On the Intelligence of Central Bankers

First, the inspiration for this post, from the Financial Times:

ECB concern over liquidity scheme
By Paul J Davies and
Norma Cohen in London and Anousha Sakoui in Vienna
Published: May 15 2008
23:37 Last updated: May 15 2008 23:41

The European Central Bank on Thursday voiced its “high concern” at growing evidence that banks are exploiting its efforts to unblock the frozen funding markets by using its liquidity scheme to offload more risky assets than it envisaged.

Yves Mersch, a governing council member, said the ECB was now “looking very hard at whether there is not a specific deterioration of collateral” which the central bank is accepting in return for funds.
He was speaking amid signs of some banks creating low-rated assets specifically so they can be traded for treasuries at the European Central Bank.

Hmmm... let's see here. The point of swapping illiquid securities (worthless paper) for liquid ones (good paper) is to bail out insolvent banks by offloading their impaired collateral to the ECB. Sounds like it's working perfectly. I always find it ironic when people set up some program, and then complain that it's working. Be careful what you wish for.

The Bank of England recently created a facility for UK banks to access funding for mortgages and the Financial Times has learnt that almost 90bn ($175bn) worth of bonds are being created to be placed there – almost twice the £50bn in­itially expected when the scheme was launched only three weeks ago.

How can this be surprising? The first rule of government funding is that someone will find a way to sell the government what they want. They will manufacture it. If the government pays for mental health services, for example, people will manufacture a need for mental health services. That is why government funded programs need strict controls and must be run in a common sense manner.

But the ECB, which is proud of having always had in place the same system to support bank liquidity, accepts a far broader range of collateral than other central banks. It now appears to have some worries about what is being used by banks.
On Thursday, however, speaking at the International Capital Market
Association in Vienna, Mr Mersch said the type of collateral now being
accepted was: “A matter of high concern.”

It should be "A matter of high concern". Crappy paper is dirt cheap. The Central Banks are paying top dollar for it. I think they've finally realized that they are paying people to manufacture bad loans. I wonder if they are making any new ones or just reshuffling the old ones?

His comments come as banks, whose main centres of operations are not within the eurozone, are structuring new bonds based on assets other than mortgages in order to gain access to ECB funding.

The ECB’s main mortgage-bond exposures so far are believed to be from
Spanish, Dutch and some UK deals, but the central bank publishes few details on the collateral it holds.

However, this week Glitnir, the Icelandic bank, is in the process of clearing the use of a €890m ($1.37bn) collateralised loan obligation (CLO) for
funding at the ECB. Similarly, Lehman Brothers recently structured a €1.1bn CLO, which it is expected to use for ECB funding.

Meanwhile, Macquarie Leasing, a unit of the Australian bank, has done a
securitisation of Australian motor loans, which will have a euro-denominated slice so that the investors who buy the deal can use it at the ECB.

Investment bankers who work in securitisation say that their main business is structuring bonds that are eligible for ECB liquidity operations. Some analysts have concerns about whether the bonds being created will ever be saleable if markets recover.

“There is moral hazard . . . and we are not in the business of taking over
the market,” Mr Mersch said. “That means there must be an exit strategy.”

The importance of central bank involvement in supporting securitisation
markets has been shown again in the UK, where the Bank of England’s Special Liquidity Scheme has already attracted almost twice the level of demand originally anticipated.
According to debt market sources, the banks planning to use the scheme are the UK’s eight largest lenders.