How Central Bank Repos Create Conflicts Of Interest

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Introduction (via FT/ Alphaville)

While investors will be looking for signs that the ECB may be preparing to wean banks off their liquidity programmes, Moody’s warned on Wednesday that such operations may cause conflict of interests for structured finance originators — the banks that create CDOs and the like. Here’s the statement:

Excerpt (Via FT/Alphaville)

Banks have been creating structured finance bonds to use as collateral for central bank operations. The banks post the notes at places like the ECB in exchange for cash (otherwise known as liquidity). Now, the banks don’t intend to sell these things — they are intended purely for the repo ops. Hence the notes are issued by a related entity (an SPV or the like) and often bought back by the originator (the bank) to be used as collateral. Crucially the central banks often have ratings criteria for the kind of stuff they’ll accept as collateral. The ECB for instance, accepts ratings of BBB- and above only.

Conclusion (Via FT/Alphaville)

So central bank repos have a tendency to cause conflicts of interest since they encourage originators to acquire structured finance notes in anticipation of using them as collateral — and may lead them to use their position as originator to restructure the deal in their interests — using those deal documents. But they discourage ratings downgrades, at least by Moody’s, since originators will be loathe to risk a downgrade.

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