A surprising call from the ECB for the resurrection of the European ABS markets
Nobody expects a central banker to say anything interesting any more, even about subjects other than monetary policy. So it was more than a surprise to listen to Yves Mersch, a member of the executive board of the European Central Bank (ECB), this week. Speaking at the Clearstream Exchange of Ideas event in London on Monday morning, Mersch issued an unequivocal call for the revival of a vibrant asset-backed securities (ABS) market in Europe.
In the ranking of official remedies for a broken financial system, a return to the structured credit instruments that sparked the great financial crisis seems an unlikely solution for a central bank to advance. Indeed, Mersch even noted in his speech that pension funds, insurance companies and (reach for the garlic) hedge funds had a natural appetite for asset-backed securities that match their maturity needs and return expectations, as if the notorious “hunt for yield” in the structured credit markets of 2002-06 had never occurred, let alone been denounced retrospectively by every official analysis of the crisis since 2008.
Mersch argued in effect that a hunt-for-yield-induced crisis had indeed never happened, at least in Europe, where ABS default rates (1.5 per cent) averaged a twelfth of their American equivalents (18.4 per cent) in the critical years of 2007-08. He now wants to “act fast” to return to that blessed era, and advanced a number of ideas designed specifically to encourage the growth of the ABS market.
He called on the framers of the Basel III capital adequacy framework to stop believing that the same risk weighted capital needed to be applied to European ABS, because experience showed that their delinquency rates were so much lower than those of their American counterparts. "Not all EU securitisations deserve the stigma attached to them in recent years," said Mersch.
He went on to criticise the preferential capital treatment accorded to covered bonds, and promised that ECB collateral eligibility criteria would be adjusted to encourage the issue of ABS, because investment banks could then use them freely to access central bank money. Apparently the ECB and the Bank of England are making a joint pitch at the spring meetings of the World Bank and the IMF this week on the need to revive the ABS market in Europe.
It is interesting to speculate why European central banks have concluded, a mere seven years after securitised sub-prime mortgage debt propelled the global financial system into the greatest and most prolonged financial crisis since the 1930s, that what Europe needs now is a larger and livelier structured credit market. After all, it cannot be long before all sorts of complex and synthetic derivatives of orthodox ABS are being floated, and latter day equivalents of CDO Squareds are back on the balance sheets of the investment banks and their clients.
A large part of the explanation of this apparent volte-face is that the major European banks are still in an astonishingly fragile financial condition. The stocks of all the great continental European banks - BNP Paribas, Credit Agricole, Deutsche Bank, Société Générale and UniCredit – are trading at sizeable discounts to book value, indicating investors continue to believe the assets of the banks are worth considerably less than their management mantains.
The central bank demonstrably agrees. The ECB is currently engaged in an "asset quality review," designed to encourage European banks to purge their balance sheets of non-performing loans worth trillions of euros or incur the cost of additional capital requirements to improve their stress-tested ability to withstand adverse market conditions. In theory, cleaner and/or better capitalised bank balance sheets will restore the confidence of investors in (and lenders to) European banks, and so help to reduce the reliance of the banks on central bank funding.
A lively ABS market, enlarged by loans re-packaged by investment bankers as tradeable securities, could absorb some of the assets being offloaded by the banks. ABS could also enable credit to continue to flow to the real economy even as bank balance sheets shrink. In fact, Yves Mersch noted approvingly in his speech that the growth of the European corporate bond market already matched almost exactly the deleveraging of European bank balance sheets.
He also pointed out that 99 per cent of European companies are SMEs, and that they account for two out of three euros of output. The ECB is concerned a fragile and shrinking banking system is starving them of the credit they need to grow. ABS provide a means by which SMEs can bypass the banking system altogether. If investment banks re-package hundreds of SME loans into tradeable securities and sell them to end-investors, it could put in the hands of investors assets the banks no longer wish to hold.
While acknowledging that SME loans are risky, Mersch was astonishingly sanguine about the risk of a European version of the sub-prime crisis, raising the links between securitisation, leverage, complexity and OTC derivatives only to dismiss them as remote. Indeed, he argued that, if ABS were not encouraged, even dodgier credit instruments would be manufactured and distributed. He also pointed out that the European regulators had taken counter-measures to prevent a re-run of 2007.
Investment banks are now obliged by European regulation to apply the same credit criteria to any issuer whose securities they underwrite as they would to a corporate loan to the same borrower, and to retain a material proportion of any securities they originate. Regulatory reporting requirements also insist on the disclosure of information about the underlying assets on a loan-by-loan basis too, equipping potential investors with the data to make up their own minds about the risks, including correlations between them.
As always, transparency is an excellent idea in principle, but Mersch undoubtedly under-estimates the extent to which a revivified ABS market would continue to be heavily intermediated by investment banks, fund managers and credit analysts, including our old friends the rating agencies. End-investors are simply not going to do the due diligence. They are not going to look at the data, or make up their own minds. As a result, the risk that the quality of the underlying assets will deteriorate, and that less scrupulous investment bankers will re-package the riskiest loans and sell them to unsuspecting investors, is as real today as it was in 2006.