative solutions should be considered.

a.      Bond buying by Italian pension funds

Italian pension funds and other Italian real money accounts should be natural buyers of Italian BTP (the same applicable to Spain et al). This would address the problem of moral hazard of the ECB bond purchase program. It would also show the commitment of Italian accounts towards their own economy. If necessary a compulsory investment program should be contemplated.  

b.      Writing of CDS by Italian real money accounts (pension funds, long term investors)

In order to take pressure off the CDS markets Italian real money accounts should be aggressive sellers of default protection. This would help the OTC market and provide better liquidity. The aggressive buyers of protection would also think twice about seeking too much protection.

c.       Writing of CDS by the ECB and EFSF

We also suggest that the ECB and EFSF write CDS on a range of periphery credit markets, either directly or via a selection of market counterparts.  Again, this would take pressure off the markets and would put the ECB /EFSF in the driving seat.

Conclusion

Unless the authorities take a pro-active stance the markets will continue to be nervous driven by rumour and fear. The ECB bond program will give only temporary relief and lead to more moral hazard. Smarter moves and active participation by the countries are overdue.  

Jacob H Schmidt, international financial markets expert, HF expert, Webster Finance Professor. Anglo- Austrian, multi-lingual, -cultural, critical thinker. CEO of Schmidt Research Partners Ltd, an investment advisory firm and MD of SFP-International Ltd, a consulting and training company. Available for high quality investment advisory, due diligence and consulting projects.  

This commentary is for information only. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be solely relied on in making an investment or other decision. It is not an invitation to buy, sell or subscribe and is by way of information only.