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In this short post I would like to emphasize the important role of the ECB (conditional) commitment for Outright Monetary Operations (OMT) in reducing tail risks and credit spreads in the Euro periphery bond markets. In order to do that I will analyze OMT in terms of option pricing and insurance.

The role and details of OMT are quite well known by now. The main factors that made the commitment so successful (without even having to implement them) were:

  1. The OMT portfolio will be pari passu with private bondholders. As a result, bonds purchases by the ECB do not create a senior debt-holder (as was the case for the SMP portfolio) while remittance of Eurosystem profits due to these operations allows troubled debt countries to effectively earn seignorage income and lower their debt servicing costs.
  2. Operations are conditional on an official bailout (which is usually accompanied by strict conditionality). Since bailouts tend to favor creditors at the expense of domestic citizens (with austerity measures targeting essential government services and private sector wages but usually not capital income and gains) they lower the risk of debt restructuring in the sense of making it much more difficult for the debtor country to prioritize its own citizens welfare. Furthermore, by having the ECB buy a large part of the country’s debt, private bondholders are not subordinated in the same way as a pure ESM bailout.
  3. The fact that the ECB will probably remit its OMT profits back to the debtor country plus the low interest rates in ESM loans (in contrast with the initial high rates of the Greek Loan Facility) mean that a large part of a country’s deficit reduction will come from interest expenses and not from savings in expenses or higher taxes with a much milder result on economic growth (and a positive impact on long-run debt sustainability).

Still a lot of people find it odd that OMT was able to lower spreads by such a large amount without any operations actually taking place in the bond markets. One has to realize that by committing to OMT, the ECB is essentially setting a ceiling on the spread of government bonds (although a bit vague) since any large increase in credit spreads will lead a country to ask for a bailout and an activation of OMT. As a result, a private bond holder is guaranteed that the price of her bonds will not fall lower than a specific floor, since in that case, she will have the option of ‘selling’ them to the ECB. In other words, the ECB is writing a set of ‘free’ put options on Eurozone debt, standing ready to buy bonds at current market prices after the relevant country has requested a bailout.

In order to look into the issue from a more technical angle, lets assume that the bond hazard rate (probability of default in a period conditional on survival until that period) follows an Ito process similar to the CIR process of interest rates (see Filipovic, chapter 13):

hazard processwhere W is a Wiener process. Given this process one can calculate the default probability which (although quite technical) obviously depends on the drift parameters (b,β) but more importantly on the volatility as well. As a result, if volatility is modeled in an autoregressive model such as GARCH(1,1), periods of high bond price volatility quickly lead to higher estimates of default probabilities. Since the default probability can be considered as the Ν(-d2) term of a credit risk put option (with a strike price equal to the expectation of the recovery rate), the model estimated probability can be used for option pricing and bond portfolio insurance.

By insurance I am referring to the policy of creating a synthetic put option (by shorting bonds) in order to insure a bond portfolio from downside risks.This has the advantage that the bond holder does not have to keep a matched book bond position but only short the proportion (determined by the default probability) of the portfolio needed to hedge against the tail risk of default (assuming of course that interest risks have already been hedged through an IRS for instance) while earning all upside gains. An increase in the default probability increases the proportion necessary to hedge the downside risk, a strategy that can create self-fulfilling issues since the bondholders sell when bond prices fall and might face difficulties in borrowing bonds (to short) through reverse repos.

By introducing OMT, the ECB becomes the writer of the above option (something very similar to a CDS) and removes the need for active hedging. This immediately reduces bond volatility (since bondholders do not need to increase their short positions) while a high σ actually makes the option more valuable and pushes bond prices higher. Periods of high volatility (such as the summer of 2012) are immediately followed by a drop in volatility under efficient markets. As long as the ECB commitment is not questioned, Euro bond prices include this put option and permanently increase in price by market forces without a need for any actual ECB operations.

Obviously, the stability of the ECB determination to implement unlimited bond purchases will play a decisive role in the future (given the recent German Constitutional Court case for instance) yet it is clear that at this point, OMT has played a decisive role in minimizing Eurozone tail risks and lowering Euro periphery countries debt costs.

The latest Spanish bond and T-Bill auctions resulted in high short term yields and 10-year rates around 5.75% (lower than the over 6% secondary market yields of the previous days). An interesting development is that, both for Italy and Spain, short-term rates are now much higher than corresponding Euribor funding costs, in contrast with previous T-Bill auctions (where the Euribor spread was negative). It seems that even short-term Treasuries are not considered risk-free anymore and the LTRO effect is fading away (since Spanish banks could use LTRO liquidity and earn a decent carry with the previous 12M 1.418% and 18M 1.711% rates). What seems strange is the fact that the yield on the 2-year bond was somewhat lower in today’s auction compared with the previous on March 20 (3.463% vs 3.495%).

Based on the usual risk-neutral default probability/intensity calculation formulas (recovery rate of 40%, risk-free rate at swap rate minus 10bp), the corresponding numbers are as follows:

The calculated default rates are closer to a B rating than the current A rating for Spanish government debt (based on Moody’s statistics for real-world default rates). The short-term hazard rate curve has ‘inverted’ compared to previous auction results signaling a deterioration of short-term debt prospects for Spain.

In general, cumulative default rates are lower than B rating for maturities up to two years, very close (to B) in the 3-5 years horizon and move to Caa-C territory for 10 year maturity. A restructuring event is quite certain in the long-term, credit quality is very low beyond the LTRO maturity and a substantial deterioration is evident in the short-term. Since both sovereign and bank funding needs are now higher (due to large NPL ratios, deeper economic recession and hidden regional debts), LTRO liquidity is now considered inadequate and funding cost is priced in, especially since remaining to-be-pledged bank assets are of low quality.

The chart below (from soberlook) shows the large difference between secured and unsecured lending rates (Eurepo and Euribor), highlighting the fact that Spanish and Italian short-term T-Bills are very far from being risk-free:

Since mostly only Spanish and Italian banks (along with other institutional investors like pension funds) buy their countries sovereign debt, another way of looking at short-term T-Bill rates is as representing the corresponding banks funding costs. LTRO liquidity is probably projected to dry up in the following months and banks will find a hard time financing their trade positions either through ECB or money markets (due to high rates and/or haircuts), especially counting collateral price volatility.

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Kostas Kalevras

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