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INTEREST RATES RESEARCH Europe| 6 January 2012ECB SMP: MARKING TO MARKETUsing ECB data and our analysis, we provide an overview of the ECB SMP: how muchit has bought of what; how much the mark to market is (probably around -€30bn,80% of those on Greek bonds); what it has bought (40% net issuance, 60%liquidations); and what the future prospects are (continued, but smaller, buying).The ECB Securities Market Programme (SMP) was activated in May 2010 on the threesmaller peripheral countries (Greece, Ireland and Portugal), and expanded in August2011, focusing then almost exclusively on Italy and Spain. Note that the purchases arecarried out by the ECB itself and the national central banks (collectively, theEurosystem), and the risks and profits and losses are shared by the Eurosystem as awhole. Below, we provide an update on the programme, presenting more informationthan is currently available.Laurent Fransolet+44 (0)20 7773 8385laurent.fransolet@barcap.comwww.barcap.comCountry split: Likely broadly proportional to the size of bond marketsThe ECB only gives a total weekly cash purchase number (and weekly redemptions),but nothing else. In particular, it does not publish any country or maturity split of whatit has bought. Although the amounts bought in each bond markets have varied everyweek, on the basis of the pressure in these markets, we make the assumption that theECB has been buying bonds broadly in proportion to the size of the underlying bondmarkets. Such a proportionality rule is likely since: 1) anecdotal evidence suggests thatit has also been prevalent in the Covered Bonds Purchase Programme (CBPP); and 2) aproportionality rule also applies to the share of buying by the various national centralbanks and the ECB itself. So in the first phase of the SMP (ie, SMP1), based on ourproportionality assumption, the ECB would have bought roughly 50%, 25% and 25%respectively of Greek, Irish, and Portuguese bonds. On the same bases, in the secondphase of the SMP (ie, SMP2), the ECB would have bought roughly 66% of Italian bondsand 33% of Spanish bonds (and a minimal amount of Portuguese and Irish bonds).While we see the advantages of proportionality (it is clear and explainable), in our view,more flexibility, and in particular, greater focus on the problem areas, is something theECB should consider for both SMP2 and CBPP2.Figure 1: Estimated ECB SMP purchases by country (€ mm)25,00020,00015,00010,000Spain (€46bn, 22%)Italy (€90bn, 43%)Portugal (€20bn, 10%)Ireland (€19bn, 9%)Greece (€36bn, 17%)5,000009-May-10 22-Aug-10 05-Dec-10 20-Mar-11 03-Jul-11 16-Oct-11Source: ECB, Barclays CapitalPLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 5

Barclays Capital | ECB SMP: marking to marketThe ECB bought a total (in cash) of €218bn between May 2010 and end of December 2011,although about €7bn of bonds/bills have matured since the start of the SMP (€5bn inGreece and €2bn in Portugal, based on the ECB weekly announcements), putting thecurrent total ECB holdings at about €211bn (and probably close to €220-225bn in nominalterms). We would estimate, based on the weekly ECB purchases officially reported, theproportionality rule above and anecdotal evidence (the week-to-week pressure on thevarious markets) that of the current €211bn SMP holdings (in cash terms at time ofpurchases), Greek bonds account for around €36bn, Portuguese bonds €20bn, Irish bonds€19bn, Spanish bonds €46bn, and Italian bonds €90bn. Obviously, these numbers should betaken as rough guides rather than more definitive estimates.The Greek holdings are likely substantial in the context of the upcoming PSI: €36bn at purchaseprice and probably around €40bn in nominal terms. Still, the target amount of €100bn ofnominal debt reduction in the Greek PSI (assuming a 50% nominal haircut on €200bn of privatedebt holdings) implies that the ECB would not participate. Indeed, the ECB was very clear that itwould not participate in a PSI when the idea was initially floated. However, we note that it hasbeen fairly quiet on the topic since then, and other (presumably large) investors have beencalling for the ECB to participate in the PSI. In our view, the ECB holdings could eventually beincluded in the PSI, while the bonds are still on the Eurosystem balance sheet or after they havebeen transferred to another entity (eg EFSF/ESM).Mark-to-market: Big losses on Greece, but very little on the restNow that we have estimated a country split for each weekly purchase released by the ECB, wecan estimate how much the current mark-to-market on these purchases is, using total returnbond indices for each country (thus taking into account price moves as well as coupons, seeFigure 2). We have assumed that the average maturity of the bonds bought was around 5 yearsin most markets (maybe a bit longer in Ireland, due to the structure of the market), as the ECBdoes not seem to have bought bonds longer than 10 years, or very short-dated bonds.Figure 3 shows our estimate of the mark-to-market (MTM) for the Eurosystem’s purchasesbetween May 2010 and end 2011 – again, we would stress that these are only broadestimates, dependent on a number of assumptions. Roughly, we estimate the ECB has a‘paper loss’ of around €30bn, of which around 80% would likely be due to losses on thepurchases made in May and June 2010, at the inception of the programme. We wouldestimate that the MTM losses on Greek bonds are the biggest, at around €20-25bn (moreFigure 2: Total return indices for peripheral bond markets12010080Greece 3-5Yrs60Ireland All Maturities40Portugal 3-5YrsItaly 3-5Yrs20Spain 3-5Yrs0Jan-10 Jul-10 Jan-11 Jul-11 Jan-12Source: Barclays CapitalFigure 3: Estimated Eurosystem mark-to-market on SMPpositions (€ mm)5,0000-5,000-10,000-15,000-20,000-25,000-30,000-35,000-40,000-45,000May10 Aug10 Nov10Source: Barclays CapitalGreece (-€24bn)Portugal (-€5bn)Ireland (-€1bn)Italy (-€3bn)Spain (€1bn)Feb11 May11 Aug11 Nov116 January 2012 2

Barclays Capital | ECB SMP: marking to marketthan a 60% MTM loss, after coupon payments), with Portuguese losses at probably around€5bn (about a 23% MTM loss), Irish ones at around €1bn, Italian ones at around €2-3bn (-2%, or on average around a 50bp yield loss), and a small gain on Spanish bonds.Thus, our analysis suggests most of the MTM losses have been on the bonds bought in theinitial stages of SMP1, and in particular on Greek bonds. In contrast, we estimate that theMTM losses since the start of SMP2 could have been relatively small: probably less than€2bn. This is remarkable, since the total cash amount bought under the SMP2 is so muchlarger than under SMP1 (€140bn vs €77bn). In our view, at the margin, such a relativelybenign mark-to-market on Italian and Spanish SMP purchases facilitates ECB SMP activityto support the market going forward.Of course the ECB is also incurring the cost of sterilizing these purchases on a weekly basis:according to our calculations (on the basis of the weekly drain auction results), the totalcost up until now, over the life of SMP1 and SMP2, has amounted to about €1.1bn.Note that, according to the Eurosystem accounting rules, the gains and losses on the SMPpurchases are mutualised across the ECB and the national central banks (NCBs), inproportion to their share in the capital of the ECB (which itself is defined on the basis ofrelative GDP and population) – this is in contrast with the CBPP, the P/L of which resides ineach national central bank and the ECB. Note as well that the SMP purchases are notmarked to market as such on the Eurosystem balance sheet, but held at cost. The capitaland reserves of the Eurosystem amounted to €81.5bn and the revaluation accounts to€394bn as at the end of 2011 (up +€3.3bn and +€63bn, respectively, versus end 2010,mostly due to gold holdings).What did the ECB buy recently? 40% new issuance, 60% liquidationsThe large buying of Italian and Spanish bonds in the SMP2 raises the question: who has beenselling to the ECB? There are two potential sellers: existing investors (typically non domesticones) and the Italian and Spanish treasuries, as they increase the stock of bonds in the course oftheir regular auctions. To estimate the relative proportion between the two, one has to comparethe ECB SMP buying with the net issuance by the two treasuries (ie, the changes in the stock ofdebt). This is shown in Figure 4: if the SMP buying is higher than the net issuance, then the ECB isabsorbing the net amount liquidated by investors. Of course, there might also be some switchesbetween types of investors (eg, international and domestic investors), but only the residualwould have to be taken by the ECB (ie, the liquidations). Conversely, if ECB SMP buying is lowerthan the net issuance, investors are taking down the new supply in some way.Figure 4: The ECB SMP2 buying: absorbing investor liquidations or new issuance?8060€ bnECB SMPNet issuance (Italy & Spain)SMP minus net issuanceInvestors taking down thenew issuance4055200-20-401030-9Heavy investor liquidations17929SMP buying mostly on theback of new issuance20 234Aug Sep Oct Nov DecSource: ECB, Spanish and Italian treasuries, Barclays Capital6 January 2012 3

Barclays Capital | ECB SMP: marking to marketWe focus here only on bonds (BTP, Bonos, Obligaciones) and have excluded the supply inCTZ, CCTs and T-bills, which the ECB has typically not been buying. Given that someauctions and redemptions occur at the very end or very beginning of some months, wewould be careful in over interpreting the month by month data and prefer to focus oncombined periods. Note that the ECB does not buy in the primary market and typically, hasnot been active around auction bonds themselves, but that does not matter as such for theanalysis, since we are trying to estimate at an aggregate level how much all investors havebeen adding or shedding Italian and Spanish risk.Figure 4 illustrates that in both August and September (calendar months) there was limitednew net issuance (close to zero in fact) and most of the ECB buying (€55bn and €30bnrespectively in August and September) was on the back of large portfolio liquidations(€45bn and €39bn respectively, for Italy and Spain). In October and November, new netsupply was much heavier (€29bn combined, mostly coming from Italy), while SMP buyingwas lower (€17bn and €29bn respectively). Hence, during that period, the bulk of the ECBbuying was actually on the back of new issuance, while portfolio liquidations were(surprisingly) more modest (29+17-29=€17bn for October and November, almost equallysplit in time). In December, net issuance was remarkably heavy (€11bn in Italy, €12bn inSpain), while the SMP was barely active (less than €5bn), hence investors absorbed thesupply (at the price of still very high yields), likely helped to some extent by some shortcovering ahead of year-end and the early December summit, as well as buying related to theECB 3yr LTRO facility conducted at the very end of December. but announced on December8. In summary, looking at Figure 4 shows the heavy liquidations of August and Septemberhave faded and that more recently, the ECB SMP buying has been relatively limitedcompared with the issuance.Interestingly, the analysis also shows that in Italy, investor liquidations dominated (roughly2/3 vs 1/3 of new issuance). In contrast, in Spain, the split between liquidations and netissuance was closer to 50/50. In our view, this could be because a lot of investors werelarge outright and relative holders of Italy and liquidated positions once the spotlight turnedto Italy, while a lot of international investors have likely gradually been reducing theirSpanish holdings over the past two years.OutlookWe note that future gross issuance in Italian and Spanish bonds is likely to be around €26bnin January and €23.5bn in February, with net supply about €26bn lower (an Italian bond ismaturing on 1 Feb) – making up a total net supply of around 23.5bn for January andFebruary combined, ie, about half of the net issuance seen in November and December. Thetrue supply pressure will be somewhere between the gross and net issuance number, andwill probably be defined by how much existing investors (and in particular the foreign ones,who still own roughly 50% of the bonds) roll over their exposures to Italian and Spanishdebt. To the extent that the big first wave of liquidations (eg, by Japanese or US investors)seem to have taken place already, we would expect liquidations to remain smaller goingforward, other things being equal, and that supply might not be as difficult to digest as mostmarket participants expect. Of course there are still plenty of event risks (eg the Greek PSI,Italian yields being at 7%, rating agencies), and hence the ECB SMP needs to remain animportant backstop going forward. But our base case scenario would be that it will probablyremain less active than it has been in Q3 and the beginning of Q4, and given its trackrecord, the ECB will likely be willing still to intervene, with some confidence.6 January 2012 4

Barclays Capital | ECB SMP: marking to marketAppendix: Sterilization - Less of a problem than generally expectedCommentators have continued to focus on whether the ECB would succeed in sterilizing SMPpurchases. Our view has been that this was a bit of a red herring, to the extent that the ECBincreases the liquidity outstanding when it purchases bonds, it should not have any problem,theoretically, in draining that liquidity less than a week later (ie,. the sterilization does notcompete with other uses of liquidity as such). Still, there are operational risks in draining suchlarge amounts on a weekly basis: conditions might be more difficult in certain weeks (end ofquarters, etc), especially as the ECB is reliant on a fairly limited number of banks (around 100)that participate in the operations. Hence, there have been a number of times when the ECB failedto sterilize the full SMP, until the next drain operation (there was only one occasion when thesterilization partially failed in two consecutive weeks, in April last year, during London holidays).Overall, the sterilization operations have had good results recently (higher bid to cover,lower average rate vs EONIA and the deposit facility), despite the increase in the amounts tobe sterilized. We expect this to continue: in a context of abundant liquidity, the drains will beeasier, and we would expect the pick-up in the weekly rate vs the deposit facility (10bp) tomove down further. Still, the ECB might decide to alter slightly the modus operandi, forexample by offering sterilizations for longer periods, along with the weekly ones. It is alsopossible that the lower pick-up versus the deposit facility could start to reduce theattractiveness of the operations.Figure 5: ECB SMP sterilizations – Higher demand and lower rates recently120100806040200-20May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11Not drained amount (LHS, € bn)Demand in excess of target drain (LHS, € bn)Average rate vs deposit facility (RHS, bp)80706050403020100Source: ECB6 January 2012 5

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