Wednesday, November 9, 2005

ciaran.ohagan@sgcib.com 33 (0) 42 13 58 60

ECB haircut hype, or threat to BTPs and GGBs?

A source at the ECB gets the FT to write on haircuts and worry investors over sovereign spreads... will it work? No not at least not as long as the ECB is too shy to introduce a haircut for single As, too politically difficult Are the large collateral holdings of banks in AA and single A sovereigns at the ECB now under threat? No. The FT today according to central bank sources warns of repo haircut for sub single A sovereigns. This is on the very top of the front page of the FT euro edition, heightening its possible effect on investors. The significance especially is in the desire by someone at the ESCB probably a high ranking hawk - to hurt the higher yielding sovereign spreads. This repo haircut story would not have had any impact a few weeks ago. Maybe it might now given that risk premia have begun to rise. As for the information itself, we dont think it is new, nor should it be market moving. The ECB already has haircuts for non-sovereigns, and for weaker credits. Greece is currently the weakest-rated sovereign. What if downgraded by S&P to BBB (S&P is at AA now)? We would expect the ECB to follow the policy of Basel in taking the highest rating. However Moodys is most unlikely to downgrade Greece much in the next few years Moodys is at A1 and a single A looks most secure. So we see no threat in a BBB haircut. What would put the cat among the pigeons is a haircut for single As. But so far, the ECB has shied away from action, much to its discredit. Sources at the ECB instead are using innuendo to hide their weakness. How it works The Eurosystem provides liquidity against eligible assets, using repos or secured loans. The ECB publishes on its website a full list of the assets eligible for use in Eurosystem monetary policy operations. The list comprises Tier 1 (e.g. sovereigns) and Tier 2 assets. Any euro securities meeting harmonised criteria set by the ECB are eligible for Tier 1. Among these criteria are high credit standards, etc. Additional assets proposed by individual national central banks are also accepted (this can be significant in the context of Italy etc). The ECB says, No distinction is made between the two tiers with regard to the quality of the assets and their eligibility for the various types of Eurosystem monetary policy operations (except that tier two assets are not normally used by the Eurosystem in outright transactions). Margin requirements and haircuts are standardised for all Tier 1 securities, but haircuts for Tier 2 assets can be higher (significantly so in some cases). Tier 1 securities are all subject to the same initial margins (e.g. 1% for intraday and overnight, 2% for longer operations etc.) and haircuts against market risk (e.g. 0% for assets with a residual maturity of under one year and FRNs, 1.5% for 1-3 years, and so on). Importantly, there is no credit differentiation among sovereigns. However the ECB was obliged to introduce some measures of risk control in March 2004, imposing a valuation haircut for credit on some non-sovereign collateral.

Background analysis
ECB collateral charge? The ECB has been very unhappy that the sovereign credit curve in euro is so flat, although it understands that this is a global phenomenon, applying to USD and also to corporates. However, after the weakening of the Stability and Growth Pact (SGP) over the past few years, it would have liked the market to price in more risk, and penalise sovereigns that have not managed to control their debt and deficits. Might the ECB would require investors to put up larger collateral for AA or single A sovereign paper, or require take other measures to reduce the attractiveness of it?

Why is the ECB so worried ?

In May 2005, in full lira crisis, ECB President Trichet made a statement on the ECBs view on collateral haircuts, when asked about the topic at a press conference, Trichet said, We have reflected a lot on that, and our conclusion was that we should not change the present arrangement. If a country is less creditworthy `the value of the bonds diminishes, and we ask for more bonds to guarantee our refinancing. Clearly we would ask for more collateral if the judgment of the market is unfavourable. After due and long meditation, we considered it was not appropriate at this stage'. We do not know what this is meant to mean (we would ask for more collateral). Maybe there is a

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Strategy Special problem in the English expression, as unfortunately happens all too often at the ECB.

Might the ECB act?

Clearly a sovereign credit haircut is a risk but only if it hits single As. Up to now, the issue had never entered investors minds. A haircut for AAs would be very bad news indeed for BTPs or GGBs. But still, with average AA banking paper trading swap +20bp in 10 years (and some large European banks are some 10bp dearer than these levels), we think the capacity for a sovereign sell off even in crisis situations - is limited. This topic has been simmering now for some months. Politically, it is obviously most difficult to implement. However if the ECB gets a chance, we think it might just find the courage, but we doubt it.

What the data says

This can to give us some clue as to what is going on. Cross-border payments sent by each RTGS system participating in or connected to TARGET as a percentage of domestic payments (data available to June 2005) would appear normal. Distribution of crossborder collateral by country of issue is published (but we just have data from 2003 see www.ecb.int/stats/payments/ securities/ html/coll2.en.html). This shows Italy was at 18%, Luxembourg at 22%. This could indicate that it might be the domestic structure of the finance industry that drives the collateral composition until 2003. However when we look at the distribution of custody by the lending country, we find that Italy was at less than 1%.

Market Reaction
GGBs lost 0.75bp on 2008, 1bp on 2010, 0.75bp on 2037. BTP 30y has been hardest hit, losing 1.5bp, with large sellers. We do not see any bigger widening move as justified.

Ciaran OHagan ciaran.ohagan@sgcib.com 33 (0) 42 13 58 60

Monday 7 November 2005

Strategy Special

FX and Fixed Income Research Team

Global Head Philippe Ithurbide (33) 1 42 13 61 27 philippe-jean.ithurbide@sgcib.com

Fixed Income

Vincent Chaigneau Adam Kurpiel Ciaran OHagan Aro Razafindrakola Jose Sarafana Khrishnamoorthy Sooben Guillaume Baron

(44) 20 7676 7707 vincent.chaigneau@sgcib.com (44) 20 7676 7708 adam.kurpiel@sgcib.com (33) 1 42 13 58 60 ciaran.ohagan@sgcib.com (33) 1 42 13 64 93 aro.razafindrakola@sgcib.com (33) 1 42 13 56 59 jose.sarafana@sgcib.com (33) 1 42 13 56 74 khrishnamoorthy.sooben@sgcib.com (33) 1 42 13 57 07 guillaume.baron@sgcib.com

Foreign Exchange

Niels Christensen Carole Laulhere Murat Toprak

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Quant Technical Analysis

Benjamin Freoa Hughes Naka Stephane Billioud

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