How bond buying turned troubled European countries around

An experimental model to find out whether a bond intervention program would stabilize markets and economies in Greece, Portugal, Ireland, Italy, and Spain shows business lessons for U.S. companies.

By 2010, the Great Recession was officially over in the U.S., though it still took several years for the economy to recover fully.

But in Europe, it was a different story. Greece defaulted on its debt, and Portugal, Ireland, Italy, and Spain continued to experience severe economic problems, causing the prices of their sovereign bonds to plummet and the bonds’ interest rates to rise precipitously. The European Central Bank (ECB) began buying up troubled sovereign bonds in an attempt to stabilize markets and economies.

At the time, Assistant Professor of Finance Seth Pruitt was working at the Federal Reserve’s International Finance Division in Washington, D.C. Would the ECB’s bond intervention program work? he wondered. Could it work?

Pruitt and two of his Fed colleagues, Michiel De Pooter, chief of the Federal Reserve Board’s Division of Monetary Affairs, and Robert F. Martin, then chief of Global Monetary and Sovereign Markets at the Federal Reserve Board’s Division of International Finance and currently an economist at United Bank of Switzerland, decided to design an experimental model to find out.

Their work eventually led to a paper, “The Liquidity Effects of Official Bond Market Intervention,” published by the Journal of Financial and Quantitative Analysis. In the paper, the authors detail the effects they thought would occur as a result of the bond-buying program, known as the Securities Markets Programme (SMP).

It turned out they were exactly right. The program unfolded just the way they predicted it would and eventually succeeded, despite widespread skepticism at the time.

The SMP is just one government program, and it doesn’t apply to the U.S., which, unlike the European Union, is a single nation, not a collection of countries with their sovereign bonds. But the authors’ research shows that at least this one time, a government intervention program did work, though it required patience. A lot of patience.

Data problems

To create a model, Pruitt and his fellow researchers needed to know which bonds the ECB bought and when they were purchased. Sounds simple enough. But the ECB, unlike the Fed, was anything but transparent, hindering their efforts.

“They wanted it to be a surprise. The ECB said they were starting this program; then they began reporting on the balance sheet that they had bonds. But they never said which countries’ bonds they were buying, or how much, or at what times,” Pruitt explains. The central bank likely didn’t want to set up expectations for bailouts, and it may have been concerned about stirring up political friction within the European Union.

Nevertheless, the financial press was rife with speculation, and rumors from traders began circulating widely. But for academics, speculation and rumors won’t do. They needed hard data.

Finally, the researchers connected with an inside source on the sovereign debts markets desk at Barclays Bank, who provided them with the information they needed. “That was key,” Pruitt says.

Then they developed a regression model to predict the program’s effects. They continued to monitor the program until it ended in February 2012.

The program unfolds

As the program began to take effect, every time the central bank made a big buy, bonds responded with overkill. The ECB bought up the entire supply of certain types of bonds in the countries it targeted, and long lines of desperate would-be sellers who couldn’t find buyers disappeared overnight. The bonds’ value rose and their interest rates plunged by an average of 23 basis points for every one percent of outstanding debt purchased.

Then the markets would begin to resume a more orderly trading pattern. Buyers returned, no longer worried that they were acquiring an asset they would never be able to liquidate. Seeing their success, more sellers jumped in. Once again, the ECB swooped in, gobbling up all the bonds on the market. Once again, interest rates came back down.

The process was repeated several times in several countries: Ireland, Portugal, Spain, and Italy. After each round of buying, critics decried the ECB’s stupidity in repeating a program that they said didn’t work. Pruitt and his colleagues sat quietly on the sidelines, examining their model and comparing it to actual results.

The ECB bought vast volumes of bonds over time. The researchers calculated that over the life of the program, they accumulated 18 percent of Ireland’s sovereign bonds, 14 percent of Portugal’s, 8 percent of Spain’s, and 5 percent of Italy’s.

In the end, most of the enormous jolt of liquidity the program had initially provided disappeared. As the ECB repeatedly intervened, interest rates fell; but they rose thereafter. The researchers had predicted that.

But, critically, some of that fall in yields remained. The researchers had predicted that, too. After the ECB’s interventions were completed, sovereign bond interest rates declined permanently by an average of 5 basis points — enough for markets to function normally and for troubled economies to get back on track. Both the model and the program worked as expected.

Without the interventions, bond yields would have remained high, Pruitt says. European banks, which held many of the bonds, would have lost money on their assets.

Slow-moving bonds also would have made it difficult for countries like Italy to issue debt, Pruitt says. Like the U.S., Italy and the other countries in the program run a deficit and need to sell government bonds to function. High debt-interest payments would have added to their fiscal pressures, prolonging an already long, arduous recession.

It may have had political ramifications, too. To cover higher debt payments, countries often implement unpopular austerity plans, massively cutting spending on domestic programs. Such an agenda might have tipped the balance in favor of the populist parties that have recently arisen in Europe.

Lessons for business

Though lessons from the ECB program don’t apply to U.S. markets, they do have implications for businesses here. Europe is a primary U.S. trading partner.

It should be comforting for businesses to know that the central bank carried out a successful intervention that calmed dysfunctional sovereign debt markets. Sovereign debt underpins corporate debt and provides stability to a country. And stable countries foster business. This is particularly important to note as Greece just now emerges from its bailout program.

A new direction

Pruitt’s paper provides a complete snapshot of the European bond-buying program from start to finish, and he sees no need to extend that research. Instead, he’s headed in a different direction — one with more practical applications. With colleagues, he is creating a new statistical model for valuing the risks of individual stocks.

Currently, investment companies group stocks into portfolios, usually based on company size. In general, large companies have fewer risks than smaller ones, so the division makes some sense.

But companies are also affected by many other variables, including profitability, labor markets, spending on research and development, fixed assets, intellectual property assets, and many more. Pruitt’s model will account for some of these characteristics and judge their effect on the companies’ risk exposure and stock prices over time.

Such calculations wouldn’t have been possible before the Big Data era, which is expanding the parameters of economic research. After examining stocks, Pruitt may adjust his model to value credit markets, once again applying the lens of data to the complex world of debt.