The aim of this paper is to investigate a range of financial techniques and policy strategies for a Quantitative Easing (QE) program by the European Central Bank (ECB) that would rely on Euro area government bonds purchases under various modalities and guises. There is widespread consensus that securities such as covered/corporate bonds and asset backed securities would not be sufficient for a large asset purchase program in the Euro-area given their outstanding amount and market liquidity. However a successful ECB’s QE program linked to the purchase of Euro-area (government) bonds would have to overcome a number of significant hurdles. In essence, a QE program based on outright bond purchases is a supply-driven monetary easing strategy, whereas the ECB operational framework - which is structured around a toolbox of “temporary” (normally, short-term) repo market transactions with a set of eligible banks as counterparties – can only accommodate demand-driven (essentially, temporary) liquidity needs; unlike the US Federal Reserve, the ECB does not rely on outright bond purchases as its routine operational tool to inject (or withdraw) liquidity in the economy (on a permanent basis). A supply driven monetary strategy becomes particularly relevant when a central banks hits the (nominal) interest rate Zero Lower Bound (ZLB) limit in its money creation process. Unless the ECB’s lending to the banking sector were to be made at negative rates – e.g. lending would become a cost (e.g., a loss) for the ECB balance sheet accounts (negative seignorage) - injecting additional liquidity in the economy by conventional demand–driven operational tools (e.g. repo transactions) could become virtually impossible. Moreover, ECB’s balance sheet concentration on short term assets - repos transactions normally lasting few weeks – requires a frequent roll-over activity only to maintain a constant level of high-power money stock (monetary base) in the economy. The issue of using government bonds for QE programs in the Euro-area goes well beyond the ECB monetary policy operational toolbox, as it raises several problems in light of the Maastricht Treaty’s prohibition of member state debt financing by the central bank. One important issue, oftentimes raised by the Deutsche Bundesbank and other national central banks, is that buying government bonds on a large scale may threaten the ECB balance sheet quality as worrisome credit risk exposure is likely to be taken up in the process - the same argument would apply to ABS or covered bonds issued by the private sector. Moreover such QE program may induce moral hazard behaviour from the Euro-area member states. Additional problems – not so often acknowledged in the policy debate - would arise if, to counter the credit-risk exposure increase, the ECB’s bond purchases were to be endowed with a credit seniority status (de facto, if not de iure) with respect to bonds owned by other investors. If the QE program were to be carried out on a massive scale, the seniority clause is bound to impart a downward pressure on bond (market) prices and that could be reinforced by the scanty level of liquidity of some Euro-area bond markets. Thus, a large QE program under the creditor seniority rule, while curbing the “moral-hazard” implications of government bond purchases through higher market rates, might have a perverse impact on euro-area systemic risk as banks balance sheet holding a large share of euro-area government bonds could suffer substantial (mark-to-market) losses. However, a broad-based QE program carried out under a pari-passu creditor rule is also fraught with problems, since it is likely to carry a significant increase in credit risk for the Euro-system central banks.
With the introduction of a securitisation framework in a government bond based QE program we can avoid both the perverse effect on banks’ balance sheet of the seniority clause as well as the additional credit risk burden on the Euro-system central banks. Also, a securitisation-based QE program can provide a platform for pursuing a policy strategy fostering the creation of a large, liquid market of euro denominated (credit) risk-free bonds in the Euro area a securitisation program based on Euro area sovereign bond portfolio as collateral pool. Our securitization framework requires the segregation of a large pool of euro-area government bonds in a special purpose vehicle (or agency) that could fund this purchase by issuing two bond tranches. The senior tranche would be designed to satisfy the requirements of a reference asset for the ECB’s QE program. In fact, it can be designed so that it could provide the desired low level of (credit) risk with the appropriate level of liquidity. As a by-product of the tranching structure, the junior tranche bonds would be carrying a meaningful credit spread, which would be providing an important market signal about the macro- economic policy of the member states. The SPV assets pool can be fully or partially “managed” and the management guidelines could be designed so that the investment policy would reflect the macroeconomic condition of individual member states.
In the empirical part of the paper we provide quantitative evidence on our securitization framework proposal and we compare it with a program of Euro-area public debt direct purchases under two alternative scenarios of: i) pari-passu creditor status of the ECB with respect to private investors; ii) preferred creditor status of the ECB. As far as the QE program size is concerned we set a reference amount of some 2.100 bln euro of ECB bond purchases, possibly varying within a range of [1.800 ; 2400] bln. Such range of values for the QE volume of purchases is obtained in our securitisation framework as we consider a collateral pool of government bond reaching some 3.000 bln euro. We also discuss the implications of smaller QE program, in the range of [500 ; 1500] billion euro.
We consider three cases of “un-managed” (fixed composition) direct purchases according to which member states bonds are purchased in proportion to: i) the “capital key” representing equity holdings of ECB’s shares; ii) a “liquidity-key” representing the relative amount of sovereign bonds outstanding; iii) an equally-weighted portfolio of sovereign bonds. We evaluate the impact of various SPV characteristics - such as bond tranche attachment choice - as well as various financial market scenarios. We provide a risk management analytical framework based on Monte Carlo simulations. It allows us to gauge quantitatively a number of possible Government-Bond-Based (GBB) QE programs for the Euro-area. More specifically, our implementation strategy allows us to compute the probability distribution of credit losses under various credit spreads and default correlation scenarios as well as designing appropriate stress testing procedures to gauge the robustness of our proposed GBB QE solutions. In this version of the paper our modelling strategy relies on the Gaussian copula assumption in default risk correlation. We intend to relax this somewhat restrictive assumption in future research application of our proposed risk management framework.
Using end of October 2014 CDS market quotes for 10 Euro-area sovereign bond market, as well as an estimate of a Gaussian copula measure based on historical CDS quotes time series, we conclude that the expected loss – e.g. fair value credit spread - would be about 75 basis points on a 5 year horizon for a senior tranche bond with 30% attachment (that is absorbing losses on the government bond portfolio beyond 30% of its value). For all practical purpose, such credit spread value would be similar to the risk of the German Bund as measured at the same valuation date. As for the junior tranche bond credit risk, we reckon an expected loss between 200 and 300 basis points – depending on the underlying assumptions - which would be comparable with Portuguese government bond credit risk at the same valuation date. Our stress test analysis - based on historical data recorded in November 2011 (Euro area sovereign debt crisis acme) - shows that the securitization structure would effectively limit the credit risk increase on the senior tranche to 5-6% of expected losses estimated in our benchmark case on a 5 year horizon. As one should expect, this fairly solid protection to the senior tranche would come at the cost of a huge credit deterioration for the junior bond tranche to an expected loss level of 60%. This implication should make the junior tranche bond a financial product suitable only for sophisticated institutional investors.
The securitisation strategy compares favourably with the direct government bond purchase if the latter is made under the pari passu credit rule: in this case the expected loss on a 5 year horizon would be equal to some 4.5%, increasing to more than 20% in our stress scenario exercise. Thus, the implied credit spread would equal some 90 bps on an annual basis and jumping to 400 bps in our stress scenario analysis. All in all, the pari-passu rule entails a level of credit risk for the ECB balance sheet that would likely be deemed as excessive. On the contrary, the direct purchase solution would hold up much better if the ECB would be given a preferred status with respect to other investors, as the seniority rule would provide a robust shield to default losses. However the seniority rule is bound to have an impact on market credit risk as (non-official) investors would shoulder sovereign default losses. Our model-based estimates suggest that such an impact would appear to be reasonably contained for a broadly-based, well-diversified QE program invested in the 10 largest Euro area bond markets. For a QE size of 1,500 bln purchases the implied market credit spread increase would be in the range of [4 ; 36] bps; raising the QE size to 2,000 euro would widen such range to [6 ; 51] bps; however for smaller QE program (500 bln) the range of credit spread increases would be restrained to only [1 ; 10] bps. Smaller Euro area sovereign debt markets, such as Portugal, would bear the largest spread increase reflecting their reduced market debt recovery rate as a result of the seniority clause attached to the QE purchases.