The central bank and the mortgage drug
What is an Irish Mortgage-Backed Promissory Note? Below the fold, some thoughts — on what may be old news — about this question.
The question is prompted by a perusal of the European Central Bank (ECB) website, since the first indicators of Ireland’s 2008-2010 economic descent were often seemingly technical in nature. The ECB has published their 2011 rules for the Correspondent Central Bank Model – this is the system that allows debt instruments issued in one country to be used in another country as collateral to get funds from that other country’s central bank.
It’s mostly a procedural document but it does contain a discussion of something called “The Irish Variant” (p12), which refers to how Irish Mortgage-Backed Promissory Notes should be handled. These appear to be a form of IOU which Irish financial institutions can write and have them backed by their pool of mortgages — but to be able to sell the IOUs to anyone else, they need to have them further backed by the Central Bank of Ireland so they will be taken by other Eurozone central banks for credit to whoever buys them.
This facility is no doubt useful for the Irish institutions during the crisis and it appears to be an additional channel of liquidity for them on top of the guarantee scheme and the NAMA bonds. But among the interesting points about the facility is that it is not new — there are mentions of it going back to at least 2002. Here for example is the Irish Central Bank’s annual report for that year –
In 2002 domestic credit institutions collateralised Eurosystem operations mainly through the use of Tier One eligible assets. Significant use was made of domestic Tier One collateral; in addition the use of Tier One assets issued in other member states continued to increase. The use of Irish mortgage-backed promissory notes which are included on the Tier Two list also increased, underlining their importance to the local market.
With persistence, we know a little more about these instruments. A 2006 ECB document describes the following class –
NON-MARKETABLE RETAIL MORTGAGE-BACKED DEBT INSTRUMENTS (RMBDs)
The following eligibility criteria are applied to RMBDs (see also Table 4):
Type of asset: It must be a debt instrument (a promissory note or a bill of exchange) that is secured by a pool of residential mortgages and that falls short of full securitisation. Substitution of assets in the underlying pool must be possible and a mechanism needs to be in place to ensure that the Eurosystem enjoys priority over creditors other than those exempted for public policy reasons.
Irish mortgage-backed promissory notes are currently the only instruments in this asset class.
A 2005 ECB document (p17) tells us more about the procedures –
The assets concerned are non-marketable debt instruments in the form of residential mortgage-backed promissory notes secured by a deed of charge (floating) over a pool of residential mortgage assets held by the issuer. The issue of promissory notes (by the original issuers) is envisaged as and when required in the context of Eurosystem monetary policy operations or intraday credit operations; these assets are not listed on a regulated market.
The risk control measures applied prescribe a loan-to-value ratio of 80%. This is the ratio, expressed as a percentage, of the balance of a loan to the last professional valuation of the relevant property. In addition, a haircut of 20% is applied, together with a margin of 1% for intraday and overnight transactions and 2% for transactions with an original maturity of more than one business day.
This sounds like a pretty good deal for Irish mortgage providers. They could write an IOU based on on a floating pool of mortgages, avoid all the hassles of having the IOU traded on any market, get a certification that the mortgages had a LTV of 80 percent, and hey presto, they had de facto ECB funding for those mortgages. Yes there was a haircut but that could be easily covered through deposits, bonds, and other funding sources.
Now as the USA experience shows, bundling the mortgages into proper mortgage-backed securities doesn’t guarantee that the securities will be better quality. But remember, no other Eurozone country had access to this ad hoc mechanism for ramping up funding for mortgage loans.
So we close with 2 more questions. Where did the facility for the Irish mortgage-backed promissory notes originate, and who was in charge of making sure that it didn’t become a massive back-door funding mechanism for a property bubble?