Possible problem in repo'ing NAMA bonds


#1

As far as I understand it the basic funding model for NAMA is this. NAMA/Min for Finance will determine total spend for acquiring assets. Lets say for arguments sake €70bn. NAMA issues bonds with a par value of €70bn which are guaranteed by the Gov’t. The Banks take these bonds to the ECB and use them as security for borrowing from the ECB, the proceeds of which can be used for lending. This is a standard tool used by central banks to inject liquidity into a banking system - repurchase agreements or repo’ing securities. So far so good.

The Gov’t is suggesting that as a bonus, these (floating rate) bonds will pay a very low coupon (talk is about EURIBOR +1%) and therefore interest costs to the exchequer/NAMA will be minimised. I think its safe to assume that after we issue a further €70bn of (effectively) sovereign debt that the yield on Irish floating rate bonds will be significantly in excess of EURIBOR +1%.

The question is at what value will the ECB repo these bonds at (i.e. how much will the ECB lend banks in exchange for these bonds)?
If the ECB lends the par value of a bond to a borrower and the borrower defaults when the market value of the bond is less than the par value then the ECB is going to have to eat the loss. If it repo’s at market value than it protects itself from this loss. For this reason I can’t see the ECB repo at par value.

The market value of these bonds will only equate to the par value of €70bn IF the market demands a yield on them equal to the coupon rate of EURIBOR +1%. If the market demands a higher yield than the coupon rate the market value will be less than the par value. A simple example demonstrates this. For simplicity look at fixed rate bonds, the principle is the same for floating rate bonds.

NewCo issues a five year, 10%, €10,000 bond. Lets say the market demands a yield on these bonds of 20% (because of the level of risk free interest rates and the perceived default risk of NewCo). In this case the market value of the bonds will not be €10,000, it will be approx. €6,900. So an investor repo’ing this bond would receive a maximum of €6,900 (ignoring repo interest costs).

The implication of this is that banks repo’ing NAMA bonds will receive significantly less than the suggested €70bn unless the ECB has decided to completely abandon any sensible lending practises.

NOTE: I may be missing something obvious here which renders all of the above wrong.


#2

I think you are missing something. The borrower is the Irish state. They are sovereign bonds. That is why they will be eligible for repo and why they will be taken at par or very near par. They will have a zero-risk rating (hah!).


#3

Sovereign bonds are subject to credit risk in exactly the same way as corporate bonds, see the oft-quoted spread between bunds and Irish/Greek/Spainish bonds. No one even pretends this is not the case. This is why even if you strip out the effects of base rate changes (e.g. in the case of floating rate bonds) sovereign bonds will only trade at par if the yield to maturity is identical to the coupon rate. For an extreme example imagine Germany and Argentina both issued a €10,000 bond paying a 5% coupon with identical terms - would they trade at the same price?


#4

If they were both in the EU and the ECB was taking them, yeah…

Effectively Ireland is Argentina.


#5

But the ECB doesn’t take Argentinian bonds.

The ECB weighs euro sovereign bonds as zero risk.

It is the ECB that counts. Both for direct repo and for interbank repo.

The ECB are not buying the bond as such, so they don’t need to know about the spread (it’s not a concern of theirs). It is not really a trade. It may have an effect in interbank repos, though, I’ll grant you that.

Better hope that the unlimited repo window doesn’t close… :nin


#6

Important issue, weathervane. There has been a lot of nonsense talked on the subject of repos. Here’s how I see it.

(1) the repo market is always based on the market value of the bond (perhaps less a haircut). as weathervane says, nothing else would make sense.
(2) the issue of FRNs vs fixed coupon bond is a red herring. there is no free lunch by using floating rates. the 10y swap rate is currently about 4%. If
NAMA FRNs pay euribor + 1% then the implied average coupon paid over the life of a 10y FRN is 5%.
(3) under normal conditions, there is a very active interbank repo market. the NAMA bonds would need to be freely tradeable/transparently priced to participate in this market.
(4)it would be CRAZY to rely on the ecb as the only repo counterparty. there will be times in future when ecb want to drain liquidity from the market. under those conditions, the ordinary interbank market takes up the slack.
(5) the claim sometimes made that nationalised banks don’t have access to repo markets is just bullshit.


#7

We will have DIFFERENT banks by then! :smiling_imp:


#8

:angry:
Yeah, but jaysus, look at the payoff if it works… |O

Don’t disagree with anything else you’ve said, but the market price of NAMA bonds will be artificially high both because they are sovereign and because they are floating rate.


#9

I wasn’t suggesting the ECB takes Argentinian bonds - the point I was making was about market value versus par value.

Okay, that may be the answer but the following hypothetical scenario outlines the problem as I see it.

Country a, a member of the eurozone, issues a €10K, 10 year bond, coupon 5%. Two years after issuing this country a’s credit rating has deteriorated and the yield to maturity on this bond has increased to 10%. Its bonds will now trade at a discount.
Bank a buys this bond on the open market for say €7K. It the repos the bond at the ECB at par and is lent €10K. Whilst the repo is in place Bank a defaults on its debts and is unable to repurchase the bond from the ECB, the ECB is now left with a €7K asset and a €3K deficit.
Does the ECB take routinely take on this level of credit risk through repo facility?


#10

It’s the country’s bond the ECB is left with.

And this is my final piece of the puzzle.

Do you know what the ECB does?

It cancels the bond. :smiley:


#11

Sorry, I know this is off topic but could someone explain to be in a paragraph or two what is the repo market?

Cheers!


#12

So what if its the counties bond, it still has an asset with a market value of €7k, and a hole of €10K. I find it hard to believe that the ECB repo’s at par because of the scenario I outlined above. I don’t understand the point about cancelling the bond??

If this is the case why don’t we pay for NAMA using perpetual bonds paying a coupon of .000000001%. i.e. worthless paper which would be repo’d at €70bn

why would the market price be “artificially” high? They are sovereign bonds, they are FRN’s…so what

wv


#13

:confused:

sorry, but can’t follow what you are saying on this topic, payoffs, artificial prices etc


#14

Mossy
repos or repurchase agreements are basically secured short term loans between two institutions. The “borrower” sells a particular security to the “lender” and agrees to repurchase the security after a specified time period for a specified price.
If a bank A wants to borrow from bank B it could sell a corporate bond to bank bank B for €10,000 and agree that one month later it would repurchase that asset for €10,100. That is effectively a loan of €10,000 for one month at 1% interest per month, secured by the corporate bond. It’s also used by central banks to pump liquidity into a banking system. So the ECB might agree to repurchase Government bonds from banks at say 2% per annum, Banks would sell bonds to the ECB and agree to repurchase them after a specified time for principal + 2%(annualised).

wv


#15

The payoff refers to the ‘CRAZY’ plan. How crazy is it to lever an economy up on the property market? These are not rational actors we are dealing with. A plan so crazy it might just work. Eh, no.

Artificial - from a limited understanding -
price is related to prevailing interest rates, but a floating rate note increases it’s yield to match.
sovereign = ECB does not have quality criteria for sovereigns, so a downgrade is irrelevant from an repo ECB point of view.

Or have I gone astray again?
(I agree with you that it is hanging totally on the ECB, but I can’t see this particular funding mechanism being put in place without some nod and wink that there will always be liquidity for bad bank bonds - we are not the only ones putting in place bad banks…).


#16

Lets not forget the ECB is not FF, they are relatively rational

Yes price is directly related to interest rates or yield to maturity YTM. The YTM investors will demand from a particular security depends basically on two factors. Risk free rates, which as you point out are negated by issuing floating debt. Risk premium - the coupon on FRN’s does not adjust to take account of this therefore the market value of these bonds will flucuate with changes in the percieved risk of lending to Ireland/NAMA. I think there may be confusion about “haircuts” the ECB is applying to assets’ market value (not par value) i.e. €10K corporate bond, trading at €7K, ECB applies 10% haircut and lends €6.3K. You may well be right that the ECB does not apply these haircuts to sovereigns, that doesn’t change my point.


#17

Right, but unless the issuer (the Irish state) gets in trouble, these bonds are going to be rock solid. And, as we all know, no eurozone country has ever failed to repay its debt.

Also, I think the ECB haircut is on par value? Which is why they only take highly rates commercial debt and then apply a haircut.


#18

Eh, maybe not!:

ecb.int/home/glossary/html/glossv.en.html

Um, yeah, that does create a problem, alright.


#19
  1. In the scenario above it doesn’t matter if the state never defaults the market value of the bonds is less than the loan to the defaulted bank.
  2. You can have AAA rated corporate bonds (or sovereign bonds) that trade at a fraction of their par value because risk free interest rates change over time.

#20

This has had me thinking over the last few days.

If we’re going to come under the protection of the ECB for a bond issuance; invariably, this means we are getting a German bale-out. If this is the case, is there not a case for buying German CDS’s in the expectation that they can’t possibly stay so low when they’re going to end up holding the can for the PIIGS?

It would only take the merest of doubts on Germany and you could double, triple or quadruple your money?