Why the ECB Plans to Buy Covered Bonds (Not Something Else)

When the European Central Bank (ECB) announced plans to purchase some €60 billion (USD $80.5 billion) in covered bonds as a stimulus measure, Americans and others may have been surprised that it chose investment in a financial instrument that is relatively obscure in the U.S.

Why did the ECB opt for covered bonds, and not something else?  Answers may be found on three levels.

Level One

Jean-Claude TrichetThe first level is what ECB President Jean-Claude Trichet expressly said when he made the public announcement (May 7):

• "Covered bonds were considered by the [ECB] Governing Council as a segment of the private securities markets that in general has been particularly affected, more so than others, in terms of the impact of the financial turbulences."

• "[T]he idea is to revive the market, which has been very heavily affected, and all that goes with this revival, including the spreads, the depth and the liquidity of the market."

• "If I might use our own vocabulary, it is part of our 'enhanced credit support' operations. . . . [I]t is a way of improving the functioning of the market that had been affected particularly markedly by the financial turbulences."

The gist of those remarks by Trichet seems to be that the covered bond market has been disproportionately damaged by the ongoing financial crisis, and the ECB's planned purchase is intended (at least in part) to improve that situation.

But are there no other financial instruments that have been "affected, more so than others"?  Is there any additional explanation as to why the ECB chose to benefit covered bonds in particular?

Level Two

That brings us to a second possible level: internal ECB politics.

Behind the scenes, apparently some major players in Europe's central banking system have opposed the idea of fighting recession through asset purchases.  According to Bloomberg, the opposition was led by Axel Weber, who heads Germany's powerful central bank.

However, Germany has the lion's share of the covered bond market, so it stands to gain more than some other European countries from the planned ECB purchase.  Market News International quotes an analyst at BNP Paribas as noting that "covered bond markets are not equally developed across the eurozone.  It is particularly important for Germany, for example, which may be one of the reasons why support for it could be achieved on the [ECB] Governing Council."  (Italics added.)

When Trichet publicly announced the ECB's purchase plan, he was actually asked a question relating to this issue:

"[I]f I can recall correctly, covered bonds are mainly used by the banks in which a lot of German is spoken for refinancing, and not so much in the rest of the eurozone. So are you not implicitly delivering an advantage here to banks that use this particular asset to refinance?"

Trichet's response was to the effect that "what we are doing is what we judge appropriate for the single [eurozone] market with a single currency."  He did not address Germany's prominence in the covered bond market.

Level Three

The third possible level of explanation for the ECB's decision is simple, but not necessarily obvious to non-Europeans who are not so familiar with covered bonds: they may well be the safest type of purchase the ECB could have chosen.

Covered bonds traditionally have been considered more secure than any other debt instrument except government-guaranteed securities.  That is why they have become popular in "repo" programs, where central banks have accepted covered bonds as collateral from financial institutions in exchange for loans to boost liquidity.  In fact, a recent report by Fitch Ratings cited this trend as a reason why covered bond programs have proliferated over the past year-including many first-time issuances.

The gap between accepting covered bonds as collateral and buying them outright does not seem large.