UPDATE 1-ECB likely to base bond buy on collateral rules-sources

* ECB to probably buy same covered bonds used as collateral

* Central bank officials say could spend more down the track

* Exit strategy to be for whole program, not just bonds

(Adds reaction, quotes)

May 27 (Reuters) - The European Central Bank will probably buy the same covered bonds under its asset purchase program that it accepts as security in central bank liquidity operations, euro zone central bank sources said. The purchases are unlikely to be unwound directly by selling bonds back at a certain date, central bank officials said, and the extra injection of liquidity will instead be offset in a broad-based exit strategy further down the track.

"Everything that you can use as collateral as a covered bond ... you can imagine that that would come under the umbrella of the outright purchase program," a euro zone central bank official said.

Two other officials, who spoke to Reuters on condition of anonymity, said the ECB was open to spending more than 60 billion euros ($83.7 billion) depending on market developments after its initial intervention.

"There is no discussion now of purchasing more," a second senior official said, adding that the initial spend could fall short of 60 billion if markets showed little appetite to sell.

But the ECB could also up the programme down the road, if additional gains were seen by doing that.

"If we get 60 billion and if it works, I don't think that anyone would be ideologically blocked against the idea that there could be more. We need to buy them first; this could take a few weeks or a few months, it will not happen overnight."

The ECB announced earlier this month it would buy covered bonds -- debt backed by a pool of assets such as mortgage or public sector loans that remain on a bank's balance sheet -- issued in the euro zone and denominated in euros, but gave no further details. It also cut rates to record low 1 percent.

The purchase program aims to revitalise the covered bond market, providing banks with more sources of funding which they would then lend on to households and firms, and indirectly boosting the economy.

The second official noted the ECB's announcement alone had already encouraged new issuers into the market. Banks including the Netherlands' ING Bank NV (ING.AS) and Deutsche Bank (DBKGn.DE) have announced new issues in the last weeks.

"Just saying that there is a buyer of last resort has had a surprisingly big impact on the market," this official said.

"The objective of this programme is to revive the covered bond market; if this can be done without us, all the better."

Barclays Capital economist Julian Callow said the willingness to consider further purchases showed the ECB was ready to follow other central banks into bigger asset buys.

"Overall, this shows that the Eurosystem has indeed crossed the Rubicon and is prepared to print money to fund asset purchase," he said in a note to clients.

Policymakers discussed the technicalities of the purchases at their mid-month meeting on May 20 and are due to finalise them on June 4. Speculation is running high about which bonds will be eligible and how the ECB will spread the impact of its buys for the widest benefit around the 16-nation euro zone.

"The idea is to exhaust the 60 billion euros in asset purchases, and if it's not enough, the bank will consider more purchases. As (ECB President Jean-Claude) Trichet has said, they haven't closed the door on expanding this," a third official said.

A Reuters poll found analysts were split over whether the ECB would extend the plan past 60 billion, given conflicting comments from policymakers. [ID:nLR9743]

Officials, who spoke following the ECB's mid-month meeting, said the ECB could avoid the charge of favouring countries which account for most covered bond issuance -- Germany, France and Spain -- by buying bonds both in the primary and secondary markets, or from investors as well as issuers. "The direction things are going, there will be two elements. There will be purchases on the primary market, and there will be purchases on the secondary market," the first official said.

"Countries which have no covered bond issuers, the smaller countries, are home to banks which certainly have covered bonds -- from Germany, Spain or wherever -- in their portfolios."

"That means the measure helps not only the countries where the issuers are, but also the countries which have banks which have invested in covered bonds."

WHAT'S ELIGIBLE?

This official expected the ECB to apply the same criteria to the purchase programme as it does to the assets it accepts as security in liquidity operations. On average in 2008, 1.2 trillion euros worth of covered bonds were eligible as collateral although only about 10 percent was used.

This approach could include French common-law covered bonds or Spanish Multi-Cedulas which do not comply with the official Directive on Undertakings of Collective Investment in Transferable Securities (UCITS) but the ECB still accepts as collateral, although the official said they could be treated slightly differently from plain vanilla bonds.

"German Pfandbriefe belong to covered bonds, Spanish cedula, the French obligations foncieres and possibly -- and that's a point which is still being finalised -- also products which are not UCITS compliant but which are also on the single list," the official said.

Two other officials said policymakers were also still debating whether to buy bonds backed by public loans, given legal restrictions on extending credit to the public sector. France's Christian Noyer also said on Wednesday this was still an open point. [ID:nLQ951984]

"Whether it will be mortgages or public sector loans has not been decided. We are discussing this," the second official said.

The third official said there should be no issue about mortgage-backed bonds not meeting the ratings threshold, which for most collateral is BBB-.

"Nearly all the mortgage-backed bonds (in the euro zone market) are AAA," this person said. ECB Executive Board member Jose Manuel Gonzalez-Paramo, who is responsible for market operations, has said the ECB is likely to start buying bonds within weeks of its June 4 decision. [ID:nLP468557]

The first official said the purchases would likely take the form of either reverse auctions -- where commercial banks suggest a price -- or direct purchases by the central bank.

"There is a very transparent way of doing it, that would be auctions, and there's another method that is not untypical for the capital markets, that would be direct purchases by the Eurosystem," the official said.

EXIT STRATEGY EYED

Policymakers have also stressed the importance of a credible exit strategy from the extra liquidity the ECB is providing through asset purchases as well as extra loans to banks.

But central bank officials said this was unlikely to involve the ECB selling covered bonds back to the market at a set time.

Instead, the ECB would seek to mop up excess funds, potentially via issuing IOUs or debt certificates, a step ECB Executive Board member Lorenzo Bini Smaghi has said is under consideration.

"When the day comes to sterilise, it won't be applied to specific assets; it won't apply to covered bonds in particular," the second official said.

In a similar vein, the third official said printing money was not the aim.

"The (central bank) buys the bonds and pays the money to the bank for the covered bond. This bank has debts to the ECB through other operations. In the end, everything will be equalled out. It's not necessary to print money. This is how sterilisation works. This is not inflationary."

The first official said debt certificates were an option in the ECB's toolbox, but did not expect a concrete announcement on June 4.

"I think the Eurosystem will keep some discretionary room to move and keep its options open, it will depend on how the markets develop. One could also imagine that the (covered bonds) form part of the central bank's portfolio, it wouldn't necessarily have to be that the central bank sells the bond back in six months or so."

Bini Smaghi said in a speech in Geneva on April 28 that it made sense to exit from non-standard measures before starting to raise interest rates.

Analysts polled by Reuters expect rates to remain on hold at 1 percent until the end of 2010 at least and officials saw no prospect of imminent hiking. [ECB/INT]

"Nobody is thinking about hiking interest rates until the economy returns to growth," the third official said.

(Editing by Toby Chopra/Victoria Main) ($1=.7172 Euro)